Eileen Kinsella
Some Think Bad-Loan Numbers Give Banks Too Much Credit
By Eileen Kinsella
Staff Reporter
6/19/01 7:36 AM ET
URL: thestreet.com
Banks have been selling off distressed loans in an effort to beautify their balance sheets. But some people worry that the sales could serve to mask ugly credit-quality trends.
On the one hand, the practice can be useful, observers say, because it allows a bank to salvage some return on an investment that might otherwise become a total loss. But if banks ratchet up their use of the practice, analysts and investors say, they risk misleading investors on their true creditworthiness.
"Passing the hot potato" is how David Hendler, financial services analyst at CreditSights.com, describes the practice of selling off distressed loans to vulture investors at a discount. "Distressed loan sales make the reported data look better than they really are," says Mike Mayo, banks analyst at Prudential.
A number of banks have moved to banish bad loans from their balance sheets in recent quarters: Bank One (ONE:NYSE), which sold $375 million in nonperforming assets; First Union (FTU:NYSE), which sold $90 million in assets; Bank of America (BAC:NYSE), which sold $300 million worth; and FleetBoston Financial (FBF:NYSE), which sold a $225 million chunk (in addition to a $1 billion package of troubled loans last December).
For some banks, banishing bad loans also has coincided with the use of accounting methods that can camouflage the hit a bank takes on the sale, analysts say. One method involves covering the loss on the loan with income or capital from outside the loan-loss reserve, a cushion against loan writedowns that investors use as a gauge for risk.
Fatigue = Army Clothes
"If you back out the impact of the loan sales, companies such as Bank One and FleetBoston have shown quite high trends" for increasing levels of bad loans, says Mayo.
One of the most "egregious camouflagers" in 2000 was First Union, says Hendler. As part of a restructuring, the bank switched $7.9 billion in nonperforming loans to its trading account. (Nonperforming loans are those past due that haven't been charged off.) Over the course of the year, First Union took about $1 billion from its loan loss reserve and posted a $650 million loss against other income, Hendler says.
Following investor scrutiny and conversations with the Office of the Comptroller of the Currency, First Union changed the way it accounted for the loans. The change meant the bank had to add a hefty 61%, or $657 million, to its reserve in 2000.
"Initially First Union was trying to soften the provision expense and associated net charge-offs ... by offsetting about 40% of the losses to the trading account," says Hendler. "First Union was attempting to get rid of the risk without taking the hit to reserves. Ultimately this episode did not work."
For its part, Bank One says there is no confusion about its numbers. "From our point of view we want people to understand what we've done very clearly," says Bank One spokesman Tom Kelly. "We state very clearly what we sold and what was nonperforming." The bank sold $599 million in loans, of which $375 million were nonperforming, he says.
Toughening Up
Recently, in response to increasing use of distressed loan sales, bank regulators have gotten tougher with accounting rules, issuing guidelines to ensure that losses come out of the reserve and not anywhere else on the balance sheet, making writedowns plain to see. But Hendler says banks still have some wiggle room where marking the value of the loans to the market is concerned because there are no regulations that banks must grade their entire portfolio.
Banks can "cherry-pick which loans go into these distribution pools," says Hendler. "You're not taking the credit hit that you're supposed to take. No one wants to broadcast it that [they're] not a very good underwriter."
"It's a question of pricing," says Marni Pont O'Doherty, banks analyst at Keefe Bruyette & Woods. "We're in a full-blown credit cycle. Once or twice, the market is willing to accept that [banks] have to use these as an exit vehicle," she says. But continually labeling the charges one-time in nature is not going to fly, she says. "The more they recur, the harder it will be to look past them."
Hendler broke down a handful of banks' risk profiles before and after their loan sales. For instance, at the end of the first quarter, Bank One's ratio of nonperforming loans to total loans, a key measure of risk, was 1.55%. Adding back distressed loans that have been sold off, the nonperforming loan ratio is a considerable 22 basis points higher at 1.77%. For First Union, the ratio increases to 1.37% from 1.30% and for FleetBoston, to 1.11% from 0.95%.
Hendler says investors don't get an accurate picture of credit quality over time if banks are "cosmetically offloading credit risk selectively at their convenience." |
