Preferred Issues: 2 Banks’ Woes Revive Market Value Debate

As investment banks increase their share of the syndicated loan market, so blurs another of the lines distinguishing Wall Street investment houses from commercial banks — except when it comes to how the companies account for those activities.

Last week that difference became more than an academic matter to many investors. Take the market’s response to the most-talked-about problem loan of late, a $1.7 billion facility to Sunbeam Corp. that is widely believed to be behind the simultaneous announcements by First Union Corp. and the Bank of America Corp. that their nonperforming assets would jump in the fourth quarter. They weren’t the only banks in on the beleaguered deal, which soured just months after it was arranged in March 1998 by its three lead banks — the old BankAmerica Corp. (now Bank of America Corp.), First Union Corp., and Morgan Stanley Dean Witter & Co.

But despite their near equal participation, Morgan Stanley shares breezed through last week without major harm, while the two banks were dealt a drubbing.

The reason appears to stem from simple accounting practices. According to John Otis, a financial institutions bond analyst with Bear, Stearns & Co., Morgan Stanley has been adjusting the market value of its portion of the loan regularly over the last several quarters by marking it to market.

Therefore “we do not believe this will have any notable impact” on Morgan Stanley’s fourth-quarter earnings, Mr. Otis said.

First Union, on the other hand, held most of its portion in the “held for investment” category, meaning it did not adjust most of the value of the loan on its books. This quarter, it will reduce some of the value of those assets held for sale; it also expects to charge off about $50 million this quarter.

Likewise, Bank of America said in its 10-Q that it might take a chargeoff on what it is calling a “large commercial credit,” again believed to be Sunbeam, and will put the rest in nonperforming assets for the fourth quarter. That commercial credit, combined with other items, could boost its net chargeoffs to double its $435 million level in the third quarter, the bank said.

News of the large nonpeforming credit on the books of Bank of America and First Union set off a near fire sale on both banks’ stocks. First Union shares fell 8.52% to $27.50 on Tuesday, the day it spoke to analysts and investors about the credit. Shares in Bank of America, which filed a 10-Q detailing its problem loan expectations the same day, fell 3%, to $45.875; the following day they fell another 8%, to $42.

The issue reopens a long-running debate in banking circles: whether banks should mark their loan portfolios to market value just as any bank or broker-dealer frequently adjusts its trading book — its securities portfolio.

Investment banks always marked their assets to market “because of their buy and sell mentality,” said James Lam, founder and vice chairman of enterprise risk management consultancy eRisks. “In contrast, commercial banks traditionally buy and hold.”

Mr. Lam, a former chief risk officer for Fidelity Investments and GE Capital’s capital markets division, contends that the best-practice approach for risk management is to mark all items to their market value.

“Quarter to quarter it may introduce additional earnings volatility, but that’s economic reality,” he said. “It also will save you longer-term from more dramatic markdowns.”

Don’t hold your breath for the method to catch on. The potential for more frequent shifts in earnings is a big deal, said one banker, especially if only some banks start to regularly mark their loan books to market.

“If everyone is marking to market their book, that would be one thing,” said Robert Mark, chief risk officer for Canadian Imperial Bank of Commerce. Not that CIBC doesn’t look at its portfolio; it marks its loan book to market for internal purposes, he said, but not for the investment community.

Mr. Mark and others interviewed said there are some very real hindrances to treating a loan book like a portfolio of securities, as some broker-dealers do. Part of it has to do with liquidity, part of it with cultural differences.

“Securities firms come from a culture where you mark everything to market — but that’s because they’re used to being able to liquidate things overnight,” said David Fanger, senior credit officer for Moody’s Investors Service. But with syndicated loans, there may be no market by which to assess their current price — and therefore no way to assign a market value to them, Mr. Fanger said.

Still, observers say banks are moving toward assigning market values for their assets. “The banks who are most sophisticated in managing loan books are increasingly treating their loan books as a trading book,” said Mr. Fanger. “But they haven’t necessarily taken the next step of marking them to market — at least for public consumption.”