A study commissioned by a banking trade group has concluded that disclosures of the market value of loans are likely to be unreliable.
The reason: Estimates will vary from bank to bank because of imprecise assumptions about the timing of future loan repayments.
The disclosures, which are required starting at the end of the year, are the first step in a push by the Securities and Exchange Commission to force banks to carry assets on their books at market value, rather than historical cost.
Earnings Volatility Cited
The banking industry maintains that market-value accounting is too complex and would make earnings too volatile. It has mobilized against the proposal and will use the study's findings as ammunition.
"The study should give pause to those most intent on instituting market-value accounting in the banking industry," said John F. Ruffle, vice chairman of the board of J.P. Morgan & Co. and trustee of the Banking Research Fund of the Association of Reserve City Bankers.
The research, which was conducted for the Reserve City Bankers by the accounting firm KPMG Peat Marwick, found that banks aren't the only players that oppose booking assets at market value. So do most of the surveyed analysts and investors who would use the data to evaluate credit quality and performance.
About 95% of them preferred sticking to historical-cost values in financial statements, with a separate disclosure of market values.
That's the system which will take effect with yearned financial reports. But the study also found potential problems with simply disclosing the market values.
Those estimates will vary widely for loans that are not readily marketable and when the borrower is of poor credit quality, said Steve Roberts, a consulting partner with Peat Marwick and co-author of the study.
To estimate fair value, banks must make assumptions about future cash flows, and relatively small differences in these assumptions will result in a wide range of values, he said.
"Problem assets are and always will be difficult to |fair value' with any degree of accuracy," said Mr. Roberts.
Nine participants in the study gave widely varying estimates of the fair value of two hypothetical low-quality loans.
Some of the Disparities
For one nonperforming secured loan with a principal of $927,000, participants estimated the fair value was anywhere from $300,000 to $686,000, or 32% to 74% of principal value.
In another case, the estimated fair value ranged from 55% to 86% of principal.
"The danger in using fair-value estimates is that you don't know what you're dealing with by looking at raw numbers," said Mr. Roberts." "Understanding the detailed methodologies and assumptions used to estimate the fair values is critically important," he said.
The banking industry has been concerned that fair value estimates could be misinterpreted by investors.
A banker's nightmare is that "somebody adds up the fair-value numbers and says this is the market value of the company, without thinking about it," said Edward Smith, a partner at Peat Marwick and co-author of the study.