We have been reassured that our large banks are well capitalized. That implies that they are carrying enough cash to pay depositors and cover losses. Losses in banks are a funny thing, though. If a bank has a 30 year mortgage as an asset, it has some value on the books. If the homeowner stops paying that mortgage, the loan is a nonperforming asset. At that point, the bank can declare a certain level of losses based on how much is left on the loan and how much they expect to get out of the foreclosure process. But, a foreclosure doesn’t occur right away. Sometimes a homeowner just falls behind and catches up. So it doesn’t make sense to declare a loss right away. When mortgages are bundled and securitized, things become a little more complicated. Some value needs to be assigned to the asset and reported on the balance sheet.

There’s a few ways to value assets. Banks can sell assets to other banks. There’s a market for such things. The price that a bank could sell an asset is called the market price (FMV, for fair market value). Unfortunately, the market prices for many assets, such as mortgages, are lower than their initial cost. This would be bad for banks. Right now, banks are allowed to carry assets on their books at a different price than the market price. What is the gap between what the banks report on their balance sheets and the market price of the assets?

There’s a story from Bloomberg, Next Bubble to Burst Is Banks’ Big Loan Values, by Jonathan Weil, that answers the question:

Check out the footnotes to Regions Financial Corp.’s latest quarterly report, and you’ll see a remarkable disclosure. There, in an easy-to-read chart, the company divulged that the loans on its books as of June 30 were worth $22.8 billion less than what its balance sheet said. The Birmingham, Alabama-based bank’s shareholder equity, by comparison, was just $18.7 billion.

…

While Regions may be an extreme example of inflated loan values, it’s not unique. Bank of America Corp. said its loans as of June 30 were worth $64.4 billion less than its balance sheet said. The difference represented 58 percent of the company’s Tier 1 common equity, a measure of capital used by regulators that excludes preferred stock and many intangible assets, such as goodwill accumulated through acquisitions of other companies.

Wells Fargo & Co. said the fair value of its loans was $34.3 billion less than their book value as of June 30. The bank’s Tier 1 common equity, by comparison, was $47.1 billion.

That’s quite a gap. Now, it is possible that the market is drastically undervaluing these assets. If a bank wanted to hold these to maturity, the actual value might be higher. If a bank’s life didn’t depend on artificially high values, it wouldn’t have to pretend. Fortunately, with the recent failure of Colonial Bank, we can see what a bank would determine the value of various loans to be. The WSJ has an article, Colonial Bank Marks a New Low for Loans, which I am going to shamelessly re-quote from Calculated Risk:

In doing the deal, BB&T is marking down Colonial loans and real-estate collateral by 37%, a number that reflects a large amount of estimated losses. The biggest mark is on construction loans; BB&T is cutting their value by 67%.

Amazing how an asset changing hands can drastically effect the amount of estimated losses. It’s almost as if the banks were totally full of crap toxic legacy assets.