Regionals options suffer due to accounting rules

Seven years ago, I was involved in a merger that was the last proposed under the old pooling of interests accounting rule that was phased out after June 30, 2001. This methodology was great because it didn’t necessitate acquiring companies to re-mark assets on the companies balance sheets to reflect impairment of intangible assets.

Needless to say, the accountants got rid of this method of accounting after the halcyon tech bubble and AOL-Time Warner merger days. The result was huge impairment charges as many had overpaid for the purchased companies. Vodafone and Time Warner are two companies that were hit by this rule in particular.

Now, a new rule on the horizon is creating more headaches for companies looking to avoid writedowns: FAS 157. For regional banks this may be a problem.

I wrote about the problem with FAS 157(named for the Financial Accounting Standards Board, which governs U.S. accounting standards) two months ago saying:

Smaller regional and local banks are still involved in mortgage lending and lending too for real estate construction and commercial property. However, they hold most of these loans on their balance sheet at book value. They have not re-distributed the risk of these loans in the securities markets as much as the money-center banks.

What’s noteworthy is that these loans are held at book value meaning that they are on the balance sheet as if there has been no impairment to the loans. So, you ask, how could that be when big players have been writing down hundreds of billions? The answer lies in FAS 157. This rule does NOT apply to bank loans. It only applies to freely traded securities. Translation: there are enormous hidden losses on the balance sheets of most regional and local banks from these loans.

Translation: if you have bank loans, all is fine and well — don’t mark to market. But, as soon as an acquisition occurs, if you have significant writedowns to assets — intangible, goodwill or otherwise — that are unaccounted for, these must be reflected in the post-merger accounts. It’s basically marking to market, which is what has killed the money-center banks as they have had to writedown their CDO and Asset-backed security investments.

One reason you haven’t seen many companies stepping up to the plate to buy the likes of WaMu, NCC, Zions, Fifth Third and all the other U.S. regional banks is that they have tons of assets sitting on their balance sheet that would, if marked to market today, in this environment, mean huge losses.

Now, if you need some serious net operating losses (NOLs) as a tax shield (as Bank of America apparently needed in its acquisition of Countrywide Financial) that’s just great. You can goose future profit by carrying forward these NOLs. But most acquirers don’t want to do this. Rumor has it the Canadian banks have been scared off for just this reason.

Washington Mutual Inc. Chief Executive Officer Alan Fishman, who sold the last bank he ran, may not be able to repeat the feat because new accounting rules for devalued loans are driving away buyers.

At least three potential acquirers ended talks this year to buy either Seattle-based WaMu or Cleveland’s National City Corp., according to two bankers involved in the talks. A sticking point, they say: a rule change that will force acquirers to compute a target’s assets at market prices instead of deriving values from measures including the purchase price.

The Financial Accounting Standards Board’s change, effective in December, may delay consolidation in an industry saddled with more than $500 billion in writedowns and credit losses. Loan prices may drop by about 30 percent from their valuation at maturity, said Robert Willens, a former Lehman Brothers Holdings Inc. accounting analyst and executive who teaches at Columbia Business School.

“The new rule will curtail M&A by making it too expensive,” said Willens, who also runs a tax consulting firm in New York. “With loans fetching their greatest discounts since the Great Depression, it sharply reduces the value of a target’s assets. That will force an acquirer to raise additional capital in this very difficult environment.”

Brad Russell, a spokesman for Washington Mutual, declined to comment on potential acquirers and the FASB rule, as did Kelly Wagner Amen at National City.

`Fragile’ Market

The new rule isn’t the only obstacle to bank mergers. Plunging home prices and rising defaults have punctured mortgage securities, forcing lenders to conserve cash. U.S. markets remain “volatile and fragile,” and bankers are reluctant to lend because of increased risk, Deutsche Bank AG Chief Executive Officer Josef Ackermann said at a Sept. 5 conference in Canada.

Fishman, for that matter, said in an interview that a sale isn’t in the bank’s future. “You don’t build a company to sell it,” the 62-year-old lifelong New Yorker said in a Sept. 8 interview. Fishman, who replaced ousted predecessor Kerry Killinger, 59, was CEO of Brooklyn’s Independence Community Bank Corp., which was sold to Sovereign Bancorp in 2006.

Others aren’t so sure.

Whatever the reason for suitors to be gun shy, this limits options for the likes of NCC and Washington Mutual in the future.

Related posts
The regionals versus money center banks

Source
WaMu, National City Lose Suitors on Accounting Rule – Bloomberg