Professor Cole's Finance Blog

During the past few weeks, the largest of the Wall Street banks have reported their earnings for second quarter 2010, and the reports are quite rosy. However, after reading these reports and comparing the data on which they are based with the data reported to bank regulators, I have come to the conclusion that the positive results are the result of smoke and mirrors, and, potentially, improper accounting practices.

At issue is what constitutes a “nonperforming asset.” For reporting purposes, the banks appear to be counting only loans in nonaccrual status and foreclosed real estate. Unfortunately, this badly misrepresents the banks’ actual asset quality and earnings.

For example, look at Bank of America, which reported 2Q earnings of $3.1 billion and nonperforming assets (nonperforming loans, leases & foreclosed properties) of only $35.701 billion. Unfortunately, regulatory data for 2Q will not be available until late August, but we can compare information for 1Q 2010, for which BofA reports nonperforming assets of $35.925 billion. Yet, on its 1Q 2010 Y9C regulatory filing for the consolidated holding company, BofA reports $38.819 billion in nonaccrual loans, $3.274 billion in foreclosed real estate, but also $37.060 billion in loans past due 90 or more days and still accruing interest, and $24.938 billion in loans past due 30 – 89 days and still accruing interest. In other words, non-current assets total $104.091 billion, while “nonperforming assets” total only $35.925 billion. How convenient!

As bad as this looks, things get worse. Bof A is still accruing interest on $37 billion in loans that have missed at least three monthly payments. Assuming an average interest rate of 5%, this translates into accrued interest of almost $2 billion per year on loans to borrowers that are highly unlikely to ever make another payment.

This is really bad, but things get even worse. If and, most likely, when the bank has to move these loans into nonaccrual status, it will have to charge off the loan, resulting in a future hit to earnings of up to $37 billion. Even if the ultimate recoveries are 50%, this implies a future hit to earnings of more than $18 billion.

Bank of America is not alone in this shady accounting practice. Wells Fargo reports 2Q 2010 nonperforming assets of $32.936 billion. For 1Q, Wells reports nonperforming assets of $31.500 billion and an additional $5.957 billion in loans 90+ days past due and still accruing interest. (I credit Wells with at least making a partial effort to report its past due portfolio!) Yet on its 1Q 2010 Y9C filing, Wells reports $27.408 billion in nonaccrual loans, $3.976 billion in foreclosed real estate, $38.629 billion in loans past due 90 or more days and still accruing, and $20.914 billion in loans past due 30 – 89 days and still accruing interest. In other words, noncurrent assets total $90.927 billion while “nonperforming assets” total only $31.500 billion.

As with BofA, Wells is still accruing interest on $38 billion in loans that have missed at least three monthly payments. Again, this translates into almost $2 billion per year in earnings on loans to borrowers that are highly unlikely to ever make another payment.

But what about that paragon of banking virtue—J.P. Morgan Chase? Surely, JPM would never engage in such shady reporting? Think again! For 1Q 2010, JPM reports nonperforming assets of $19.019 billion. Yet on its 1Q 2010 Y9C filing, JPM reports $28.079 billion in nonaccrual loans, $2.216 billion in foreclosed real estate, $24.006 billion in loans past due 90 or more days and still accruing, and $14.250 billion in loans past due 30 – 89 days and still accruing interest. In other words, noncurrent assets total $68.551 billion while “nonperforming assets” total only $19.019 billion.

As with BofA and Wells, JPM is continuing to accrue interest on its past due 90+ portfolio, but its smaller past due portfolio translates into a smaller gain—only about $1.5 billion per year in earnings on loans to borrowers who are highly unlikely to ever make another payment.

So, I now await publication of the 2Q 2010 regulatory filings, which I’m sure will confirm that these three banks, which control $5.6 trillion in banking assets, have materially misrepresented their true asset quality and earnings.

How can they get away with this? It is difficult to answer that question. The reporting rules are quite clear. A loan past due more than 90 days is supposed to be reclassified as nonaccrual and charged off unless it meets two criteria: (1) it is adequately secured; and (2) it is in the process of collection, which means that collection efforts are expected to result in the prompt repayment of the debt or its restoration to current status.

I challenge these banks to document how their past due loan portfolios meet these two criteria.