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The AAO Weblog covers accounting issues and current events as they relate the practice of investment analysis.

 
 
Nov 17

Written by: Jack Ciesielski
11/17/2010 9:07 PM 

First-things-first disclosure: I own M&T Bank in my accounts and in accounts of clients.

T​he acquisition of Wilmington Trust by M&T is an interesting illustration of how current disclosures of fair values alone just don't cut it when it comes to giving investors insight into a firm's financial standing. The contradictions that are apparent in the public filings of the two companies speak volumes.

Take a look at the Wilmington Trust September 30, 2010 10-Q filed on November 8, and scoot to footnote 6 regarding the fair value of financial instruments, excerpted below.

Carrying values and estimated fair values

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

As of September 30, 2010

 

 

As of December 31, 2009

 

 

 

Carrying

 

 

Fair

 

 

Carrying

 

 

Fair

 

(in millions)

 

value

 

 

value

 

 

value

 

 

value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financial assets:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and due from banks

 

$

199.7

 

 

$

199.7

 

 

$

202.9

 

 

$

202.9

 

Short-term investments

 

 

837.8

 

 

 

837.8

 

 

 

180.5

 

 

 

180.5

 

Investment securities

 

 

727.5

 

 

 

724.9

 

 

 

860.5

 

 

 

849.4

 

FHLB and FRB stock

 

 

32.4

 

 

 

32.4

 

 

 

26.8

 

 

 

26.8

 

Loans, net of reserves

 

 

7,616.3

 

 

 

7,560.0

 

 

 

8,715.7

 

 

 

8,579.6

 

 

Notice the difference between the carrying value and fair value of the net loans: the fair values are lower than the carrying value by a mere $56.3 million dollars. 

Click over to the M&T Bank 8-K filed on November 4, the day the acquisition of Wilmington Trust was announced, and take a look at slide 8: over 11 days, a 40-person team from M&T reviewed 450 commercial loans representing half the loans outstanding in that category. Another team “conducted on-site due diligence for the Consumer and Residential Mortgage portfolios.”

Keep in mind that M&T is looking at these loans as an acquirer – and they’re going to record the assets acquired at their fair value, as acquisition accounting requires. When all was said and done, M&T believed that the loan loss reserve was inadequate, by their estimate on slide 9, by $506 million – nine times larger than the gap between carrying value and fair value as self-reported by Wilmington Trust. Quite a difference in fair values, and on the very same date.

If the disclosures of fair value are supposed to assist users in understanding the amount of assets a firm has at its disposal, and if they’re supposed to help investors assess the worth of a company in the hands of an acquirer (an area where they certainly should help but didn’t) - how could such a disparity between reported fair values exist?

To understand that disparity, remember that M&T should be using a fair value definition that’s based on an exit price – what the asset is worth at a given point in time if it was to be exchanged in an orderly market between a willing buyer and seller, without duress. That’s not the definition of fair value Wilmington Trust uses: they estimate fair value at entry price – the value that would be reported if the same kind of loan were made at the balance sheet date. So, there’s bound to be a wide gap between the two fair values. From the Wilmington Trust September 10-Q’s Note 6:

Loans. To determine the fair values of loans that are not impaired, we use discounted cash flow analyses, which we present net of the reserve for loan losses. In these analyses, we use discount rates that are similar to the interest rates and terms currently being offered to borrowers. For the September 30, 2010 fair values that are shown in the table below, we added risk premiums to the discount rates used for loans with watch-list or substandard-accruing ratings to reflect the uncertainty of the cash flows within these portfolios. These methodologies are consistent with the guidance in ASC 825-10-55-3, and we believe our disclosures provide fair values that are more indicative of an entry price. This technique does not contemplate an exit price.

That guidance in ASC 825-10-55-3, by the way, is not some explicit permission to use entry price instead of exit price. It’s only an example of a disclosure, and the model disclosure about the calculation of the fair values says “…The fair value of other types of loans is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities.” That leads one to an entry price for the fair value – which yields some pretty counterintuitive results and doesn’t do much to endear fair value reporting to investors who are puzzled by such differences.  

It’s not exactly illuminating guidance. And it doesn’t produce illuminating results. Wilmington Trust is not the only firm to use “entry prices” in disclosing fair values of loans: other financial institutions include Bryn Mawr Bank, Fox Chase Bancorp, First State Bancorporation, and Ohio Valley Banc. The concern here is not so much what Wilmington Trust did or didn’t do – the concern is that the standard is not producing consistent, meaningful results among companies. One has to wonder if this is the kind of result the FASB intended when they formulated ASC 825-10-55-3. One also has to worry if they’re going to produce compromises in their financial instruments at fair value project that might also produce unintended consequences.

* * * * * * * * * * * * * * * * * *

Add to the list of things to wonder about: if firms had been reporting at fair value – exit price fair value, not entry price fair value – would the market “allow” firms to get into as much trouble as they did?

Think of it this way: if fair values were reported directly in the financial statements, and they were showing declining loan values much, much earlier – market participants would certainly act upon that information and they would probably flee the stock much earlier. The key word: earlier. If market participants showed disapproval of investment actions sooner, maybe managers wouldn’t continue to engage in the same risky transactions and shareholder capital might be preserved.

Markets don’t function well without robust information, however. When there’s not even clear agreement on what constitutes a fair value amount – depending on whether it’s placed in a footnote or placed directly in a balance sheet – you can’t expect markets to do much of a job to rein in managers - which is just the way they like it.

The price bid by M&T Wilmington Trust surprised many: it was a “take-under” price valued at  $3.84 when announced. At the close of the trading day before, the stock’s price was $7.53 – a 49% discount.

Yet the price is surprisingly close to the fair value of Wilmington Trust’s underlying assets at fair value. The schedule below shows the calculation of Wilmington Trust’s adjusted book value, using M&T’s loan fair value and all other fair values as reported by Wilmington Trust in the 9/30 10-Q. A 35% tax rate assumption completes the estimate; the result is what Wilmington Trust’s equity would have looked like on a fair value basis assuming exit prices on the loans:

 All figures in $ millions, except per share

Common equity, 9/30

 

$744.3

Fair value differences (from footnote 6):

Loans - MTB estimate

($506.0)

 

Investment securities

(2.6)

 

Deposits

(71.9)

 

Long-term debt

(4.4)

 

 

(584.9)

 

Deferred tax benefit @ 35%

204.7

 

Net effect on equity

 

(380.2)

Adjusted equity

 

$364.1

Shares outstanding

 

91.5

Adjusted equity per share

 

$3.98

 

It makes sense that M&T’s bid would reflect fair values: after all, that’s the amount at which an acquirer will record an acquisition. Rigorously reported fair values give investors a view into the mind of acquirers; historical cost reporting only leaves them guessing at the proper “discount to book value Company XYZ deserves” or some other investment cliché.

It’s not hard to see why banks and other financial institutions oppose fair value reporting so much. But it’s not nearly as clear to understand why investors don’t like it more.

 

 

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