The fair value (FV) of loans at major U.S. banks relative to their carrying amount dipped along with the beginning of the recession in 2007, Fitch Ratings said in a new report. 

The rating agency reviewed the FV disclosure of bank loans at 20 large U.S. banks in the last 10 years to find out if the FV of loans derived from current disclosure provides a leading, lagging or immediate indicator of credit losses.

The weighted average FV of loans used in the sample dropped to a multi-year low of 95.4% as of June 30from a multi-year high of 102.5% of net book value at Dec. 31, 2002. The FV decreases were mostly focused on five banks' loan portfolios.

"It is difficult to establish a long-term trend between the deterioration in the fair value of net loans disclosed by the banks reviewed and loan loss/net chargeoff metrics," said Olu Sonola, a director at Fitch. "Therefore, interpreting differences between the fair value and the carrying amount of loans, with current disclosure, is ambiguous at best."

The Financial Accounting Standards Board (FASB) is expected to unveil a new proposal in 1Q10 that would require all financial instruments, including loans, to be measured on the balance sheet at FV. Based on the rating agency's review, if the proposal for loans was adopted in the 3Q09, it would result in a decrease in shareholder's equity of $130 billion, which is roughly 14% of the combined total equity of all the 20 banks reviewed. This reduction excludes offsets from applying FV to the liabilities that fund the loans.

From a credit ratings and financial analysis perspective, the FASB proposal to improve disaggregation of loan portfolios in bank disclosures should help isolate trends. Additionally, if the disclosure of the methods and considerable assumptions used in the valuation process are robust and transparent, more insight would likely be gleaned by the analysts.

The agency finds that, as a result of the quality of the disclosures offered to date and the inherent judgment required to know the loans' FV — because of a lack of liquid markets for such instruments and the need to rely mostly on internal models — historical FV numbers were mostly consistent with management's loan loss estimate, which was incorporated into the loans' carrying amount measured at amortized cost, the rating agency said.

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