current topics in bank valuation

7/31/2019 Current Topics in Bank Valuation

1/31

Current Topicsin Bank Valuation

Andrew K. Gibbs, CFA, CPA/ABV and

William J. Wilhelm, CPA/ABV

September 12, 2008

Reflections on Industry Trends and Emerging Financial Reporting Issues


2/31

Andrew K. Gibbs joined Mercer Capital in 1999 and currently serves as a senior vice president and the leader of

Mercer Capitals Financial Institutions Team. Mercer Capital is a premier business valuation and investment

banking firm serving a national and international clientele.

Andy provides valuation and corporate advisory services to financial institutions for purposes including

mergers and acquisitions, employee stock ownership plans, profit sharing plans, estate and gift tax planning

and compliance matters, corporate planning and reorganizations.

Andy has experience working with financial institutions in merger and acquisition advisory engagements.

He has assisted buyers in evaluating the attractiveness of acquisition candidates, determining a price for the

target institution, structuring the transaction, and evaluating different forms offinancing. For sell-side clients,

Mr. Gibbs has analyzed the potential value that the institution may receive upon a sale, assisted in locatingpotential buyers, and participated in negotiating a final transaction price and merger agreement. Andy has

also participated in projects in a litigated context, including tax disputes, dissenting shareholder actions, and

employee stock ownership plan related matters.

In addition, he actively participates in projects involving compliance with SFAS 141 and 142, which entail, for

example, the identification and valuation of intangible assets under SFAS 141 and impairment testing under

SFAS 142.

Andrew K. Gibbs, CFA, CPA/ABV

901.322.9726 :: [email protected]

William J. Bill Wilhelm, CPA/ABV

317.706.2637 :: [email protected]

Bill has spent his entire 38 years with Crowe Chizek serving its financial institutions and business valuation

clientele in an audit, tax, valuation and financial advisory capacity. He has helped institutions structure

management or investor group buyouts, purchase or merge with other institutions and has assisted in the

sale of institutions. He has helped de novo institutions assemble business plans, prepare financial and capital

needs projections and obtain regulatory approvals.

Bill is a 1970 graduate of Indiana University, Bloomington with a B.S. degree in Accounting. He is a member

of the American Institute of Certified Public Accountants and the Indiana CPA Society. Bill was one of the

first group of CPAs to pass the examination and be awarded the ABV (Accredited in Business Valuation)

designation in 1998. He is a frequent speaker on the subjects of mergers and acquisitions and business

valuations.


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4/31

2008 BV Resources 2

CurrentTopicsinBankValuation2008BVResources

3

Asset Quality

Construction&

development

loans

are

now

at

historically

high

levels

Source: FDIC

Construction

lendinghasbeen

thecocaineinthe

bankingindustry

forfolksthat

weren'tableto

growC&Iloans

WilliamRuh,Castle

CreekCapitalLLC

Construction Loan Exposure

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

1Q08

Construction&DevelopmentLoans/Loans


4

Asset Quality Nonperformingassetstrendingupacrosstheindustry

Currentlywellbelowthe1980sbankingcrisisbutabovethe200102recession

Source: FDIC

(Nonaccrual Loans + Other Real Estate Owned ) / ( Loans + OREO)

FDIC-Insured Commercial Banks 1984-2Q08

2Q08, 2.07%2002, 1.56%

1991, 4.98%

0%

1%

2%

3%

4%

5%

6%

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

1Q08


5/31

2008 BV Resources 3


5

Asset Quality

Loanloss

reserves

asapercentageofloansbottomedoutin2006,leavinglesscushionfortheeventualriseinnonperformingassets

Downsideisthatloanlosseswillcomeoutofearnings

Regulatorypressure?

Source: FDIC

Loan Loss Reserve Adequacy Measures

2Q08, 95.0%

2004, 174.7%

1990, 71.1%

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

1Q08

LoanLossReserve/Loans

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

LoanLossReserve/(Non-AccrualLoans+90DaysPastDue

Loans)

Loan Loss Reserve / Loans Allowance / Nonaccrual and 90+ Day Past Due


6

Asset Quality Alargeportionof

theassetqualityissuesareconcentratedinAZ,CA,FL,andNV

WecomparedassetqualitytrendsinthesestatestoTexasinthe1980sandearly1990s

Constructionloanexposureinthese

states

is

much

greaterthanthenationalaverage

Source: FDICandSNLFinancial

Construction & Development Loans / Total Loans

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 2005 2006 2007 1Q2008 2 Q2008

CommunityBank Industry Arizona California Florida Nevada Texas

Timeperiodistruncatedbetweenclean-upofTexasissuesin

theearly1990sandthebeginningofthecurrentcycle

DateonTexasbanksperSNLFinancialforthe19841993period.Dataforthe20052008periodperSNLFinancial.Theanalysisincludescommercialbanks,savingsbanks,andsavingsinstitutionswithtotalassets33.3%,andconsumerloans/totalloans


6/31

2008 BV Resources 4


7

Asset Quality

NonperformingassetsaregenerallyhigherinAZ,CA,FL,andNV

NowherenearthelevelexperiencedbyTexasattheworstofitscrisis

Source: FDICandSNLFinancial

Non-Performing Assets / (Total Loans + OREO)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

2005

2006

2007

1Q2008

2Q2008

Community Bank Industry Arizona California Florida Nevada Texas

Timeperiodistruncatedbetweenclean-upofTexasissuesinthe

early1990sandthebeginningofthecurrentcycle

Timeperiodistruncatedbetweenclean-upofTexasissuesinthe

early1990sandthebeginningofthecurrentcycle

DateonTexasbanksperSNLFinancialforthe19841993period.Dataforthe20052008periodperSNLFinancial.Theanalysisincludescommercialbanks,savingsbanks,andsavingsinstitutionswithtotalassets33.3%,andconsumerloans/totalloans


7/31

2008 BV Resources 5


9

Capital & Earnings

Earningsareweakening

About50%ofbanksreportedlowerearningsin1Q08vs.1Q07

OverallindustryROAin1Q08wasthesecondworstsince4Q91

1,125banksreportedaYTDlossthrough6/30/08

Asearningsweaken,banksincreasinglyneedtoaugment

capital

Biggerbanksbeganraisingcapitallastyear

Communitybanksnowbeginningtorecognizetheneedtoraisecapital

Regulatorypressuretoshoreupcapital


10

Capital & Earnings

Byregulation,banksneedtomaintaincertainratiosofcapital

toassets

Tier1Capitalisbasicallydefinedasshareholdersequity,minus

intangibleassets,plus/minustheloss/gainonAFSsecurities

Alsocanincludepreferredstockandtrustpreferredsecurities(subjectto

certainlimits)inTier1capital

Tier2capitalincludestheloanlossreserveandsubordinated debt

Capital Alternatives

Subordinated DebtTrust Preferred

Securities

Straight Preferred

Stock

Convertible

Preferred StockCommon Stock

- Lower Cost- Better Tax Treatment- Less Dilution- Less Advantageous

Capital Treatment

- Higher Cost- Less favorable TaxTreatment- More Dilution- More Advantageous

Capital Treatment


8/31

2008 BV Resources 6


11

Capital & Earnings

Costofcapitalisrising

Trustpreferredsecuritieswereavailabletocommunitybanksinunderwritten,

pooledofferingsatLIBOR+~150bp

Pooledtrustpreferredmarkethasevaporated

Seeingsomeprivatelyplacementsoftrustpreferredsecuritiesandsubordinated

debt,butcostisoftenLIBOR+~300400bp

Mostpreferredstockofferingsareconvertible. Yieldsarehigh (often8%+)and

conversionpremiumsareoftennearthemarketpriceofthecommonstock

Popularformofinvestmentforinstitutionalinvestors

Commonstockofferingsarerisingwithmanytakingtheformsofrights

offerings. Offeringsareusuallyatadiscounttothemarketprice


12

Liquidity Liquidityisbasicallyhavingsufficientcashoraccesstocashtohandledeposit

outflowsorloancommitments. Sourcesofliquidity:

Unencumberedsecurities,FedFundssold,retaildeposits,brokereddeposits,FedFunds

lines,borrowingcapacityatFederalHomeLoanBank

Increasedfocusonliquidity:

BearStearnsandIndyMaccollapsesresultedinpartfromliquidityissues

FailureofANBFinancialinArkansashasincreasedattentiononbrokeredCDs

Impactoncommunitybanks:

Pressuretoreducewholesaleborrowings(suchasbrokeredCDs)

Pressureonbanksdepositrates,becauseofneedtoraisedeposits. Potentialimpacton

growthaswellduetofundingconstraints

Pressureonindustrysdepositrates,becausesomeinstitutions(e.g.,Countrywide)lookto

depositsasafundingsourcewhenotheralternatives dryup


9/31

2008 BV Resources 7


13

Regulatory Issues

Capital

LoanLossReserves

LoanGradings

LiquidityandFunding

Newlawsandregulations(e.g.,mortgagelendingstandards)


14

Valuation Issues1. AnalyzingAssetQuality

2. Earnings&EarningsQuality

3. GuidelinePublicCompanyMethod

Howdoyoudefineareasonablegroupofguidelinepubliccompanies?

4. GuidelineMerger&AcquisitionMethod

Transactionmarketisalmostdead

Howdoyoulocateareasonablegroupofguidelinetransactions?

5. Issuesrelatedtoproblembanks


10/31

2008 BV Resources 8


15

1. Analyzing Asset Quality

Whattrends

would

indicate

potential

asset

quality

issuesinthecurrentenvironment?

Levelandtrendinnonperformingassets

Compositionoftheportfolio(e.g.,levelofconstructionloans; typeofconstruction

loans,suchaslandvs.finishedhouses)

Highgrowthinloansinthelastfewyears

Weakmarket(AZ,CA,FL,NV,Atlanta,etc.)

Highloanyields

Outofmarketloans,particularlypurchasedparticipations

Largeexposurestooneborrower

Experienceofmanagement

Offbalancesheetexposure(lettersofcredit,forinstance)

Lowrecoveries

on

prior

charge

offs

Amountofloanspayinginterestoutofinterestreserves


16

1. Analyzing Asset QualityRightnow,toomanycommunitybankersarehavingtoohardatime coming

togripswiththeproblemsthathaveemergedintheircommercial realestate

portfolios. Thesebankersarereluctanttochargeoffobviously troubledloans

orevenflagproblemstotheirexaminers.

Whilethisresistancetorecognizingproblemsatthebeginningofan

economicdownturnmaybehumannature,itsnothealthy,because denialis

notastrategy. Itwontserveanyonesinterestinthelongrun. Infact,itonly

assuresthatproblemsgetworseandhardertoresolve.

JohnC.Dugan,ComptrolleroftheCurrencyinaspeechdatedApril16,2008


11/31

2008 BV Resources 9


17


Loanloss

reserve

represents

an

amount

necessary

to

cover

probable

incurred

lossesintheportfolio

Underthecurrentaccountingmethodology,thereservecontainsthree

components

Specificreservesagainstimpairedloans(SFAS114)

Forrealestateloans,bankwillgenerallyestablishaspecificreservebasedonthedifference

betweenthecollateralsvalueandtheloanamount

Reservesbasedonthebankspriorchargeoffhistory(SFAS5)

Isanaverageofthepast5yearsappropriateincurrentenvironment?

Reservesforenvironmentalfactorsthatcouldcausefuturelossestodivergefrom

recenthistory

Changesinportfoliodelinquencies,localeconomicconditions,loanconcentrations,etc.

Forfurtherguidance,seetheInteragencyPolicyStatementontheAllowanceforLoan&LeaseLosses,December2006,

www.federalreserve.gov/boarddocs/srletters/2006/SR0617a1.pdf


18

1. Analyzing Asset Quality LoansLossReserveAdequacy

Reserve/LoanRatio

Effect: Decliningratiosuggeststhatthebanksloanlossprovisionisnotkeepingupwith

growthorloanlosses. Futureincomecouldbeaffectedasprovisionsarerecordedtoaccount

forpreviousgrowth

Reserve/NonPerformingAssets

Effect: Decliningratiosuggeststhatcreditriskintheportfolioismountingandreservemaynot

beadequatetocoverpotentiallosses

Directionalconsistency

Expectthatreserveshouldincreasealongwithproblemloans

Compositionofportfolio

Gutinstinct impressionofmanagement,marketsinwhichthebankoperate,product

typesemphasized


12/31

2008 BV Resources 10


19


Assumethat

you

believe

the

reserves

are

appropriate

and

management

has

a

goodgraspoftheportfolio. Howshouldyoureflectassetqualityissuesinan

appraisal?

Locateagroupofguidelinecompanies/transactionsthatsharethecharacteristicsofthe

subjectbank

Factortheassetqualityissuesintothecashflowsofadiscountedcashflowanalysisor

adjustthediscountrate

Assume,ontheotherhand,thatyoudontbelievethereservesareappropriateor

thatcreditriskisgreaterthanmanagementbelieves. Howshouldyoudealwith

thisissue?

Adjusttheloanlossreservefortheassumeddeficiency

Adjusttheguidelinecompany/transactionmultiples

PerformsometypeofscenarioanalysisinaDCFwithhighercreditlossscenarios


20

2. Earnings Quality Generally,earningsareunderpressure

Netinterestincome

Manybankswereassetsensitive asthePrimeratedroppedthisyear,netinterestincome

wasaffectedbecauseloansrepricedmorequicklythandeposits

Loanslikeconstructionloansoftengeneratedsubstantialloanfees

Noninterestincome

Weakmortgagebankingactivities

Lossesonsaleofotherrealestateowned

Impairmentcharges,suchasmarktomarketissuesonloansheldforsale

Noninterestexpenses

Expecttoseemorepressureonbankstoreduceexpense

Alreadyseeingsomebankscurtailexpansionplansorevenclosebranches

Coststocleanupproblemassets

Impairmentcharges,suchasgoodwillimpairment


13/31



21

2. Earnings Quality

Issuesto

look

for

in

evaluating

earnings

quality:

Loanlossprovision


14/31



23

4. Guideline Public Co. Method

Price/tangiblebook

valuemultiplesareat

levelslastseeninthe

mid1990sandlower

thaninthelast

recession

Multiplesforsmaller

banks(theindexof

bankswithassetsof

$500MM $1BNare

athistoriclows


24

3. Guideline Public Co. Method Banksareusuallyvaluedoffsomemultipleof

earningsorbookvalue:

Whatisearningpowerinthecurrentenvironment?

Tangiblebookvalue(shareholdersequityminus

intangibleassets)isoftenmoremeaningfulthanstated

bookvalue


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25

3. Guideline Public Co. Method

Givenabank

with

pressure

on

earnings,

valuation

analysts

haveperhapsfourvaluationoptions:

1. Valuethebankoffcurrentearningswithmultiplefrombanksinsimilar

financialsituation

2. Normalizeearningstorecognizethepotentialearningpowerof the

bank

Istheresuchathingasanonrecurringloanlossprovision,giventhatbanks

areinthebusinessoftakingcreditrisk?

3. Placemoreemphasisonalternativemeasuresofvalue,suchastangible

equity

4. Performadiscounted

cash

flow

analysis


26

3. Guideline Public Co. Method Factorstoconsiderinselectingguidelinepublic

companies

Location

Compositionofloanportfolio

(constructionvs.otherloantypes)

Nonperformingassets

Similarityofprofitability


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27

4. Guideline M&A Method

TheguidelineM&Amethodusesmultiplesof

earnings,bookvalue,tangiblebookvalue,deposits,

coredeposits,orassetstoderiveavalueforthe

subjectbankonacontrollinginterestbasis


28


DifficultieshaveariseninapplyingtheguidelineM&A

method

Havethesameissuesindeterminingearningpowerasinthe

guidelinepubliccompanyanalysis

Inaddition,itisimportanttohavetransactiondataderivedfrom

dealsundertakeninthepresentuncertainenvironment

Buyersstockpriceshavedeclined. Asaresult,buyerscouldnotpaythe

samepricesthattheydidin2006withoutincurringexcessiveearnings

dilution

Financingforcashtransactionsiseitherunavailableormoreexpensive,

reducingtheamountabuyercouldpayandstillgeneratethesame

return


17/31


18/31



31


Thefollowing

chart

provides

alonger

term

trend

on

M&A

activity

M & A Overview ('90 -6/08) - Price to Tangible Book Ratios

0.0%

50.0%

100.0%

150.0%

200.0%

250.0%

300.0%

19901991 19921993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 YTD6/08

MedianPricetoTangibleBookRatios

0

75

150

225

300

375

450

NumberofDeals

Price/Tangible Book Ratio Number of Deals


32

4. Guideline M&A Method WhatoptionsexistinusingtheguidelineM&Amethodinthecurrent

environment

Dothebestyoucanwiththecurrenttransactions

Adjusthistoricaldealvaluesortransactionmultiplestoreflectdeterioration

inthemarketplace. Forinstance,givenacertainnumberofsharesissuedto

thesellerinatransaction,youcouldrecalculatethedealvalueusingthe

buyerscurrentstockpricetoestimatehowmuchtheycouldaffordtopay

inthecurrentmarket. Thisassumesthatthebuyerwouldhavethesame

earningsexpectationsforthesellerasitdidwhenthetransactionwas

announced

Usecontrolpremiumsfromhistoricaltransactionsandapplytoguideline

companymultiples

or

use

as

atest

of

reasonableness.

Useadiscountedcashflowanalysis. Whatistheterminalvalue?


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33

5. Issues with Distressed Banks

Howdo

you

deal

with

banks

faced

difficulties

(depressedearnings,assetqualityissues,capital

issues,etc.)

Severaloptionsexist:

Lookatprice/tangiblebookvaluemultiplesfromguideline

publiccompanies

Lookatthepricingobservedinrecentrecaps

Discountedcashflowanalysis


34

5. Issues with Distressed Banks GuidelinePublicCompanyMethod

Anumberofbankscurrentlytradeatsignificantdiscounts

totangiblebookvalue,duetothemarketsconcern

regardingthedepthoftheassetqualityissuesand

potentialdilutivecapitalraises

Oneapproachistocomparethecircumstancesofthese

publicbankstothesubjectbank(i.e.,comparethedepth

of

the

asset

quality

issues,

the

strength

or

lack

thereof

the

marketarea,ortheadequacyofcapitaltoworkoutthe

problems)


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35


Recaps

Anotherapproachistolookatrecentrecapsofbanks

Whatistheimpliedprice/tangiblebookvaluemultiplesinthese deals?

Howmuchownershipisbeinggivenawayforthecapital? Whatis the

discounttothemarketpriceinthesedeals?

Severallargerecapshaveoccurredthisyear(WashingtonMutual/TPG,

NationalCity/Corsair). Numerousotherbanksarecurrentlylookingto

raiseequitycapital

Dilutiontoexistingshareholdershasbeensubstantial(dealshave

occurredatadiscounttothemarketprice)


36

5. Issues with Distressed Banks InvestorPerspective

Investorsaredoingaburndowntypeofanalysisfor

bankswithassetqualityissues

Burndowntangibleequitytoanormalizedlevelafter

consideringtheestimatedloanlossesembeddedintheportfolio

Valueisthenbasedontheburneddowntangiblebookvalue


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37


Discountedcash

flow

Giventhecomplexityofthesituation,itsoftenhelpfulnowto focus

ontwokeyvariables

PreTax,PreProvisionIncome(netinterestincome,plusnoninterest

income,minusnoninterestexpenses)

Notethathistoricalpretax,preprovisionincomedatamaynotberealistic,

givenhigherlevelsofnonperformingassets(nonaccrualloanscan

significantlyaffectnetinterestincome,leavingasidethecoststoresolvethe

problemloans)

Expectedloanlosses

Nogoodestimatesexistinthemarketplaceyetforlossesonproblemloan

types.

Difficultto

do

afrequency

and

severity

analysis


38

5. Issues with Distressed Banks Discountedcashflow

Thepretax,preprovisionincomehelpsfocusonthemostimportant

variablesaffectingvalue:

Howmuchcanthebankbeexpectedtoearnbeforeloanlosses?

Howmuchwillthebankwriteoffonloans(isolatingthisfactorallowsyou

torundifferentscenarios)

Howlongwillittaketocleanuptheproblemloans(notethetradeoffs

betweentimetocleanupandothervariables)

Giventheforecastsfortheaboveitems,doesthebankhavesufficient

capital?


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39


Discountedcash

flow

Valueisthenafunctionof:

Presentvalueofdistributabletangibleequityovertheinterim

forecastperiod

Distributabletangibleequityistheamountofthebanksequity

minustheamountnecessaryforthebanksnormaloperations

Aterminalvalueforthebankoncetheassetqualityissueshave

beenresolved

Discountratewouldbehighertoreflecttheriskposedbythe

bank


40

Financial Reporting Issues

1. TheDefinitionofFairValue

2. Securities

3. Loans

4. Goodwill

5. SFAS141R


23/31



41

1. Definition of Fair Value

SFAS157

defines

fair

value

as

the

price

that

would

be

received

to

sell

anassetorpaidtotransferaliabilityinanorderlytransactionbetween

marketparticipantsatthemeasurementdate

AccordingtoSFAS157,theobjectiveofafairvaluemeasurementisto

determinethepricethatwouldbereceivedtoselltheassetorpaidto

transfertheliabilityatthemeasurementdate(anexitprice)

Whatisanorderlytransaction

SFAS157statesthatanorderlytransactionisatransactionthatassumes

exposuretothemarketforaperiodpriortothemeasurementdatetoallow

formarketingactivitiesthatareusualandcustomaryfortransactions

involvingsuchassetsandliabilities;itisnotaforcedtransaction(forexample

aforced

liquidation

or

distressed

sale)


42

1. Definition of Fair Value AwhitepaperfromtheU.S.CenterforAuditQualityprovides

someguidanceonthemeaningoforderlytransaction

Thewhitepaperreferencesa2004accountingandauditingenforcement

releasefromtheSEC. Inthismatter,theregistrantusedadefinitionoffair

valuethatassumedsupplyanddemandwereinbalance,whenGAAPdefines

fairvalueastheamountatwhichanassetcouldbeboughtorsoldinacurrent

transaction. TheSECconcludedthattheregistrantshouldhaveconsidered

currentmarketconditions,suchasimbalancesinsupplyanddemand,when

determiningfairvalue. TheSECobjectedtotakingalongerviewofthe

market(i.e.,

when

market

prices

would

be

more

rational)


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43


Distressedtransactions

or

illiquid

markets?

SFAS157statesthatthedefinitionoffairvalueisnotmeanttorepresentadistressedsale

Thewhitepaperstatesthatiforderlytransactionsareoccurringbetweenmarketplaceparticipants,thenthosetransactionsarenotforcedsales

Lowervolumedoesnotmeanthattransactionsareforcedordistressed

Persuasiveevidenceisrequiredtoestablishthatanobservabletransactionisforcedordistressed

Fairvaluemeasurementrequiresconsiderationofcurrentmarketconditions,includingtherelativeliquidityofthemarket


44

1. Definition of Fair Value ValuationGuidanceintheWhitePaper

Thevaluationmodelshouldusethepricingofsimilarsecurities orcreditdefaultswapstoinferassumptionsastoinputssuchasdefaultrates

ThisappearstorecommendtheusageofinstrumentsliketheABXindextopricesubprimeMBS

Toreflectmarketconditions,aliquidityadjustment,orhigherdiscountratemaybenecessaryinthevaluationmodel

Valuationmodelsthatusehistoricaldefaultdataoranentitys own

default

assumptions

are

not

appropriate,

even

if

the

assumptions are

stressed. Themodelmustuseassumptionsthatmarketparticipantswoulduseinvaluingthesecurity,suchascanbegleanedfromthepricingofsimilarsecurities


25/31



45


Tosummarize,

Amodelshoulduseassumptionsforinputssuchasdefaultratesthat

areconsistentwithmarketparticipantsexpectations,nottheentitys

ownestimatesastodefaultratesorotherinputs

Fairvalueestimatesshouldconsidermarketilliquidity

Limitedvolumeinasecuritydoesnotindicatetheexistenceof

distressedtransactions;eveninfrequenttradingmayneverthelessbe

sufficienttoestablishfairvalue


46

2. Securities Portfolio Issues Twokeyquestionshaveariseninthecurrentmarketthataffectthe

valuationofsecurities

1. Whatisthefairvalueofthesecurities?

2. Isanyimpairment temporaryorotherthantemporary

CommunitybankswerenotbuyersofsubprimeMBS. However,a

coupleofareasexistwherewehaveseenissuesarise:

1. FannieMae/FreddieMacpreferredstocks

2. NonAgencyMBS(AltApaper)

3. Pooledtrust

preferred

offerings

4. CertainmutualfundsholdingMBS


26/31



47

2. Securities Portfolio Issues

Question1: Whatisthefairvalueofsecurities?

Spreadshavewidenedoutdramaticallyonsomebondtypes

Mostbanksuseabroker/correspondentbanktopricetheirportfolio.

Willthebrokerbuythebondsatthepricesusedasfairvalue?

Spread over Treasuries (basis points)Alt -A RMBS 6/30/2007 9/30/2007 12/31/2007 3/31/2008 6/30/2008

AAA 132 205 265 675 800AA 175 295 600 1,150 1,700A 225 600 850 2,225 2,800BBB 550 850 1,500 3,225 4,000BB 950 1,700 2,300 $10 $10B 2,000 3,300 4,400 $7 $6NR $20 $10 $5 $4 $2

Source: Hyperion Brookfield Asset Management, Inc.


48

2. Securities Portfolio Issues Question2: Whenisanimpairmentotherthantemporary?

Otherthantemporaryimpairmentsresultinachargetoearnings. Whereas

temporaryimpairmentshavenoeffectonregulatorycapital,otherthan

temporaryimpairmentshaveaneffect

Animpairmentisoftendeemedtemporaryduetochangesinmarket

interestrates. Anotherthantemporaryimpairmentresultswhen thereisa

beliefthatthecontractualcashflowsmaynotbereceived,such asdueto

unexpectedlyhighdefaults

Whatcriteriaareimportanttoauditorsinevaluatingmanagements

assertionsastowhethertheimpairmentistemporaryorotherthan

temporary?


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49

3. Loan Portfolio Issues

Accountingfor

loan

portfolios

in

acquisitions

is

somewhatconfusing:

Loansaremarkedtofairvalue,but thefairvalue

measurementdoesntdirectlyreflectcreditissues.

Creditissueswillbereflectedintheloanlossreserve,

whichofcoursethebuyermayadjust

ImpairedloansunderSFAS114areaccountedforunder

SOP033. Theseloansarerecordedatadiscounted

valuerelativetotheirprincipaltoreflecttheinherent

losson

these

loans


50

3. Loan Portfolio Issues SFAS107givessomeguidanceastoloanportfoliovaluation

SFAS107statesthatthefairvalueofavariablerateloanthat re

pricesfrequentlyisequaltotheoutstandingbalanceaslongas the

loanscreditriskhasnotchangedmateriallysinceorigination

Marketpricesshouldbeusedforvariablerateloans,butifno

marketpricesareavailable,thenavaluationmodelmaybeused

thatconsiderscurrentratesofferedforsimilarloansintheentitys

ownlendingactivities


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51


Valuationmodels

are

frequently

used

in

practice

to

value

loanportfolioinbankacquisitions

Usecommoncharacteristicsoftheloans(suchascollateraltype,

term,rate,etc.)tocreatesubgroupsoftheportfolio

Then,valuetheloansusingratescurrentlyofferedbythebankon

similarloans

Valuationsarecreditneutralinthatanycreditdeterioration inthe

loanswouldbereflectedinthebanksLLRorSOP033calculations


52

3. Loan Portfolio Issues Currentissues

SFAS141Rhasbeenseenasanobstacletobankacquisitions. Under

SFAS141R,loanlossreserveswouldnotbecarriedovertothe

acquirersfinancialstatements

Marktomarketadjustmentscouldbeverylargeifthereturns

requiredinthebondmarketarecarriedovertoloanportfolio

valuations

Howmuchweightshouldbeplacedoncurrentbidsforloansinthe

marketplace?

Lotsofinvestorgroupslookingtobuyloansforcentsonthedollar?

Shouldthesebidsbeconsidered?


29/31



53


Example:

Bankof

Americas

acquisition

of

Countrywide

Pre-Tax Adjustments to Reflect Assets Acquired and Liabilities Assumed at Fair Value:

Loans ($8.10)

Mortgage Servicing Rights (1.70)

Deferred Costs and Currency Adjustments on Loans and Debt 1.60

All Other (4.60)

Total Pre-Tax Adjustments ($12.80)

Deferred Income Taxes 4.50

After-Tax Adjustments ($8.30)

Countrywide Stockholders' Equity $8.40

- After-Tax Adjustments to Reflect Fair Value of Assets & Liabilities ($8.30)

= Fair Value of Net Assets Acquired $0.10

Purchase Price $4.10

- Fair Value of Net Assets Acquired (0.10)

= Goodwill $4.00

$ in billions

Source: Bank of American Corporation 6/30/08 10-Q filing

BACwrotedown

CFCsloansby

$14.3billion. Since

CFChadreserves

of$5.1billion,the

netadjustment

wasabout$8.1

billion

Thegross

adjustmentis

about13%

of

CFCs

3/31/08loans


54

4. Goodwill Impairment Byourcount,34publiclytradedbankshavewrittenoff$13.2billionof

goodwillsinceJune30,2007

Goodwillimpairmentrequiresavaluationofthereportingunitona

controllingissuebasis

Goodwillimpairmenthasbecomeasignificantissue,sincealarge

numberofbankstradeatdiscountstobookvalue

Goodwillimpairmentswerefirstconcentratedinmortgagebanking

reportingunits;nowspreadingtobankingreportingunits

Particularlyanissueforbanksbuiltonacquisitions(i.e.,thosewithlimited

orno

legacy

operations

built

from

scratch

over

along

time

period,

versus

thosepursuingarollupstrategy)


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55

4. Goodwill Impairment

CurrentIssues

Lackofmarketdata,becausetransactionmarkethas

driedup

Howmuchweightshouldbeplacedonthestockpriceof

thereportingunitsparent?

UnderSFAS157,isthemarketpricedeterminativeoffairvalue,

particularlyforacompanywithasinglereportingunit?

Auditorsseeminterestedinthepremiumimpliedbythe

valuationsofthereportingunit(s)relativetomarketcap


56

4. SFAS 141R ExistingSFAS141governsbusinesscombinations.

ItwillbesupersededbySFAS141R,whichaffects

calendaryearcompaniesbeginningwiththe2009

fiscalyear

DifferencesbetweenSFAS141RandSFAS141

Transactioncosts

Currentlycapitalizedaspartofthetransactionvalue. Under

SFAS141R,transactioncostswillbeexpensed


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57

SFAS 141R

Differencesbetween

SFAS

141R

and

SFAS

141

Contingentconsideration(suchasearnouts)

Currentlyrecordedasanadjustmenttogoodwillwhenamountisknown.UnderSFAS141R,thecontingentconsiderationwillberecordedatfairvalue(withadjustmentsthroughincomeoncethecontingencyisresolved)

Loanlossreservesandvaluationallowances

Assetsarestatedatfairvaluewithnoseparatevaluationallowances

SFAS160andstakeouts

Abankmayrecordagainifitacquiresacontrollinginterestinabankin

which

it

previously

owned

a

minority

interest


58

Questions? AndrewK.Gibbs,CFA,CPA/ABV

901.322.9726

[email protected]

WilliamJ.Wilhelm,CPA/ABV 317.706.2637

[email protected]

current topics in bank valuation

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