Citigroup's loan disclosures: Over-provisioned or fudging fair value?

There has been a great deal of talk in the financial media of late about bank's loan values, which may be vastly overinflated due to flexibility offered by accounting rules. The SEC revealed that it sent a memo to a number of CFOs at banks, telling them, "Clear and transparent disclosure about how you account for your provision and allowance for loan losses has always been critically important," and "although determining your allowance for loan losses requires you to exercise judgment, it would be inconsistent with generally accepted accounting principles if you were to delay recognizing credit losses." (Hat tip, Zero Hedge).

Clearly, there is concern that many banks are not taking the appropriate marks on their loan portfolios. Last week, DailyFinance discussed the next hundred-billion-plus-dollar question for the banking system: whether or not the enormous gap between some banks' book values and market values was a cause for concern. One curious development since then has been the Financial Times' revelation that Citigroup CFO Ned Kelly was forced out by U.S. regulators shortly before reporting second quarter results.

As Kelly joined the revolving-door club at that position, the FT's assertion that his resignation was driven by discussions with regulators should bring increasing scrutiny to Citigroup's recent 10-Q filing. Replacing a CFO after such a short tenure is an odd move, to say the least, so DailyFinance compared some disclosures relating to loan loss reserve levels and fair values at the "big four" banks -- Citigroup (C), Bank of America (BAC), J.P. Morgan (JPM), and Wells Fargo (WFC) -- to see if there might be something that Citi was less-than-forthcoming about disclosing.

The loan loss allowances at the four banks were compared to the net carrying value of loans -- which helps understand what impairments management thinks is necessary -- as well as the bank's estimated fair market value of the loans, which shows what discount level is implied by market pricing. Interestingly enough, Citigroup had the most conservative carrying value marks, with its loss provision resulting in loans being carried at 94.38 cents on the dollar. The next lowest mark came from J.P. Morgan, which carried its loans at 95.72 cents on the dollar. The highest marks, which suggest the lowest level of losses, was from Wells Fargo at 97.20 cents on the dollar.

Contrasting those results with the fair value estimates for each company's loan book yields an interesting conclusion. Citigroup, which is apparently reserving the most for bad debts, places the fair value at 94.17 cents on the dollar -- basically the same as its carrying value. But the next highest fair value mark is from J.P. Morgan, at 93.30 cents on the dollar, and Bank of America establishes a fair value of 89.33 cents on the dollar. These are all massive loan portfolios in excess of $600 billion, so it's hard to believe they are enormously different in composition just because of the law of averages.

An extremely knowledgeable hedge fund manager once told me that a deep dive into a bank's loan practices is always superior to rule-of-thumb measures, and the market prices that help create fair value estimates aren't perfect. But I find Citi's combination of higher-than-average reserves with higher-than-average market prices to be puzzling, and maybe Ned Kelly did too, much to the chagrin of regulators who would like the appearance of a stable bank. Is Citi actually over-provisioned by several billion dollars, or are they simply using generous fair value assumptions to appear that way -- meaning other big banks need to increase loss reserves?

James Cullen edits and writes at He is the Vice-President of the Boston College Investment Club, which owns BAC and JPM, but has no personal position in the stocks mentioned above.

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