Goodwill Hunting - The rise in Goodwill impairments on Banks Balance Sheet

The Goodwill issue is an important one to take into account when looking at possible Goodwill impairments on Banks Balance Sheets.

Why so?

When a bank acquires another one, goodwill as intangible asset goes on its balance sheet. When a medium bank acquires a smaller one, goodwill is created onto the balance sheet. But, when the medium bank is acquired by a larger one, there is a compounding effect given that the larger bank will also create some more goodwill of its own and therefore inflates its balance sheet.
As the process goes on and on, for banks on the acquisition war path, you find more and more goodwill making up the capital.

On June 29, 2001, The Financial Accounting Standards Board (FASB) unanimously voted in favor of Statement 142, Goodwill and Other Intangible Assets. Prior to this statement, goodwill was amortized over its useful life not to exceed forty years. Under FASB 142, goodwill will still be recognized as an asset, however, amortization of goodwill will no longer be permitted. Instead, goodwill and other intangibles will be subjected to an annual test for impairment of value. This will not only affect goodwill arising from acquisitions completed after the effective date, but will also affect any unamortized balance of goodwill.

According to the Financial Accounting Standards Statement No. 142, goodwill is not amortized but is instead tested for impairment at the reporting unit level at least annually.

An exemple of Goodwill Impairment Test can be found here:

Deutsche Bank Annual report:
http://annualreport.deutsche-bank.com/2009/ar/notes/notestotheconsolidatedbalancesheet/23goodwillandotherintangibleassets/impairmenttest.html

On the 13th of February 2008, this was the situation for some well known American Banks:

Bank                       Goodwill/ Capital
Bank of America             53%
Capital One                     53%
Sovereign Bank               54%
Wachovia                        59%

Source: http://www.bankstocks.com/ArticleViewer.aspx?ArticleID=3732&ArticleTypeID=2

And what is the return on goodwill? Probably zero given it cannot be easily deployed.

Looking at non-cash intangible assets (i.e., goodwill) can be a good indicator and used as a proxy to determine the health of banks:

http://zerohedge.blogspot.com/2009/04/using-goodwill-impairments-to-determine.html

Following the financial crisis, there have been a steady rise in Goodwill impairments for many financial institutions.

Charlotte-based Wachovia, now owned by Wells Fargo & Co., took more than 24 billion USD in goodwill impairment charges in 2008 as it struggled in the financial crisis.

Royal Bank of Canada took in April 2009 a non-cash related impairment of 850 millions USD impairment related to its US banking business impacted by the declining US housing market as stated below.

Global Banking News-20 April 2009-Royal Bank of Canada to take goodwill impairment(C)2009 ENPublishing - http://www.enpublishing.co.uk

"Royal Bank of Canada (TSX:RY) has announced that it is expecting to take a goodwill impairment charge.

The bank is expected to take a USD850m non-cash goodwill impairment charge for the second quarter on its US banking business. The bank said that the charge would be taken because of the declining US housing market and overall economy. The charge followed a two-step review started last quarter.

In a statement, the bank said, 'This expected charge reflects the impact of prolonged challenging economic conditions that have affected our international banking reporting unit. We have now completed the second step of the testing process and have determined that the international banking reporting unit goodwill is impaired, resulting in the expected charge to second quarter earnings."

More recently DBS posted a second quarter loss on a 747 Millions USD Impairment charge:

http://www.bloomberg.com/news/2010-07-29/dbs-posts-surprise-second-quarter-net-loss-on-goodwill-impairment-charge.html

"DBS Group Holdings Ltd., Southeast Asia’s biggest bank, reported an unexpected second-quarter loss as it booked a one-time goodwill impairment charge at its Hong Kong unit because of pressure on interest margins.

The loss of S$300 million ($220 million) compares with net income of S$552 million a year earlier, the company said in a statement today. The average estimate of eight analysts surveyed by Bloomberg was for a profit of S$572.9 million. Excluding the S$1.02 billion goodwill charge, DBS’ net income for the second quarter rose 30 percent to S$718 million."

Goodwill impairment charge is sometime viewed that a bank or one of its franchise is impaired.

The questions you need to ask yourself when looking at the valuation of a bank is: What the bank is going to do with its business and the capital deployed in it, and, how it is going to increase the return on that capital?

"Banks wrote down more than $25 billion in good will in 2008, up sharply from $790 million a year earlier, according to data compiled by Frank Schiraldi of Sandler O’Neill & Partners. By the end of the year, banks still had $291 billion worth of good will on their books. An incomplete tally of write-downs from the first quarter showed that banks had taken a $3.5 billion hit to good-will values."

Source: http://www.nytimes.com/2009/04/27/business/27bank.html

The significance of the write-downs on Goodwill is often presaged as rough waters ahead. These losses often take a real bite out of corporate earnings. It is therefore very important to track the level of these write-downs to gauge the risk in earnings reported for banks.

As indicated clearly by Susan Osterfelt in her article Goodwill Hunting:

"A large amount of goodwill on a company's balance sheet could be an indication that the company's acquisition premiums, which may have been justified at the time of acquisition, may result in future write-downs based on the annual test for impairment. This puts us all in the position of being goodwill hunters."

As a reminder:

AOL Time Warner recorded a goodwill impairment of 54 billion USD in 2002, reflecting its "difficulty in realizing the value of the merger of AOL with Time Warner", which represented for me at the time the best representation of the internet bubble, when the over pumped AOL merged with the solid Time Warner. I know the story, it was different this time...

Large Goodwill Impairments increase the debt to equity ratio.

Bank of America had a total of 85.8 billion USD in goodwill counted as part of its 2.4 trillion USD in assets as of the end of the second quarter 2010. Bank of America Corporation reported a net loss of 7.3 billion USD, or 0.77 USD per diluted share, in the third quarter of 2010, including a non-cash, non-tax deductible goodwill impairment charge of 10.4 billion USD.

As we can see in the above example for Bank of America, Goodwill Impairments can hurt income significantly, without impacting capital. Countrywide represents 4.4 Billions USD of Goodwill in Bank of America's balance sheet.

It is therefore paramount to track goodwill impairments in relation to future banks earnings. As we can see in the case of Bank of America and DBS, the impact on the income can be very significant.

Statement 159 - Debt Valuation Adjustments - Déjà Vu 2008.

Statement 159, adopted by the Financial Accounting Standards Board in 2007 allows banks to book profits when the value of their bonds falls from par. This rule expanded the daily marking of banks’ trading assets to their liabilities, under the theory that a profit would be realized if the debt were bought back at a discount. How convenient...

I commented previously about the first quarter being the perfect game, the second quarter will be seriously different for Banks profits this time around.

A fast and furious tightening of credit spreads allowed Banks to publish record profits for 2009.

With the recent increase in volatility in conjunction with a reduction in debt issuance in the second quarter, banks have had a hard times to reap in similar profits they made in Q1.

As per below's Bloomberg article, Banks are now using the same accounting trick they used previously to boost their profits in a difficult trading environment.

http://noir.bloomberg.com/apps/news?pid=newsarchive&sid=a3Eg4vzAbneA

“What’s on investors’ minds are the macroeconomic issues, as reflected by the interbank market in Europe, the very low yields on U.S. Treasuries and recent data on economic growth, jobs and housing,” Credit Agricole Securities USA analyst Michael Mayo said in an interview. “To the extent that the earnings power is less, the banks would not generate as much capital, so there’s less capital available to absorb future losses.”

The capital buffer is shrinking...and the DVA (Debt Valuation Adjustments) are returning with a vengeance.

DVA Gains:

"Including Bank of America, the four banks probably had debt-valuation adjustments, or DVAs, amounting to an average of 18 percent of pretax income, based on Citigroup Analyst Keith Horowitz’s estimates."

Accounting ‘Abomination’

"In practice, it’s an accounting “abomination” because fluctuations in the value of the debt don’t change the amount the banks owe, said Chris Kotowski, an analyst at Oppenheimer & Co. in New York."

David Hendler, Senior Analyst from CreditSights Inc. sums it up nicely in the Bloomberg article quoted above:

“When the prevailing winds of credit spreads tighten, they make a lot of money, and when spreads widen, they can’t make as much,”

Hence the recourse to DVA accounting practices.

When the game is not going your way, just change the rules...

Another nice move from FASB in 2007.

FAS 157 was reviewed in 2009 to allow more flexibility and issued in September 2006.

http://en.wikipedia.org/wiki/Mark-to-market_accounting

"On March 9, 2009, In remarks made in the Council on Foreign Relations in Washington, Federal Reserve Chairman Ben Bernanke said, "We should review regulatory policies and accounting rules to ensure that they do not induce excessive (swings in the financial system and economy)". Although he doesn't support the full suspension of basic proposition of Mark to Market principles, he is open to improving it and provide "guidance" on reasonable ways to value assets to reduce their pro- cyclical effects.

On March 16, 2009, FASB proposed allowing companies to use more leeway in valuing their assets under "mark-to-market" accounting, a move that could ease balance-sheet pressures many companies say they are feeling during the economic crisis. On April 2, 2009, after a 15-day public comment period, FASB eased the mark-to-market rules. Financial institutions are still required by the rules to mark transactions to market prices but more so in a steady market and less so when the market is inactive. To proponents of the rules, this removes the unnecessary "positive feedback loop" that can result in a deeply weakened economy.

On April 9, 2009, FASB issued the official update to FAS 157 that eases the mark-to-market rules when the market is unsteady or inactive. Early adopters were allowed to apply the ruling as of March 15, 2009, and the rest as of June 15, 2009. It was anticipated that these changes could significantly boost banks' statements of earnings and allow them to defer reporting losses. The changes, however, affected accounting standards applicable to a broad range of derivatives, not just banks holding mortgage-backed securities.

In January 2010, Adair Turner, Chairman of the UK's Financial Services Authority, said that marking to market had been a cause of inflated bankers' bonuses. This is because it produces a self-reinforcing cycle during a rising market that feeds into banks' profit estimates."

Basically, FAS 157 enabled banks to boost earnings in good times and pay themselves record bonuses and suffer catastrophic losses during the credit crisis, generating excessive margin calls on derivatives trades.
At the same time FAS 159 for DVA, enables banks to increase earnings in bad times.

The issue was anyway excessive leverage in conjunction with inappropriate accounting principle FAS 157, which led to seismic losses in US banks. Whereas in Canada bank leverage was capped to around 20 times. The capital buffer was therefore more significant. RBC still boast a AAA Rating.

The shadow inventory of REOs (Real Estate Owned, following rises in foreclosures) is putting additional strains on banks earnings. Inevitable adjustments to interest rates would as well put additional pressure on Banks Balance sheets. The current steep yield environment is helping tremendously banks in shoring up capital, provided their play is short duration (2 to 4 years). The risk is higher for Banks if they start buying longer duration trades on MBS (Mortgage Backed Securities). MBS are more abundant than US treasuries or short term liquid investments and are also offering higher yields as well. The temptation is there...and the risks are real if there is a sudden rise in interest rates.