A SERVING OF DOUBT ON BANK VALUATIONS / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

HEARD ON THE STREET

MARCH 6, 2011, 4:49 P.M. ET.

A Serving of Doubt on Bank Valuations
.
By DAVID REILLY

Some big bank stocks may be more expensive than investors realize.


That may become more apparent amid debates on how banks are compensated for servicing home loans, and separately, on whether banks should forgive some principal of troubled mortgages. Such changes could potentially affect the value of bank assets tied to servicing mortgages. The country's six biggest banks have more than $50 billion in such assets, equal to about 7% of common equity.


Banks' mortgage-servicing businesses collect and disburse mortgage payments, as well as deal with loan modifications or foreclosures. Mortgage servicing has fallen under the regulatory and legal microscope following last fall's "robo-signer" scandal.


Currently, banks receive a flat fee, usually about 0.25 percentage points of the outstanding mortgage balance. But there is a push to move to a variable payment system. This would mean banks receive higher payments for troubled mortgages, but less for performing loans, the bulk of most servicing portfolios.


The upshot: The six biggest banks, who service about $5 trillion in mortgages, may receive lower compensation. That would likely reduce the value of mortgage-servicing-rights assets, which are based largely on the current value of future payment streams.


At the same time, federal and state investigations have led to proposals for banks to forgive mortgage principal in some cases. Any reduction in outstanding mortgage balances would shrink the value of mortgage-servicing rights.


Granted, such changes likely wouldn't hit all at once, so banks would have time to manage them. And banks hotly oppose principal forgiveness.


The potential changes affect bank-stock valuations because of how mortgage-servicing rights have been presented to investors. Over the past two years, Many banks have lumped the rights in with their tally of tangible equity, even though they are intangible assets. They can do this because tangible equity isn't defined by accounting rules. Banks only have to disclose how they come up with the figure.


The maneuver bolsters tangible equity—also known as tangible book value —and in turn flatters valuation metrics. Shares in J.P. Morgan Chase, for example, trade at about 1.5 times tangible book. Exclude servicing-rights assets and the multiple rises to about 1.7 times. At US Bancorp, the multiple rises to 3.2 times from about 2.9 times.


More confusing, not all banks provide a tangible-equity figure. But analysts sometimes forget that when they compare bank values. Many put Bank of America, for example, at a price-to-tangible-book ratio of about 1.1 times and Wells Fargo at 2.1 times. But Wells's figure excludes servicing rights, while Bank of America's includes them. Strip them from Bank of America's tangible equity and the multiple rises to about 1.25 times.


The mortgage-servicing business is in for some big changes. Given that, investors should make sure they know just how much they are paying for a bank stock.

Copyright 2011 Dow Jones & Company, Inc. All Rights Reserved