Accretable yield - accounting magic?

All of a sudden stories are popping up of banks turning purchases of “toxic loans” into profits. A good example of this is JPMorgan’s purchase of WaMu’s assets ($1.9 billion for all of WaMu’s assets). The mysterious accounting rule that banks are using to accomplish that is called “accretable yield”. Sounds like magic, right? That's what the mass media is insinuating - that this 2003 accounting rule is new (post-crisis), and somehow banks are "getting away with something".

What many people (even many of those in the financial services industry) don’t realize is that banks generally don’t mark originated loans to market. Most loans are part of what’s called the “banking book” (otherwise known as the accrual book). Let’s say the bank lent $100 MM at an average rate of 7%. The bank will then be taking into income $7 MM a year. If some loans become non-performing, the bank will take a provision (based on expected losses) against those loans and stop accruing interest on the non-performing loans. The rest of the loans will continue to accrue – no matter what the secondary market for such loans does.

So what happens when a bank buys a portfolio of loans from another bank at a discount? That’s when banks can apply the accretable yield methodology. Back to our example, the bank buys a loan portfolio with $100 MM face for $60 MM (60 cents on the dollar). Let’s say the bank believes that 85% of those loans will be repaid and the average maturity for that portfolio is 10 years. The bank expects to make $25 MM (expected repayment of $85 MM less the cost of $60 MM) of profits over 10 years and will therefore accrete $2.5MM per year. In addition it will accrue 7% x $100 MM x 85% (since only 85% of loans pay interest) = $5.95 MM of accrued interest. So the accretable yield on the portfolio is the total annual income over the purchase price = ($2.5MM + $5.95 MM)/ $60 MM = 14%. Magic? Not so much.

For those who absolutely love accounting and absolutely must know the language, here is the official pronouncement (2003) issued by the Accounting Standards Executive Committee:

SOP 03-3--Accounting for Certain Loans or Debt Securities Acquired in a Transfer

"This Statement of Position (SOP) addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor's initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part. to credit quality. It includes such loans acquired in purchase business combinations and applies to all nongovernmental entities, including not-for-profit organizations. This SOP does not apply to loans originated by the entity. This SOP limits the yield that may be secreted (accretable yield) to the excess of the investor's estimate of undiscounted expected principal, interest, and other cash flows (cash flows expected at acquisition to be collected) over the investor's initial investment in the loan. This SOP requires that the excess of contractual cash flows over cash flows expected to be collected (nonaccretable difference) not be recognized as an adjustment of yield, loss accrual, or valuation allowance. This SOP prohibits investors from displaying accretable yield and nonaccretable difference in the balance sheet. Subsequent increases in cash flows expected to be collected generally should be recognized prospectively through adjustment of the loan's yield over its remaining life. Decreases in cash flows expected to be collected should be recognized as impairment."