Despite playing a starring role in the past financial crisis, the largest banks in the U.S. have retained fairly faithful investors. And that faith is being rewarded with rising earnings per share, even if not fully deserved by all such banks.
Positive signs abound. “Fewer institutions reported quarterly losses, lending grew at a modest pace, credit quality continued to improve, more banks came off the [FDIC] problem list, and fewer banks failed,” said Federal Insurance Deposit Corp. chair Martin J. Gruenberg in his third-quarter 2013 banking report. Researchers and asset managers are singing the banks’ praises; one research team is recommending nine different exchange-traded funds (ETFs) in the financial sector. Analysis of the accounting of the big banks, however, suggests their flush condition may be coming from rainy day reserves, rather than growing revenues.
The euphoria of financial sector analysts seems focused on money-center banks that have plump cash reserves. Michael Lillard, CIO of Prudential Fixed Income, praised their liquidity, telling reporters at the company’s annual briefing in January that he is “very positive on our large banks due to decreased risk and improved balance sheets.”
As for the equity side, S&P Capital IQ’s director of mutual fund and ETF research, Todd Rosenbluth, reports that “faster loan growth and improving credit quality should boost earnings per share visibility for this S&P 500 Index sector.” In early January S&P Capital IQ’s Equity Strategy Group listed 38 ETFs as “buys” or “strong buys.” Among them are IShares U.S. Regional Banks ETF (IAT), up 32 percent for the year, and the Financial Select Sector SPDR Fund (XLF), which is up 32 percent for the one-year period ended January 3.
“S&P Capital IQ also raised its technical opinion on the sector to bullish, from neutral,” writes Rosenbluth in a January 6 report titled “A Focus on Financials in Early 2014.”
But other, less visible statistics suggest that some of the rosy earnings reports have been helped along as banks release cash intended for bad loans, a practice known as loan-loss reserve release. Some increase in these releases — and a drop in loan provisions — has been justified by the charge-off or payment of bad loans and by new loans of better credit quality.
But Gruenberg and comptroller of the currency Thomas Curry have cautioned banks to go easy in reducing loan-loss provisions. Curry devoted the bulk of his September 16 address to the American Institute of Certified Public Accountants to significant reserve releases continuing, despite reports from bank “examiners that credit risk is once again on the rise.” Noting other economic influences, Curry said, “It seemed to us a singularly bad time for banks to be scrimping on their allowances against their loan losses.” On October 25 the Wall Street Journal quoted Curry as saying in a statement, “We continue to caution banks not to move too quickly to reduce reserves or become too dependent on these unsustainable releases.” Examiners at the Office of the Comptroller of the Currency, he added, “will continue to challenge allowances on a bank-by-bank basis if necessary.”
Gruenberg notes in his third-quarter report, “The largest positive contribution to the year-over-year change in quarterly earnings came from lower loan-loss provisions. Banks added just $5.8 billion to reserves in the third quarter. This is $8.8 billion less than banks set aside in the third quarter [of 2012], and the smallest quarterly total in 14 years.”
Since the start of the year, Bank of America released $800 million in reserves, Citigroup $227 million, Goldman Sachs $1.84 billion and J.P. Morgan $700 million (and gained $250 million in price-to-earnings), according to data compiled by Deutsche Bank analysts Matthew O’Connor (a member of Institutional Investor’s 2013 All-America Research Team) and David Rochester. The analysts noted several instances in which releases represented a drop from fourth quarter 2013, which also supports Curry’s concerns that the beneficial balance-sheet effects are unsustainable.
The concerns appear to be well founded. According to recent FDIC data, in the third quarter of 2013, as in the second, “about 40 percent of FDIC-insured institutions reported quarterly net charge-offs that exceeded their quarterly loss provisions.” In other words, the banks were lowering loss provisions too much. “The ratio of total loss reserves to total loans and leases fell from 1.93 percent as of June 30 to 1.83 percent at September 30.” The level is the lowest for this ratio since 1.81 percent was reported at midyear 2008 — and not so low as it was in the credit-crazed 2000s.
Then again, revenues are not thriving. Third-quarter “net operating revenue was $6.1 billion lower than a year ago,” Gruenberg reported. There were 30 percent fewer mortgage originations in the third quarter compared with the second quarter, and mortgage sales were down 24 percent. So why are analysts so optimistic about this sector?
Prudential Fixed Income’s Lillard was asked during the January press event if loan-loss reserves might account for some of banks’ fat cash positions, and hadn’t regulators chastised banks for misapplying the funds? He replied that he was not aware of the issue and deferred further questions to “our bank analyst.” In response to a follow-up e-mail to Prudential’s asset management area, a spokeswoman wrote, “I don’t have a bank analyst for you. Not sure why Mike [Lillard] mentioned that ... Prudential Fixed Income considers its credit research proprietary, so we generally decline comment.”
In response to a similar request for comment, S&P Capital IQ equity analyst Ken Leon said that such a cash analysis finding “would be below the radar.” Asked if Rosenbluth takes these cash movements into account, Leon said, “Todd is an ETF specialist not a bank analyst ... [and] our bank analyst had nothing to add.”
The present basis for calculating how much cash a bank should be setting aside for bad deals is U.S. generally accepted accounting principles (GAAP) rules, based on what Curry calls “imprudent allowance practices,” that is, rules that prevent banks from reserving capital for an “impaired asset” until a “triggering event” occurs. After the event, banks can use different methodologies to calculate asset impairment amounts. “The current model,” says Curry, “precludes banks from taking appropriate provisions for emerging risks that the bank can reasonably anticipate to occur.”
Change appears to be on the way. The two major accounting boards, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board, are proposing that the current after-the-fact approach be replaced with what is called the current expected credit loss model, or CECL, into which banks would plug in economic conditions, historical performance and “reasonable supportable forecasts” to estimate expected shortfalls over the life of a loan. CECL would create “one consistent measurement for all financial assets not accounted for at fair value through net income,” instead of multiple credit loss models.
The proposal is open for comment. “The board received input from over 70 analysts and investors through discussions with them on their views on how best to improve financial reporting of credit losses for the benefit of investors,” FASB spokesman John Pappas said via e-mail. “By almost a 3-to-1 margin, investors and other users prefer a model that recognizes all expected credit losses (as opposed to maintaining a threshold that must be met before all expected credit losses are recognized or permitting recognition of only some expected credit losses).” That model would be the CECL model, which will be tweaked according to the boards’ review of letters, whose number exceeds 350, as well as other input, with a final standard scheduled for approval by mid-2014.
Anyone with an interest in not repeating last decade’s financial crisis would be well advised to examine this proposal carefully.
