Bank Accounting Fudges Loan Losses

Investors often assume dangerous, unnecessary risks by owning stocks on the basis of sloppy economic and financial analysis. For each stock you own, you should frequently reassess the reasons for owning it. Also, you need to remain on the lookout for signals that the future operating environment for a particular stock has changed.

Right now, the market has priced bank stocks for perfection, but the earnings outlook remains bleak. Investors are excited about the wide yield curve that’s enabling banks to borrow at ultra low rates and lend at much higher rates. But starting a few years ago — and going forward a few more years — losses on loans made during the bubble will matter more than the wide yield curve. More bank failures, capital shortfalls, dividend cuts and shareholder dilution are in the cards for most bank stock fans.

Because bank stocks usually act as a canary in the coal mine, a continued bear market in banks translates into a continued bear market in most other stocks. The evidence tells me we’re experiencing a bear market rally, not a new bull market. The promoters of the idea that this is a new bull market are ignoring one of the worst enemies of stocks: uncertainty. Right now, especially considering aggressive government policies, uncertainty about the future business environment is very high.

As regular readers of Whiskey & Gunpowder know, the government’s land grab is going to make things worse. It seems that there’s no end to the threats facing corporate profits, which will make corporate loans that much harder to pay back. This is not a garden-variety recession. It’s more like a depression, so the so-called economists parroting the “recession is over” message will have a rude awakening soon enough.

Let’s briefly consider the sentiment toward overall market. Aside from the investor sentiment polls, you can tell how bullish investors are by the multiples they are willing to pay for stocks. And right now, after the sharpest 5-month rally since the 1930s, the market is trading at valuations that require a strong economic recovery, and a return to credit bubble conditions. The rally was powered entirely by P/E multiple expansion, not earnings growth. That sort of rally would be justifiable if corporate revenues and earnings were about to soar, but they’re not. Most earnings surprises were due to cost cutting, rather than top-line growth, which is like burning your furniture to stay warm.

The market is not even that cheap when you consider how artificially inflated earnings were at the 2007 peak. Financial earnings made up 18% of the S&P 500’s earnings in 2007 — much more if you add the “earnings” from the finance divisions of industrial conglomerates like GE and GM. Any claims that the S&P 500 is cheap because 2007 somehow represents “normalized earnings power” are bogus. The corporate profit margins and earnings won’t return to that level for many years.

The talking heads are getting more creative in their rationale for owning stocks right now. Most money managers seem to be thinking: “I don’t believe in this rally, but I’ll ride it until it looks like it’s over, and then I’ll sell.” This is the type of dangerous crowd psychology that consumes most people during bubbles. When enough investors share this Ponzi sentiment, and nobody’s investing on the basis of sober, rational fundamental analysis, the result is sometimes a crash.

Bank Accounting: Educated Guesses about the Future

This brings us to the poor quality of earnings, particularly at commercial banks. Accounting — especially the accounting that produces income statements at banks — is more art than science. It’s as much opinion as it is fact. Bank executives have a lot of leeway in how and when they recognize credit losses. As you’d imagine, some of them have more creative imaginations than others. Some are actively engaging in “extend and pretend,” a practice in which banks refinance deadbeat borrowers to avoid reporting loan losses.

Banks make loans expecting to receive interest and principal payments in a timely fashion. Banks book revenues, expected credit and operating costs, and profits associated with every loan upfront. But as we’ve discovered, the credit costs, or losses, often wind up being much larger than originally expected. When this happens, banks must dramatically ramp up their “loan loss provision” expense, which cuts into earnings, often pushing earnings into the red.

So the ultimate credit costs associated with bank revenues often take a year or more to be reflected in earnings and capital cushions. That’s why regulators require banks to maintain an “allowance for loan losses.” This allowance is a contra account on the asset side of a bank’s balance sheet, and its purpose is to absorb credit losses from loans as they run through the default and recovery phases. Loan losses, net of recoveries, deplete the allowance. Banks can rebuild their loan loss allowance by booking larger provision expenses, but this process cuts directly into earnings.

The chart below shows how under-reserved banks are right now, so they still have a ways to go in accounting for the losses on loans made during the bubble. These numbers are the combined figures for over 7,000 U.S. commercial banks insured by the FDIC. In blue, you see the combined loan loss allowance climbed to $156 billion by the end of 2008. In red, you see that noncurrent loans — the raw material for credit losses — had soared even faster to $200 billion by the end of 2008, and are still climbing sharply. As a rule of thumb, to remain well capitalized, and to prevent their allowance from shrinking to dangerously low levels, banks should book provision expenses in line with the increase in noncurrent loans.

But since the credit crisis began, this has not been happening. As the green line shows, the ratio of loss allowance to noncurrent loans for the entire banking system has fallen below 100%. To rebuild the industry wide loss allowance back up to an adequate level, provision expenses will have to rise faster than delinquencies. Some banks can only catch up by raising new capital from investors. Those banks that are too far behind, and cannot raise capital, will be taken over by the FDIC. All of this translates into a strong headwind for bank earnings over the next few years.

Recall that bank executives have lots of control over the timing of loss recognition. Evidence that banks are delaying loss recognition is springing up all over the place. For instance, some banks that provided unsecured revolving lines of credit to highly indebted REITs have waived some restrictive loan covenants. In residential mortgages, we’ve seen lots of instances where banks are stringing along underwater homeowners with modifications that do little more than kick the can down the road.

It would make more sense to restructure mortgages on underwater properties where the bank receives a property appreciation right in exchange for a large reduction in mortgage principle. This makes more sense from a societal perspective, and would help accelerate the return to a healthier, less “zombified” banking system. But this idea is not popular among bankers, because doing so would force the bank to immediately recognize lots of losses, which could cut heavily into the bank’s capital.

This state of bank accounting is not limited to the U.S. In fact, in some instances, the accounting at some foreign banks is even more detached from reality than it is in the U.S. For readers of Strategic Short Report, I recently uncovered a non-U.S. bank that’s been especially tardy in disclosing its credit losses. It’s a very attractive short sale right now, especially because the market loves this bank, and is totally ignoring the wave of credit losses to come in the near future.

Dan Amoss

August 13, 2009