Sell Bank Stocks: The "Truth" Behind Non-Performing Loans

Whoever said, “Opposites attract,” didn’t know what they were talking about…or maybe they did know and just didn’t provide all the details.

The world around us provides ample evidence that opposites do, in fact, attract…but not always toward a favorable outcome. Sometimes opposites attract like gravity attracts a crippled airliner…or like a field mouse attracts a rattlesnake…or a bare foot attracts a rusty nail…or a Rusty Nail attracts an alcoholic…or accounting chicanery attracts a gullible investor.

Accounting chicanery converts sad truths into happy stories and statistics. And no one loves a happy story more than a gullible investor. If it were not so, dear reader, Wall Street would still be an anonymous little alley in Lower Manhattan. Instead, Wall Street has enriched itself by converting sad truths into happy stories as often as possible.

Wall Street doesn’t usually lie; it merely fails to tell the truth. The resulting deceptions cause their clients to suffer delusionary episodes at inopportune moments. Sometimes their clients mistake the very top of a bull market for a “deep value opportunity”; and sometimes they mistake a fraudulent earnings report for “a great growth play.”

These classic investment errors are not entirely Wall Street’s fault. But behind every major investment error you usually find at least one glossy research report. The Wall Street research machinery knows how to tell the kinds of happy stories that will elicit buy orders from gullible investors. And they keep telling these stories because gullible investors keep believing them.

Remember Enron? That was a happy story for many years…so was Boston Chicken…and Worldcom…and AIG…and Fannie Mae…and Lehman Bros. But these infamous disasters all featured a variety of sad truths in their financial statements, well before disaster struck their stock prices. A handful of insightful short-sellers made some money as these stocks collapsed, but gullible investors simply lost everything…or almost everything.

Accounting chicanery takes many different forms, but it always produces the identical result: deception.

Remember, we’re not talking about lying; we’re talking about not telling the truth. Lying is not usually legal; but not telling the truth is not usually illegal. Let’s consider a bit of chicanery that is unfolding right below our noses at this very moment: Many banks across the country are reporting a drop in non-performing loans (NPLs). That’s usually a sign that credit conditions are improving.

But this time around, falling NPLs sometimes has more to do with accounting games than with credit quality. Some banks are utilizing every accounting mechanism in their toolbox to move lousy loans into a loan category – any loan category – other than “NPL.”

The astute minds at M3 Funds, an investment management firm specializing in bank stocks, provide this worrisome observation:

“Much of the enthusiasm in the bank sector [is] based on perceived signs of a turning point in the credit cycle. However, in many cases, improvement in credit quality is the result of loan modifications, a financial sleight-of-hand tactic that only optically improves credit quality in the near-term.

“A modified loan appears when a bank takes an existing loan on its balance sheet (often one that is no longer paying) and alters the terms to keep the borrower from defaulting. Modifications usually take the form of an extension, temporary below-market interest rate, or an interest-only grace period. They help banks delay collateral repossession, but in doing so only push problems down the road. In past cycles, the re-default rate on modified loans was more than 50%. Despite such a high failure rate, banks utilize modifications, in part, because they instantly improve credit, as most institutions do not classify a modified loan as nonperforming.

“Nowhere was this practice more evident than in the regional bank space…SunTrust Banks (STI) reported a 2.5% decline in non-performing loans (‘NPLs’) for the fourth quarter, and many analysts were quick to anoint this second consecutive quarter of improvement as an inflection point in the credit cycle. Consider though, that over the past two quarters, NPLs have declined by $101mm, but modified loans increased by $716mm! Still, shares of STI increased by 20% in January, despite losing $245 million for the quarter. TCF Financial (TCB) and Zions Bancorp (ZION) reported similar trends: modest increases in NPLs coupled with dramatically higher loan modifications…

“With negative trends in commercial loan quality beginning to develop and loan modifications being used as a temporary crutch, we believe the banking sector is still facing meaningful credit losses over the upcoming years…”

Beat the rush; sell bank stocks now.

Eric Fry
for The Daily Reckoning