Accounting For Nought

Some might think that with all the public money flowing into their coffers –including capital injections and seemingly unlimited access to cheap credit – the banks would have gone out of their way to give the impression that they are running their businesses in a much more prudent fashion than in the past.

Unfortunately, that does not seem to be the case. Aside from the fact that the leaders of many of the banks and other financial firms at the center of the storm have neither taken responsibility nor apologized for the role they played in creating the mess we are in, they still seem intent on engaging in the kinds of silly accounting games that will only end up prolonging the agony.

In “Banks’ Unnerving Reserving,” the Wall Street Journal’s Heard on the Street column details one particular example.

When a storm threatens, you batten down the hatches — unless you are a bank, it seems.

Despite the darkening outlook for the U.S. economy, few banks have taken extra precautions to protect against sharply higher bad-loan losses.

Make no mistake: Banks have been building up some defenses against credit deterioration. In their third-quarter earnings, released over the past two weeks, they added large sums to their loan-loss reserves, the protective buffer on the balance sheet that absorbs credit losses.

But even after this strengthening, many banks’ reserves should be stronger as the economy sputters badly.

Additions to loan-loss reserves are an expense on the income statement. As a result, moves to beef them up could crush banks’ earnings power.

Renewed fears that credit will hammer earnings is one reason why the KBW Banks Index has fallen more than one third since mid-September. But a closer look at the scale of reserves suggests many banks’ stocks could go even lower.

In particular, in the third quarter, one metric of reserve strength weakened for most large banks. That is the ratio of the reserves to nonperforming loans, which fell from the second to third quarters at Bank of America (BAC), SunTrust Banks (STI)  and BB&T.

The banks argue that they don’t manage their reserves to this one ratio. But if the souring economy causes more loans to become nonperforming, this ratio will start to flash red and investors will want to see higher reserve additions to hoist it back up.

And that inflection point may be close for SunTrust, where the ratio dropped to 62% in the third quarter from 130% a year ago.

Taking the reserve up to, say, 90% of nonperforming loans, the average for the last five quarters, would make a real dent in future earnings.

Reserving is a good test of a bank’s credibility. If a bank suddenly has to boost reserves by far more than expected, management looks bad. Meanwhile, banks that don’t produce reserve shocks can win premium valuations from investors.

What is worrying is that so many banks have let their reserve as percentage of nonperforming loans drop. That suggests a large part of the industry felt credit wasn’t going to get markedly worse — as recently as September. That viewpoint would have been hard enough to support at the start of the year, let alone a month ago.

As a result, it might pay for investors to favor banks that have raised their reserve-to-nonperformers ratio. J.P. Morgan Chase (JPM) did that. Citigroup (C) also upped it in the third quarter. Of course, Citi likely needs every penny of that in this economy.

Posted in Categories: Contributor, External Research, Financial, Stocks, USA.

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