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An Update On Bank Credit Quality And Loan Loss Reserves
The bank industry’s nonperforming loans, loan losses, and delinquencies, which surged during the economic downturn, have all fallen dramatically since the 2007-2008 period, to levels considered almost normal.
Alabama-based Regions Financial (RF), for example, has offices in markets like Florida, where real estate values plunged during the recession. Commercial real estate loans to investors to finance construction were especially problematic for the bank. Repayment of this type of loan depends on funds generated by the property or by the sale of real estate collateral, sources that dried up during the real estate downturn.
Partly owing to a deterioration in its investor real estate loans, Regions’ problem assets rose from $864 million or 0.9% of its loans and foreclosed properties at the end of 2007, to over $4.4 billion or 4.8% by the close of 2009. The good news is that by September 30, 2013, the company had worked down its investor real estate exposure considerably, and its total problem assets had fallen to $1.5 billion, with the problem asset ratio at about 2%. Though not quite back down to the 2007 level, the 2% nonetheless represents substantial progress.
Large banks, in the news recently due to their legal problems, have also made good strides in improving credit quality. Bank of America’s (BAC ) problem assets, which rose from a relatively low 0.7% of its loans and foreclosed real estate in 2007 to nearly 4% in 2009, have since fallen, to just under 2.2% at the end of the 2013 September term. In the past 12 months alone, its early-stage delinquencies and potential problem commercial credits have declined 15% and 19%, respectively.
Likewise, JPMorgan Chase & Company’s (JPM -Free JPMorgan Stock Report) problem assets of $3.9 billion at the close of 2007 soared to nearly $20 billion by the end of 2009 but have since fallen back to just over $10 billion. Its loan losses followed a similar path, rising from about 1% of loans at the end of 2007 to 3.4% in 2009, then plunging to 0.7% at the end of the 2013 September quarter.
Meantime, while the banks’ problem assets were falling, their reserves for loan losses were also declining significantly. Banks charge off bad loans against their loan loss reserves, which they replenish with loan loss provisions. Provisions, like expenses, reduce earnings. To be sure, when problem loans are low, as they are now, bank loan loss reserves don’t need to be as large as when bad loans are high. In recent years, however, banks have been criticized for bolstering earnings by making loan loss provisions that fall well short of the loans that they charge off.
In some cases, the shortfall has been significant. JPMorgan Chase, for example, charged off over $1.3 billion of loans in the 2013 September term and made a $543 million negative loan loss provision in the quarter, in effect reducing its loan loss reserve by over $1.8 billion. The negative loan loss provision partly offset lower revenues and higher expenses in the quarter, thereby mitigating the loss that the company reported in the September term.
Banks probably can’t underprovide for loan losses forever, much less continue to draw down reserves with negative loan loss provisions, even if credit quality trends remain favorable. And with borrowers still rather cautious, intense competition to make loans has allegedly caused some banks to relax their credit standards. Some banks may be planting the seeds of higher problem loans sometime down the road. We expect loan loss provisions to bottom in 2013 and start increasing again in 2014, limiting banks’ earnings growth in the new year.
Note that the banks say that they are caught in the middle of two opposing views on reserves. Regulators, like the Federal Reserve Board and Comptroller of the Currency, want banks to maintain as strong loan loss reserves as possible. Accountants, however, worry that excess reserves may enable companies to “manage’’ earnings.
Under current accounting rules, banks need to be fairly sure that a loan will go bad before they make a provision for a loan to the loan loss reserve. Under this system, banks have a hard time justifying building up their loan loss reserves until things are bad. They end up taking sizable loan loss provisions in tough times that decimate earnings.
The Financial Accounting Standards Board (FASB) has proposed that banks instead switch to an approach that enables them to build up their loan loss reserves in good times, when they are better able to do so. Loan loss provisions probably wouldn’t fluctuate as sharply from quarter to quarter under this new method, as they have recently, and probably would have less of an impact on earnings trends.
This method has its drawbacks, since estimating a bank’s reserve needs would still be a somewhat subjective process. But it probably will turn out to be an improvement over the current reserve methodology.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.