Inside Financial Services

The Myth of “Low-Quality” Bank Earnings

News flash: a dollar is a dollar

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Nancy Bush, a bank analyst for whom I tend to have a lot of regard, spouted an unfortunate piece of conventional wisdom this week in a piece she published on SNL:

While I know that the SEC mandates pretty stringent parameters on the formulation of loan loss provisions and they their utterly insane pro-cyclical bias on this subject continues to hold sway, I also have been around long enough to know that there is some latitude for the building of reserve to account for future expectations of loan growth. I would hope that banks would take full advantage of those expectations to start minimizing loan loss reserve releases, lest poor earnings quality continues and the industry sows the seeds of the next credit crisis. [Emph. added]

Nonsense. I’m hearing a lot of blather like this lately-one always does at this point in the cycle-about how reserve releases somehow constitute “low quality” earnings for banks. I don’t buy that. What’s “low-quality” supposed to mean, anyway? The earnings are only worth 80 cents on the dollar? Seventy? That must be some new accounting rule I haven’t heard about. Earnings are important because they build capital and there is no sliver of capital deemed “low-quality” because it was created via reserve reversals. Capital in turn can be used for shareholder-friendly actions such as dividends and share buybacks.

Besides, back when the banks laid on those reserves during the recession and suffered huge losses as a result, no one questioned the quality of the losses or dismissed them as somehow figments of the accountants’ imagination. They were real enough at the time-so real that hundreds of banks became collapsed as a result. Why shouldn’t the reversal of those reserves be just as real?

Bush herself admits that reserving rules have an “utterly insane pro-cyclical bias,” which is the same thing has saying that the banks had no choice but to over-reserve for years during the slowdown. But if that’s so, why should they be shy about reversing that built-in redundancy now?

As I say, Nancy Bush isn’t the only one spouting this line. It’s standard on among sell-side bank analysts now, most of whom seem to want to come off as no-nonsense tough guys. Why, I can’t say. In any event, don’t believe them. The banks’ earnings recovery is real-and very high quality.

What do you think? Let me know!

12 Responses to “The Myth of “Low-Quality” Bank Earnings”

  1. Fraudster

    Low quality as in unsustainable, one time windfalls that leave Capital vulnerable to bad loans. As opposed to earnings from actual business transactions.

  2. VS

    I completely agree with TOM. There is no release of reserves. What happens is that if credit card balance for $100 is delinquent for 90 days in period 1, bank knows that 80% of them will default so they will do a provision of 80Dollars. Next period they will write off almost all the amount. Next quarter if there is no account that is delinquent then there will be no reserve. But the sell side analyst will says that charge off is $ 80 and bank released the reserves of 80. This I feel is that some of analyst have no clue as to how accounting works. In period 1 the credit losses were 80 and in period 2 credit lossed were 0. Real reason is that the accounts were delinquent in period 1 and not in period 2. But the way it is characterised is Oh the reserve release happened in Q2.

  3. rivvir

    On this one i agree with you. l immediately thought of “low quality” losses myself. However, i think we both are more protesting the not taking into account this when it goes negative for the financials rather than protesting her negative outlook on the sustainability of getting earnings from this source. While imo we will continue to get more since we are still in recovery and have a ways to go yet, at some point we will have reached at least fair value, and will probably overreach.

    Once we overreach then, again imo, you can start calling this segment of earnings low quality bordering on or truly in the realm of the imaginary. That’s what led us into the deep recession, was it not? We both took advantage of the low point of mark to market. Next time we should both be very wary of the pie in the sky mark to market figures. Remember paarb from the yahoo fmd board? He threw up the warning on the cdo’s and cds’ before the collapse occurred, i guess the chatboard version of dr doom. I can be excused because i didn’t understand at all these things at that time, though in reality i should’ve learned about them and that takes away my excuse. You can’t because you should have known right away, given your background. And heebner, i still remember him on cnbc in the march i believe was the month, preceding the collapse. He was announcing to the world the banks were ok because they had no exposure to these things, having sold away all involvement with them. Once again i tell you, learn from history. We can’t prevent but at least we can lessen if we take the right steps. Laissez-faire works both ways.

  4. wallstreetcritic

    Tom, what losses due you refer to when you say the banks “suffered huge losses during the recession” They did not suffer anything, have you forgotten TARP which gave them money to make acquisitiiions and do as they please with the money. Enough of this nonsense about the poor banks.

  5. reality trader

    Your point is valid that the releases now represent capital as opposed to funds effectively ear-marked to write off likely losses from an identified pool of troubled loans.
    Insofar as the strategy of the bank entails unusually high volatility of loan losses with some correlation to the economic cycle , disproportionately low current reserves raise the likelihood of substantially higher credit costs when the economy turns down.
    It may be foolish ;but the market may not pay the same valuation for banks with higher volatility to their earnings , either because of uncertainty about the magnitude of the jump in reserves when they occur or because it raises questions about the foresight of the institution’s management.

  6. Former Bank Auditor

    Tom,

    The quality is suspect. The carry overs from years of acquisition accounting. The tiers of measurement where assets are vaued by model at 97 while the banks bid for similar assets at 50. The problem is not necessarily with the banks but with accounting and auditors who lost their professional responsibility behind the catch phrase – “It was disclosed, so it must be alright.

    And who cares what get on SNL (Saturday Night LIve?)

  7. Mopedman

    Show me…the money. If it is there, it’s there. Who isn’t benefiting in the world right now from some form of make believe? As far as banking…too much talk about tarp and not enough about how government caused/allowed them to need it to begin with. Scapegoats in a nation of over reactors seems to apply.

  8. Charles Munger

    Bank earnings never were and never will be high quality. That’s a simple reason for that fact: LEVERAGE. The ratio of equity to assets for the S&P 500 is on the order of 40%. T. Rowe Price has a ratio of equity to assets of around 90%. It is all-but-impossible for TROW to go bust. We all know what the ratio of equity to assets is for banks. We all know what will happen to a bank if 1 out of 10 loans goes bad– and we all know that, these days, a bank’s loan portfolio is the functional equivalent of of a portfolio of junk bonds.

  9. jane doe

    The bank recovery my be real?????? I think not more if the banks had been more stringent about there lending we would not have seen one of the worst recessions in the last 5 decades. Greed greed !!!!!! Of course the b b anks all took money from the fed !!!!!!!!!!! to bail themselves out But in turn would not lend to the consumer!!!!!!!!!S

  10. jane doe

    So maybe a dollar isnt a dollar??????Everything is how you look at

  11. Neil

    Curious to know your view on SYN, and if you have a target price.

    Many thanks.

  12. Neil

    Curious to know your view on SYN, and if you have a target price.

    Many thanks.

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