It has been a splendid earnings season for U.S. banks, which may come as a surprise to Canadians who wonder how the engines of a sputtering south-of-the-border economy can fire on all cylinders.
Alas, there is something else going on under the hood, to continue our mechanical metaphor. Despite a host of problems - fiscal disorder, lingering unemployment, depressed real estate - that suggest rocky economic times will continue, the biggest U.S. banks are betting on recovery. They're setting aside less and less money to cover problem loans, boosting their earnings in the process.
To get perspective on this, we turn to Jason Goldberg of Barclays Capital, a sell-side analyst of bank stocks for more than 16 years. Of the 22 banks he covers, 21 hit their earnings expectations in this year's second quarter, with only Minneapolis-based TCF Financial screwing up. It was the best overall performance he'd seen since 1997's third quarter, when only two missed their targets out of the 48 banks he covered at the time.
The key to this year's shiny results was not big gains in revenue - the group Mr. Goldberg follows was up 3 per cent, collectively - or low expenses, as a number of banks were forced into discussing cost-cutting plans on their conference calls. Instead, the chief contributor was the estimates they made about how many of the loans on their books will go bad.
A brief primer: Banks maintain "loan-loss reserves," a set amount on their books, to cover loans gone bad. When banks put money into reserves, they make a "provision" that's charged against profits. When it's time to charge off a bad loan, the amount gets taken out of the reserve.
More provisions means lower profits; fewer provisions mean higher profits. So banks have an incentive to keep reserves as low as regulators will allow.
Here's where it's been coming into play at the largest U.S. banks: Banks have been provisioning less and less for several quarters. In Mr. Goldberg's coverage area, which includes the biggest names in banking, provisions dropped 38 per cent from the fourth quarter 2010 to the first quarter 2011, and another 15 per cent from the first quarter to the second. Only three banks - JP Morgan Chase & Co., Citigroup Inc., and Texas Capital Bancshares Inc. - provisioned more in the second quarter than they had in the first.
With less provisioning comes smaller reserves: They have declined, in the aggregate among the group of 22, in a range of 4 per cent to 7 per cent in each of the last five quarters.
When banks charge off more in bad loans than they provision - thereby allowing reserves to fall - it's called a "release." And Mr. Goldberg estimates his coverage group released $8.3-billion in the second quarter, after $10.9-billion in the first quarter. Reserve releases represented 18 per cent of second-quarter pre-tax income at the median bank, he says, down from 40 per cent in the first quarter of 2011 and 54 per cent in the fourth quarter of 2010. Reserve releases represented more than one-third of second-quarter pre-tax income at seven of the banks he covers.
What's the big deal? Maybe none - problem loans are indeed on the decline right now, as they should be so far into an economic recovery. And the median bank's ratio of reserves to loans, at 2.33 per cent, is still significantly above the 10-year average of 1.33 per cent.
And yet … increasingly, data like last Friday's report on U.S. gross domestic product suggest the country's economic recovery, never robust, is stalling and perhaps reversing. That will likely mean more problem loans, not fewer, down the road.
If you're inclined to believe the U.S. is on the tipping point of another downturn, you might consider banks' loss provisioning overly optimistic - and, by extension, their recent earnings inflated by their rosy outlook.
Mr. Goldberg does not go so far; he merely provides the data to help me point this out. But he also notes that large-cap bank stocks have declined 9 per cent year to date, while the Standard & Poor's 500 had risen 6 per cent at the time of his report last week. Mr. Goldberg's group is trading 20 per cent below its historic earnings-per-share multiple and 40 per cent below its historic price-to-book ratio.
Investors are looking beyond the recent good news, then, and seem to have decided there's more trouble ahead for the U.S. economy. If you agree, there are few bargains to be found in the sector. If, instead, you share the banks' view that problem loans are increasingly in the rear-view mirror, consider buying into this batch of happy second-quarter results.
Banking on recovery
Several big U.S. banks got a big boost to second-quarter profits by managing the way they plan for future bad loans. "Reserve releases" - money gained by setting aside less for future losses than the amount written off in the quarter - made up more than a third of pre-tax income at these seven banks:
First Horizon National Corp.
Bank of America Corp.*
SunTrust Banks Inc.
Fifth Third Bancorp
* operating basis
Source: Barclays Capital
Disclosure: I own shares in Fifth Third Bancorp.