FDIC Quarterly Banking Report: "Reduced Loan-Loss Provisions Boost Earnings"; Commercial Banker Comments on Loan Loss Provisions

Inquiring minds are investigating the FDIC Second Quarter 2010 Quarterly Banking Profile.

Quarterly Earnings Are Highest in Almost Three Years

Reductions in loan-loss provisions underscored improvement in asset quality indicators during second quarter 2010. The industry’s quarterly earnings of $21.6 billion are up dramatically from the year-ago loss of $4.4 billion and represent the highest quarterly earnings since third quarter 2007. Almost two out of three institutions (65.5 percent) reported higher year-over-year quarterly net income. The proportion of institutions reporting quarterly net losses remained high at 20 percent but was down from more than 29 percent a year earlier.

Reduced Loan-Loss Provisions Boost Net Income

Insured institutions added $40.3 billion in provisions to their loan-loss allowances in the second quarter. While still high by historic standards, this is the smallest total since the industry set aside $37.2 billion in first quarter 2008 and is $27.1 billion (40.2 percent) less than the industry’s provisions in second quarter 2009. Fewer than half of all institutions (41.3 percent) reported year-over-year reductions in quarterly loss provisions. Only 40 percent of community banks (institutions with less than $1 billion in assets) reported year-over-year declines. Reductions were more prevalent among larger institutions. More than half (56.2 percent) of institutions with assets greater than $1 billion had lower provisions in the second quarter.

Charge-Offs Fall for First Time Since 2006

Net charge-offs totaled $49 billion in the second quarter, a $214-million (0.4 percent) decline from a year earlier and the first year-over-year decline since fourth quarter 2006. Charge-offs were lower than a year ago in most major loan categories except for credit cards and real estate loans secured by nonfarm nonresidential properties. Charge-offs on loans to commercial and industrial (C&I) borrowers were $3.1 billion (37.0 percent) lower than a year ago, while charge-offs on real estate construction and development (C&D) loans were $2.7 billion (34.6 percent) lower. Charge-offs of one-to-four family residential mortgage loans were down by $1.4 billion (16.0 percent). Credit card charge-offs were $8.6 billion (86 percent) higher than in second quarter 2009. Most, if not all, of this increase was attributable to the inclusion of charge-offs on securitized credit card balances, which were not included in reported charge-offs in previous years. The change in reporting was the result of the application of FASB 166 and 167. In contrast, the $1.8 billion (107.2 percent) year-over-year increase in charge-offs of nonfarm nonresidential real estate loans reflected further deterioration in commercial real estate portfolios. Almost half (49.1 percent) of insured institutions with more than $1 billion in assets reported lower net charge-offs, while only 43.6 percent of community banks reported year-over-year declines.

Noncurrent Loans Post First Decline in More than Four Years

The amount of loans and leases that were noncurrent (90 days or more past due or in nonaccrual status) declined by $19.6 billion (4.8 percent) during the second quarter. This is the first quarterly decline in noncurrent loans since first quarter 2006. Noncurrent levels declined in most major loan categories during the quarter. The sole exception was nonfarm nonresidential real estate loans, where noncurrents increased by $547 million (1.2 percent), the smallest quarterly increase in three years. The largest reduction in noncurrent loans in the quarter occurred in real estate C&D loans, where noncurrents fell by $5.9 billion (8.3 percent). This is the third consecutive quarter that noncurrent C&D loans have declined. Noncurrent C&I loans also declined for a third straight quarter, falling by $2.7 billion (7.3 percent), while noncurrent residential mortgage loans declined by $4.7 billion (2.5 percent) and noncurrent credit cards fell by $4.2 billion (19 percent). Slightly fewer than half of all institutions (48.9 percent) reported declines in their noncurrent loan balances during the quarter. Noncurrent loan balances fell by 5.3 percent at institutions with more than $1 billion in assets and rose by 0.3 percent at community banks.

Reserves Fall as Large Banks Reduce Loan-Loss Provisions

Total loan-loss reserves of insured institutions fell for the first time since fourth quarter 2006, declining by $11.8 billion (4.5 percent), as net charge-offs of $49 billion exceeded loss provisions of $40.3 billion. Almost two out of three institutions (61.7 percent) increased their loss reserves in the second quarter, but a number of large banks reduced their loss provisions, producing net declines in their reserve balances. In particular, some institutions that converted equity capital into reserves in the first quarter in accordance with the requirements of FASB 166 and 167 reported lower provisioning in the second quarter. Although the industry’s ratio of reserves to total loans fell from 3.51 percent to 3.40 percent during the quarter, it is still the second-highest level for this ratio in the 63 years for which data are available. The industry’s “coverage ratio” of reserves to noncurrent loans improved for a second consecutive quarter, from 64.9 percent to 65.1 percent, as the reduction in noncurrent loans slightly outpaced the decline in loss reserves.

Rising net chargeoffs are a legitimate reason for loan loss reserves to decline, but this report shows other interesting things. For example, 61.7% of banks increased loan loss provisions but total loan loss reserves declined because "a number of large banks reduced their loss provisions".

Here are a few bank charts to consider. Click on any chart for sharper image.

Wells Fargo (WFC) Daily Chart



Bank of America (BAC) Daily Chart



Citigroup (C) Daily Chart



JPMorgan Chase (JPM) Daily Chart



The S&P 500 is down less than 15% from the April highs and in spite of that glowing bank report, especially for the big banks, Wells Fargo is down about 32%, Bank of America is down 37%, Citigroup is down by 26%, and JP Morgan is down by 25%.

The above charts do not necessarily imply large banks have insufficient loan loss reserves. Correlation is not causation. There could be any number of reasons for bank stocks to be taking a hit.

Nonetheless, additional data does not seem to pass the smell test.

Allowances for Loan Losses as Percentage of Nonperforming Loans

After reading the glowing report above I thought it might be interesting to compare loan loss allowance percentages between banks of various sizes.

The charts below depict the ratio of loan loss provisions to nonperforming loans. Click on any chart for a sharper image.

Banks with Total Assets up to $300M



Banks with Total Assets from $300M to $1B



Banks with Total Assets from $1B to $10B



Banks with Total Assets from $10B to $20B



Banks with Total Assets over $20B



Allowances for Loan Losses as Percentage of Nonperforming Loans
By Bank Size

• Banks with Total Assets up to $300M: 43.14%
• Banks with Total Assets from $300M to $1B: 31.91%
• Banks with Total Assets from $1B to $10B: 26.92%
• Banks with Total Assets from $10B to $20B: 31.15%
• Banks with Total Assets over $20B: 14.11%

The most striking comparison is between the adjacent classes of Banks with Total Assets from $10B to $20B and Banks with Total Assets over $20B.

Possible Explanations

• Large banks have taken a larger share of writeoffs than smaller banks.
• Large banks customers are in better shape, out of the blue.
• Large banks are playing more games with fantasy level-3 valuations.
• Large banks are reworking more loans to classify more loans as "current".

The sad thing is it is not really possible to know. It could be a combination of various factors, but whatever it is, it does not feel right.

California Banker Chimes In

I discussed loan loss provisions a couple days ago in Banks Recruit Investors to Oppose Honest Valuation of Assets; Just how Unprepared are Banks for Major Losses?

If you have not done so, please check it out for many additional charts and comments.

I asked my California Commercial Banker friend to chime in on the post.

"California Commercial Banker" writes ...

Hello Mish

I've had a chance to talk to my Chief Credit Officer to confirm accounting for nonperforming loans and reserves, which in turn impacts net income and profitability.

When a loan is charged off, nonperforming assets decrease by that amount of the loan while reserves also decrease by the same amount, as the reserves being used pay for the loss at final recognition.

In the case where a bank is continually downgrading a loan and increasing its expectation of losing money on a loan, one of two things happens. If the bank feels its reserves are adequate to support the entire bank plus that potential loss then they do not need to add to reserves. If reserves are inadequate, the banks would then need to add to reserves which decreases income and impacts the bank's profitability.

Many people don't understand the magnitude within the banking industry to "Kick the Can" or "Extend and Pretend". We see a lot of this within the industry.

Banks with existing balance sheet issues (nonperforming loans) really don't want to recognize more loan issues because it could force the FDIC to close them down.

In that light, a bank can take a commercial real estate loan or a business line of credit having issues and do a 3 month extension at loan maturity or change loan payments to interest in an attempt to give the borrower with more time to work things out or bring more capital to the table.

In essence, a bank is hoping for a positive "cure" to the situation by providing time. As long as payments are made on time, a bank might not downgrade that loan as far as it should, which in turn means reserves for the loan are not as big as they should be.

It's not uncommon for a bank to do multiple extensions in the mode of working out a loan with principal reductions over time. I've been in the situation where extensions have lasted 1-2 years. In normal recessions, extensions have worked quite well because borrowers could take equity out of their house or sell stock market assets to cure the loan.

Unfortunately, those dynamics do not exist today. Currently, Extend and Pretend in most cases is the wrong direction and could easily increase the bank's loss in the long run because there are no assets to cure the issue. In the case of housing or commercial real estate loans, the assets are negatively appreciating. This adds to the future problem of nonperforming loans.

I believe there are lots of bad loans not being recognized as accurately or quickly as they should be within the industry at many banks. It's really a case by case basis on how liberal/conservative a bank recognizes loan issues.

I know of one CEO at a community bank who was rumored to be fired for not disclosing problem loans to the directors of that bank.

The other issue that's totally ignored regards borrowers making monthly payments on time even though the collateral is very much underwater.

Knowing the collateral value is below the loan amount would increase the potential for loss and thus force a bank to increase loan loss reserves, thereby lowering earnings. No bank really wants to do that, so most of them don't.

Lastly, I know of certain cases where loan officers at other banks are afraid to tell bank executives when they have real loan issues in the making. Bank officers might take 2-4 months to notify their executives of a potential loan loss. This too delays the recognition of the need to increase reserves for those loans.

In my estimation, if every bank had the collateral of all loans accurately appraised and each loan’s loan grading was finely tuned for an expected loss based on financial performance and collateral values, the number of essentially bankrupt banks in this county would increase by a factor of 4-5 from the current level.

In other words, there is a potential pool of 2000-3000 banks that would be on the FDIC radar's for getting closed.

The health of the industry is not accurately reported by any means.

California Commercial Banker

So, there's the data, complete with an opinion from someone in commercial banking.

There is a lot of guesswork here, but I am sticking with what I said earlier ... Banks in general are sitting on assets, not marked-to-market, both on and off their balance sheets, for which they have made no loan loss provisions.

Meanwhile credit risk for new loans is exceptionally high. Is it any wonder banks seem reluctant to lend?

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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