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Sunday, September 30, 2007 1:38 PM

Bank Balance Sheets and Earnings

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Let's take a look at banks balance sheets credit card growth and other things through the eyes of Minyan Peter, who "helped build and ultimately ran a Wall Street asset-backed securities business and was treasurer of a top credit card company and treasurer of one of the largest banks in the Midwest." Many snips of wisdom from Peter follow.

A Bird's-Eye View of the Credit Conundrum

First, having been there at the beginning, the genesis of the asset-backed commercial conduits was regulatory capital arbitrage. Through the conduits’ convoluted structures, banks were able to "lend" huge amounts off-balance sheet and collect fees on no-capital-required lines of credit. No one - and I mean no one - ever expected these conduits to move from off-balance sheet back on-balance sheet and I don't think the market yet understands the earnings, capital and liquidity impact of this migration. If you figure you need anywhere from 6-8% capital per dollar of loans, then a move of $1.0 trln from off-balance sheet to on requires $60-80 bln in additional equity capital. I don't know about you, but I don't see this kind of free capital sitting around.


The last consumer led recession was around 1990. Since then, the SEC has placed enormous pressure on the banks to minimize their loan loss reserves. The SEC hates earnings management and the loan loss provision has historically been a key way for banks to "save for a rainy day." I don't think the market yet appreciates the fact that banks are currently provisioned for the top of the market.


Finally, no one is talking about it yet, but I think the market will soon begin to realize that the credit card lenders have in essence become the consumer lenders of last resort. As consumers have been shut out of the mortgage and home equity world, the last available credit is plastic. One statistic that I have found very troubling is the degree to which credit card balance growth is running ahead of retail sales growth - a key sign that the consumer is stretched.


Digging even deeper, you come away with more unanswered questions. First, annualized net write-offs for the quarter were up 17% - 5.4% of loans versus 4.6% during the year ago quarter. But behind that, masked by 14% balance growth, there is a 32% increase in the dollars charged off. Further, and to me more troubling, Target dropped its loan loss allowance from 8.3% of loans at the end of July 2006 ($501 mln) to 7.4% at the end of July 2007 ($509 mln). Had Target kept its provision at 8.3% of loans, the incremental cost would have been over $64 mln or almost 40% of the pre-tax quarterly earnings of Target’s credit card business. Alternatively, had Target kept its provision at the same 1.8 times net charge-offs as last year (an 8.3% allowance on 4.6% in net write-offs), the required ending provision would have been over 9.7% of loans - at an incremental cost to the company of almost $144 mln – all but eliminating earnings from the credit card operation for the quarter. Put simply, when measured in dollars (rather than percentages of balances) Target’s nearly flat year-on-year loan loss allowance does not synch with the increase in loan balances, delinquencies, charge-offs, and late fees.

And while I have used Target as an example, I don’t think Target is alone. As we have seen already in other parts of the credit markets, many banks and finance companies are managing their businesses as if today’s increases in credit deterioration are merely a “blip”, rather than the beginning of a broader, potentially more serious, decline. From where I sit, it looks like it is only going to get worse, and “it’s already in the cards.”

-Minyan Peter
Bank Earnings 101
From experience, I have found that most people are surprised to learn that banks’ net income is generally only between 1 and 2% on assets. And many people are also unaware that banks are generally leveraged 10:1.

So why are these points important?

First, small changes in interest rates and loan losses have a big effect on bank earnings. For example, in 2006, BofA had 70 basis points of loan losses, but in 2002 that figure was 110 basis points – a 40 bps difference. All things being equal, (and ignoring income taxes for simplicity) if we applied BofA’s 2002 level rate to its 2006 results, earnings would have been 28% lower.


Now while it takes time for higher losses and funding costs to flow all the way through to the bottom line (not all debt rolls over at once; nor do all bad credits charge off at once), I hope you can see by this example why the financial services community is so fixated on Federal Reserve interest rate cuts. By dropping short term interest rates, the Federal Reserve helps to offset the impact of higher borrowing spreads and loan losses. The difference between and a 25 and 50 basis point cut may not feel like much to you, but when all you're earning at best is 1-2% on assets, it is a huge deal.

-Minyan Peter
Bank Earnings 102: The Best of Times, The Worst of Times
As much attention as they will get, in the bigger scheme of things, their [the banks'] net incomes this quarter don’t matter. And they don’t matter because of one simple rule for financial services firms:

The income statement is the past. The balance sheet is the future.

Let me repeat it again. The income statement is the past and the balance sheet is the future, especially now.

At the top of a credit cycle, the income statement for a financial institution shows “the best of times”, but buried in the balance sheet is “the worst of times” to come.


History repeatedly reveals the ability of highly profitable banks to go down in flames. How many of you remember Texas Commerce Bank – AAA at the top, but gone at the bottom of a severe credit cycle?

Second, one quarter does not complete a credit cycle. We are at the beginning of a material economic change. Remember, we have only just seen the first month of employment decline. Loan loss provisions are predicated on the present economy, not on possibly better or worse future economies. This quarter’s provisions are likely to be relatively light based on the strength of our current economy. Similarly, any funding cost increases are just beginning to impact net interest margin.

Go back and read the 3Q '05 financial results for a few homebuilders and you will get my point. Few reveal any clues to their future demise– particularly the potential for balance sheet writedowns. And I expect the same this quarter for many banks.

But in much the same way as the housing industry has taken one-time write down after one-time write down for land values, I anticipate that we will see increasing loan loss provisioning by banks as the economy continues to weaken. Remember, the loans have been made. The only questions now are how severe the downturn will be and how many borrowers will be affected. If the housing industry’s forecasting prowess is any indicator, I would suggest we have a long way to go before we see the bottom of this cycle.


-Minyan Peter
Bank Earnings 103: Reading Bank Balance Sheets
While I anticipate that most of Wall Street’s attention at the end of the third quarter will be on bank earnings, for reasons I outlined in Banking 102, I strongly recommend that you focus on bank balance sheets. From experience, changes in bank balance sheet composition are much better predictors of future earnings than current period income statements.

So where do you start?

First, I would look at changes across the four different major investment/loan categories.

In investments “held for trading”, I would look for a significant overall balance reduction and an upgrading in quality. Both would be indications of a reduction in overall market risk appetite and a willingness to allocate capital to “volatile” capital markets and related businesses.

In investments “held for sale”, I would also look for a reduction in balances. As I mentioned in “Whispers from the Confessional”, I expect that you will see many financial institutions reducing their “available for sale” assets given the decline in secondary market liquidity. Watch as to where the assets went. There should be associated disclosure if the assets were moved into portfolio. And remember that once in portfolio, the accountants make it very difficult to move them back out to “held for sale.” So these moved assets will have to be funded through to maturity.


Associated with the loan portfolio, I would also review the loan loss allowance. Material changes in the allowance ratios (provision to charge-offs and provision to loan balances) are warning signs. So too are increases in loan portfolio delinquency statistics. Remember, credit cycles play out over a long period of time.

-Minyan Peter
Coming Bank Themes: Whispers From the Confessional
Thanks to the annual Lehman Brothers (LEH) Financial Services analyst meeting this week we have some early clues on banking results for the quarter. Based on the presentations I have read, as well as related press releases, here are some themes that I think you will see at the end of the quarter.
  • First, expect a massive migration of “held for sale assets”, particularly non-conforming mortgage assets, into “held for investment” or “loan” categories. Some may even, as Washington Mutual (WM) did, try to portray it as “opportunistic portfolio growth”. But the reality is that the only way banks can avoid significant mark-to-market losses on mortgages they intended to sell, but can’t, is to move them into portfolio. And, remember, once these loans are in portfolio, related loan loss provisions are required. So you should expect higher provisioning even without any deterioration in credit quality, just due to forced balance sheet growth.
  • Second, expect fair value write-downs on assets held for sale. As I wrote in Banking 102: The Best of Times, The Worst of Times, please remember that these write downs won’t flow through the income statement, but through Comprehensive Income. Look, too, for changes in the composition of banks investment portfolios. I expect that you will see highly liquid securities swapped for conforming mortgage securities. And with the run up in Treasury prices, I expect that banks with long maturity Treasuries in their investment portfolios have sold them wherever they can to book gains this quarter.
  • ...
  • Finally, expect higher provision forecasts due to both forced balance sheet growth and deteriorating credit quality.
For example, at the Lehman Conference, Washington Mutual announced that it now expects a $2.2 bln provision for 2007. $2.2 bln is $500 mln more than it forecast in July and well above the $1.3 -$1.5 bln it forecast in April when it said that its provision forecast was “our best thinking regarding trends in loan delinquencies, foreclosures and housing valuations at this time.” WaMu’s latest forecast is also almost 2.5 times what it shared in its 2007 earnings outlook ($850 -950 mln) in October 2006.

-Minyan Peter
Thanks Peter!

A differing opinion can be found in Financial Sector: The News vs. The Numbers
We see three factors that could make XLF a very attractive investment for the second half of the year:
  • Earnings estimates are rising—not falling.
  • Actual results are strong.
  • XLF is cheap.
I am betting on the comprehensive analysis of Peter vs. opinions that earnings are going to rise. A focus on PEs ignores leverage, increasing write-offs, and balance sheet conditions. A compelling case has been made that we are at the top of the credit cycle which 100% of the time has spelled problems for the financial sector and stocks in general.

It is important to remember that the Financial sector is 20%+- of the S&P by weight and and that does not even count quasi-financial companies like GE and GM heavily dependent on financing operations for earnings.

Chris Puplava on Financial Sense is asking Will Financials Be to This Bull Market and Economy What Tech Was to the Last?
Secular shifts in a sector’s predominance in the S&P 500 can be seen in the figure below that highlights three different sectors that have had their period to shine.

Energy was the top performing sector in the S&P 500 [in 1980] with the sector’s weighting increasing substantially as investors chased the returns being made in the sector. However, as more energy supply came onto the markets at a time of falling demand due to high oil prices, the bull market in energy came to an end.

The next major bull market in U.S. stocks was seen in the technology sector in the 1990s. Near the start of that decade, technology represented roughly 6% of the S&P 500 and vaulted to a zenith near 33% by the end of the century. However, overcapacity and excesses in the industry ultimately deflated the bubble in which the technology weighting in the S&P 500 fell in half to roughly 15% seen at the bottom of the last bear market.

As mentioned above, there are fundamental factors that often lead to secular shifts in sectors, and the predominant factor that has led to an increase in the weighting of the financial service sector is the price of the commodity it sells -- credit. Since 1980 there has been a secular bull market in paper assets as interest rates and inflation have fallen. As interest rates reflect the cost of credit, falling interest rates have led to an increase in the demand for credit as it has become cheaper to borrow, which has fueled the growth within the financial sector.
Chris goes on to compare mass layoffs in the technology sector in 2000 with mass layoffs in financial services today. Here is an interesting chart from his article.

Chris has many other interesting charts in his article.
I encourage you to take a look.

The Quarterly Banking Profile Second Quarter 2007 shows that loan loss provisions are rising while higher expenses are holding down earnings.
Insured commercial banks and savings institutions reported $36.7 billion in net income for the quarter, a decline of $1.3 billion (3.4 percent) from the second quarter of 2006, but $772 million (2.1 percent) more than they earned in the first quarter of 2007. The decline in earnings compared to a year ago was caused by higher provisions for loan losses, particularly at larger institutions, and by increased noninterest expenses.

Insured institutions added $11.4 billion in provisions for loan losses to their reserves during the second quarter, the largest quarterly loss provision for the industry since the fourth quarter of 2002.

Net charge-offs totaled $9.2 billion in the second quarter, the highest quarterly total since the fourth quarter of 2005, and $3.1 billion (51.2 percent) more than in the second quarter of 2006. This was the second consecutive quarter that net
charge-offs have had a year-over-year increase.

The amount of loans and leases that were noncurrent (loans 90 days or more past due or in nonaccrual status) grew by $6.4 billion (10.6 percent) during the quarter. This is the largest quarterly increase in noncurrent loans since the fourth quarter of 1990, and marks the fifth consecutive quarter that the industry’s inventory of noncurrent loans has grown. Almost half of the increase (48.1 percent) consisted of residential mortgage loans.
The balance sheets and loan loss provisions of large cap financials like Citigroup (c), JPMorgan (JPM), Washington Mutual (WM) , Bank of America (BAC), and even smaller banks like Corus (CORS) will be interesting to watch as the credit bubble pops.

Most importantly, the answer to Chris Puplava's question is "Yes". Many signs are in place for Financials to be to This Bull Market What Tech Was to the Last.

Mike Shedlock / Mish

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