Reader Richard Smith provided a sighting of bank boosterism, courtesy The Economist:
The happy secret of Western banking is that the system in aggregate now has lots of capital (see chart) relative to the net losses experienced over the crisis. The kind of erosion of capital forecast by the Federal Reserve’s stress tests last year, for example, has simply not materialised. That means the Basel club can legitimately argue that banks in aggregate do not need to raise much new capital.
You know, I’ve got an idea why these losses might have simply not materialized. I have a little hunch that assets not marked to market, assets reinflated by ZIRP, assets sliding onto Government balance sheets via purchase programs, and loans not foreclosed, might all have something to do with it.
Yves here. That’s accurate. When you look at bank earnings, they are due almost entirely to revaluation of assets, yield curve arbitrage (super low rates, courtesy the Fed and other obliging central banks, has produced particularly fat profits from what used to be called “borrow short/lend long” but today looks more like “borrow short/park dough in Tresuries”) and underreserving. Only the yield curve arb is real cash earnings; the rest is accounting fictions (although the Treasury and Fed keep claiming that the current elevated prices of toxic assets are real, and their former values were irrational). We’ll turn the mike over to hedge fund manager Scott on the subject of underreserving. From his March 31 letter to investors:
FDIC-insured banks collectively showed profits of a little over $900 million dollars in their recently-reported fourth quarters. They made money! How did they do so? They reduced reserves for bad loans by $1.7 billion, even as the number of their past due loans increased. The FDIC’s press release notes that “asset quality indicators worsened in the fourth quarter” and net charge-offs (write downs of bad loans) increased by $2 billion, but the reserves banks established against future losses fell by $1.7 billion from the third quarter. Had banks simply maintained reserves at a constant percentage of delinquent loans, their $900+ million profit in the quarter would have been transformed into a loss of over $6 billion.
Yves here. Annaly Salvos, in “Bank Profit Mirage III: From FASB With Love?” provides more detail:
May 20th saw the release of the FDIC’s Quarterly Banking Profile (QBP) for the first quarter of 2010, trumpeting the headline: Industry Net Income Improves to a Two-Year High of $18 Billion. As we’ve shown in previous quarters, the banks have been serially under-reserving for losses in order to show headline profits, despite non-performing assets (NPAs) that continue to rise. We expected a similar story in the current quarter, and indeed we are told that provisions fell in the first quarter in the face of increasing NPAs. In fact, for the first time since 2005, provisions didn’t even cover charge-offs for the period….
As the graph shows, there has been continued credit deterioration, but the coverage ratio improved thanks to the large increase in reserves. The reserve against loan losses showed a build of $34.5 billion during this quarter, by far the largest single quarter build ever recorded (even larger than 2Q 2008’s $23.3 billion). But wait, the FDIC press release stated that the banks recorded profits of $18 billion as a result of reduced provisions against loan losses. And we already know that charge-offs exceeded provisions during the quarter. Maybe you’re asking the same question we are: so how did the banks manage to build reserves, when provisions fell short of charge-offs?
Spoiler alert: it’s related to the implementation of new accounting standards. In simple terms, the adoption of FAS 166/167 requires that beginning January 1, 2010, companies must bring certain off-balance sheet entities onto their balance sheets. We’ve mentioned this before as it relates to the weekly Fed H.8 report, so we won’t go into more detail here.
According to the FDIC QBP press release (emphasis is our own):
“The large jump in reported reserves was associated with the requirements of FASB 166 and 167, as affected institutions converted equity capital directly into reserves. The increased reserves caused the industry’s “coverage ratio” of reserves to noncurrent loans and leases to increase for the first time in 16 quarters, from 58.3 percent to 64.2 percent, even though slightly fewer than half of all insured institutions (49.2 percent) improved their coverage ratios during the quarter.”
This reduction in equity capital clearly didn’t flow through the income statement, as reserve builds normally would. That’s because in the adoption of FAS 166/167, companies aren’t required to run these kinds of losses through the current year’s income statement; instead, a one-time adjustment is made in retained earnings on the balance sheet. The rules don’t require restatement of prior period earnings, but strangely enough, there were substantial revisions to previously reported numbers. Remember last quarter’s happy headline of $914 million in profits? That’s been revised away and now stands at a loss of $1.3 billion. The other 3 quarters in 2009 feature nearly $3.5 billion in additional downward revisions to previously reported earnings. We have to assume that these previous restatements are unrelated to the accounting change, but we are simply unsure and there are no notes about previous restatements in the release…
Lest we forget our usual FDIC reserve math machinations: even after this quarter’s stealth reserve build, it will take $146.4 billion of future earnings to simply get the coverage ratio back to 100%. That’s one hell of a headwind.
Yves here. In other words, those peachy-looking bank earnings don’t stand up under close examination. Which takes us back to the main thread, the happy talk from The Economist:
Where Basel 3 will almost certainly have to retreat is in its proposal to force banks significantly to cut their structural reliance on short-term funding. Credit Suisse reckons the regulators’ proposed “net stable funding ratio” would require European banks to raise €1.3 trillion ($1.6 trillion) of long-term funding. Even over the course of several years, finding enough deposits or issuing enough bonds to meet that requirement is a hair-raising prospect—not least because of regulators’ parallel efforts to remove the implicit guarantee that bank creditors still enjoy.
As Richard Smith observes:
In other words, The Economist thinks there’s not much of an appetite to dismantle the European shadow banking system. And with the US financial reform program leaning hard on the promise of Basel III, I’m sure American banks will be quite happy that the stable door is going to stay wide open. Tim Geithner too, perhaps: things seem to be panning out as suggested in my last post.
Yves here. It should be no surprise that US bank regulators are continuing to prop up banks, but it’s disappointing when the media gives them and the bank earnings phony-baloney they enable a free pass.