There is a great and troubling little post up at Annaly (hat tip reader Scott) which confirms that all is far from well in bank-land. This story is consistent with the negative readings coming from bank maven Chris Whalen, whose latest proprietary stress ratings based on FDIC call reports found that :
the far worse result for our Stress Index survey vs. Q2 suggests that levels of stress in FDIC insured banks are continuing to build, from multiple factors, even as the subsidies that make the large banks look less risky are being withdrawn.
The issue it focuses on is the profits-goosing strategies employed by banks, namely underreserving. Just as retail stores haircut their revenues to allow for returns, so to do banks provide for a loan loss reserve (an expense item) in anticipation of losses. Loan losses are just as much a part of doing business for banks as returns are for retail stores.
Annaly tells us that the FDIC Quarterly Banking Profile show that loan loss reserves, although higher than the level of 3Q 2008, is lower than the levels of 1Q and 2Q 2009. And that is cause for pause:
If we had improving (or at least steady) credit performance, or a banking system that was already adequately reserved, falling provisions wouldn’t be a red flag. But we don’t. The chart below is an old favorite of ours, one you’ve seen before and one you’re likely to see again (click to enlarge).
It confirms that credit performance continues to deteriorate and the coverage ratio is certainly not what we’d call adequate for any scenario other than a rosy one. As non-performing assets and net charge-offs climb unabated, a lower loan loss provision (one that is lower than 2 of the previous 3 quarters) cannot be justified. If banks had held their coverage ratio steady at 63.6%, where it was in the previous quarter, this would have called for an additional provision of $12.9 billion, which more than wipes out the $2.8 billion in “profits” for this quarter. Instead, to produce those headline profits, the coverage ratio drifted further south, to stand at only 60.1%. It’s impossible for outside observers to say what level of reserves is adequate to cover future losses. After all, if a loan is collateralized, losses won’t total 100% of the loan. We can’t say what the “correct” amount of provisioning is, but it isn’t 60%. The average coverage ratio in the nearly 15 years before the crisis began is roughly 140%. The current coverage ratio won’t do, not when credit continues to deteriorate (and not if you want an active and lending banking system).
Extend and pretend…..and this pattern clearly shows that the regulators are enablers.