Economist Declares “Mission Accomplished” on Repairing Bank Balance Sheets

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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.

Richard’s comment:

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.

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    1. MindTheGAAP

      I really don’t understand the nuke idea–if someone really wants to bomb the thing, you’d think that conventional explosives (large ones, if need be) would be good enough. I don’t understand the infatuation with uranium warheads at the moment…

      1. Coldcall

        oh yeah, we just love uranium, its so cool! I want a jacket made out of the stuff, day-glo sort of thing :-)

        But seriously, i dont think conventional explosives have the energy to collapse the foundations of the gusher. I doubt they would use a small nuke unless it was really necessary anyway.

        1. aet

          IF they do use a nuke – and that’s dependant on geological formations, etc etc – I do hope that they get the risk -reward calculations right, THIS TIME.
          The delivery of the nuke to the depth required- which I guess would be some distance below the bottome of the sea- would also not be easy – most nukes are designed to fly through the air, not to submerge to a depth of 1000+ meters, and then to tunnel for some distance, and only then to explode.

  1. MindTheGAAP

    Yves here. It should be no surprise that US bank regulators are continuing to prop up banks,

    Actually, it should be a surprise–what the hell is banking regulation for?? (that’s rhetorical, btw). And the media has *always* given companies a free pass. Most only report the press releases. I ran into a supposedly “serious” business journalist for one of my country’s major news outlets and was shocked to find out that he didn’t even have a very basic understanding of how accounting worked–yet he reports on business earnings regularly. Given such ignorance, what can they post other than rehashed PR-issued garbage?

    Yet, whether the banks choose to recognize them or not, those NPAs are going to sink them. The English and Irish bank NPAs equate to roughly 10% of each country’s GDP. This is ludicrous (and this does not even include England’s exposure to Ireland itself), and given the rate at which both countries are likely to contract, it can’t be hidden much longer.

    Eastern Europe is in even worse condition (or, more specifically perhaps, the Western European banks that lent to Eastern Europe are in even worse shape). And since much of the money is repayable in Francs…

    This is all going to end very, very badly.

      1. MindtheGAAP

        True, but let’s hope it doesn’t regress back towards the mean:

  2. Coldcall

    The Economist, and many similar financial publications have lost all credibility. They almost on masse supported the euro, filled their editorials with brainless apologies of EU corruption, and even had the temerity to try to persuade the UK that it should also join.

    And now their theories completely and utterly falsified by current events.

    So anything the econoimist has to say is laughable.

    1. aet

      Aah, the Economist: they sure got Enron’s number wrong.
      They did apologize for their breathless, golly-gee-what-a-great-company-Enron-is reporting, did they not?

      I stopped reading them once I could predict their Editorial; stance, on any issue.
      Although they are quite good on the facts, usually.

      1. aet

        Personally, I am tried of attacks on Europe’s socil programs disguised as attacks on the Euro.
        Europe’s fine: it’s people in the US who are suffering most.

  3. tentman

    This sounds like another example which confirms my scepticism towards the quality of the work published by this weekly.

    Maybe they they lack the will to do independent journalism based on in depth research?

    One more sad point besides their often poor LatAm stories and their published unemployment rates at the end of each issue which are not always following “national definitions” even if they say they do.

  4. Bates

    aet…’The economy never ends: it only changes’…

    Certainly true, the world will continue to have an economy but it will not be one we will recognize.

    The soverigns have, in the main, shifted bank problems to the public (soverign) sector. The result is soverigns are at significant risk of default since they have too much debt to GDP to service… which leads inevitably to a loss of confidence in soverigns and eventually a currency crisis.

    In the future soverign bond holders will see the losses that they will be hit with if they remain in soverign bonds (see Greece, etc). When that happens bond auctions will begin to fail everywhere a soverign is perceived to have too much dept to GDP to service…pretty much everywhere, iow.

    When bond auctions of soverigns begin to fail the CBs will step up and print like never before…expanding their balance sheets many times over what has already occured. This CB action will bring the viability of most if not all fiat currencies into question.

    When the holders of soverign debt decide to sell their soverign bonds to avoid large losses, where will they park their wealth to avoid the oncoming currency crisis?

    If you have the correct answer to this question, you will have a glimpse of the new world economy.

  5. craazyman

    This stuff just gets worse and worse — on par with decrees from the old Russian Politburo.

    I’m seeing Obama now as some sort of African king with a pompous self-satisfied smirk, surrounded by feckless and pyscophantic advisers with no clue about nearly everything as they hide the truth even from themselves, presiding in secret and furtive bewilderment over a system helplessly descending into utter anarchy.

    And his relentless search for hagiographic interviews and messiah-like publicity tours are a modern version of the craving for deification that we sneer at as an anthropological fossil of an inferior consciousness when we see it combined with leopard-skinned robes and gold necklaces south of the equator in some jungle hell hole when a pychopathic narcissist bone-head with power over the army has a throne built for himself where he can sit and swing his big gold rod through the air while his generals and ministers accumulate cash in Swiss bank accounts and his people prey upon each other like cannibals (or banksters). ha haha ha ahhahaha ahahah.

    No, we’re not there yet and Obama’s not there, to be fair. This is a mind-cartoon. But it seems to my over-wrought sensibility that we’re edging closer, closer, closer . . . with each lie and each rationalization and each compromise with integrity.

    1. Doug Terpstra

      What a wordsmith: “psychophantic advisors”; love it.

      As Independent Accountant notes below, O’ is now somewhat reminiscent of Idi Amin Dada of Uganda, especially after recently approving “extra-judicial” assassination of US citizens—right out of Israel’s criminal playbook.

      D’oh! Did I say that out loud?

  6. charles

    A view from Europe; Eric Sprott came up with this leverage
    for the top German banks, seems like nothing has changed
    The euroskeptics, Münchau and A.Pierce-Ritchard have been commenting of late on this 800 billion writedown estimate which the Bafin came up with in early 2009 for the German banks
    Of course, we all understand how American banks prop up their balance sheets, mysterious remains to me how they manage in Europe. BNP Parisbas, which is among Europe’s top ten banks in terms of balance sheet size, is viewed by many analysts as being under Tier 1. Lax supervision
    Der Spiegel ran a story over the week-end, alas only in German, about a “French plot” with the ECB mostly buying its
    Greek bonds from French banks
    The New York Times ran an Oped yesterday on Europe’s endangered banks:

  7. Indepenent Accountant


    See the “Last King of Scotland”, 2006. I’m sure Obama’s seen it a dozen times!

    What is bank regulation for? To pretect the bankers from Pat Buchanan’s peasants with pitchforks! Laugh

  8. Robert

    It seems to me that by artificially depressing interest rates the Fed (and other central banks) are forcing bank depositors to make involuntary contributions to the capital of financial institutions for which they do not receive adequate compensation. The spread between the handful of basis points paid to the depositor and the interest earned on the Treasuries purchased with these deposits is not really income of the financial institution. At a minimum, the depositor should receive stock in the financial institution. I would not mind receiving such a low return so much if I thought some public benefit would result, but I don’t see it.

  9. RueTheDay

    All the talk about how profitable the big banks have become is absurd. It’s not difficult to show large profits when you can borrow an almost unlimited amount of money from the Fed at 0.25% and buy risk-free Treasuries at 3.6%. Unfortunately Joe Sixpack in America is too dumb to understand this and so thinks everything is ok now (because the market fixed itself, not because of Obama’s communist policies, or whatever it is Glen Beck is ranting about today).

  10. Doc Holiday

    Bank earnings at this point, are a no-brainer misnomer. Ever since FASB joined hands with SIFMA and Disney, accounting and earnings reports have been nothing less than digital animation and magic voodoo – and if it looks too good to be true that banks can fly and that banks have a new piper tune … well, get yur jammies on and make a wish ….? Can we all give a big AMEN to the dark forces of wall street who now reside in DC?

  11. Hugh

    I agree with Doc Holiday. The books are cooked. The banksters are unreformed and still in place. The casino has not been closed. Assertions that balance sheets have been repaired are meaningless.

  12. Blurtman

    Taking a contrarian viewpoint, if your goal was to rescue the banks, then allowing them to borrow at 0.25% to invest in Treasuries at 3.5% would seem to be a successful strategy.

    Changing the accounting rules to disguise technical insolvency buys time for the banks to recover.

    I don’t like it, but it seems to be a strategy that is working, although that depends on what one’s defiinition of “working” is.

    1. Bates

      “Changing the accounting rules to disguise technical insolvency buys time for the banks to recover.

      I don’t like it, but it seems to be a strategy that is working, although that depends on what one’s defiinition of “working” is.”

      Does anyone believe that any economy can recover from a credit crisis with CB rates held at zero? The problems of holding at zero are manifest and are seldom recognized before they strike.

      Discussion of bank insolvency is mute at this point. The problem has been shifted onto soverign states that are also soon to be bankrupt because they cannot print money indefinitely without punishment by soverign debt holders. If central banks attempt to step up the printing and blow out their balance sheets to 50-100 times their current bloated level the currencies fail. It no longer matters that the banks are insolvent because the Western Nations are insolvent and when failed bond auctions begin the banks are going down along with the soverigns.

      Kick the can is nearing conclusion. Discussing problem banks is now a waste of time.

  13. Doug Terpstra

    That balance sheets are not repaired at all is widely known, except on CNBS and MSM. On one count alone, “marking assets to bullshit”, Karl Denninger posts the following stats in “The Housing Fraud Continues”:

    “The percentage of older delinquent loans not yet in foreclosure is startling: 60% have at least 12 missed payments, and 35% have at least 18 missed payments. Add to this that three-fourths of delinquent loans are not in foreclosure, and we see that hidden losses well exceed those in the open.”

    35% of mtg delinquencies with a year and a half of missed payments and still not foreclosed??? If Denninge’s stats are correct, it’s a frightening pit we’ve fallen into, financially and morally, with slippery walls. Another black hole event horizon is right around the corner.

    It’s a wonder Benny and Timmy can sleep at night. There must be some deep fear driving this level of crime. Incredible.

  14. Lineman

    Its been amazing to watch the complex edifice, erected by Larry, Ben and Timmy to save the US economy, morph into a global crisis that has the Treasury Secretary globe hopping. Of course, he releases photos of himself playing basketball with the Chinese to underscore the lightheartendness of his trip. The question now is from where will the next mole emerge in this now global game of Wack-A-Mole, the EU, Eastern Europe, China, US cities/states, or some new and unanticipated corner of the financial world.

    1. Richard Smith

      Well, if there’s anyone suffering from confirmation bias, it’s me. But I am trying to fight it.

      The Basel III manoeuvring is only just starting.
      For instance there’s a shot across the bows from the BIS here

      Or if you want a very different reading of what Geithner’s up to you could try this:

      Whatever you the likely outcome will be, this is an arm wrestle between those who want tighter regulation and those who don’t. Pretty darned obvious.

      A key tactic for those who don’t want tight regs will be to exploit the international dimension. This is a time-honoured gambit and it looks as if it is being used again. Worth watching.

    2. Yves Smith Post author

      Perhaps, but I suggest you read the ECB’s just released Financial Stability Report. It is most decidedly downbeat re the health of banks.

      I have independently have had bank employees write me telling me how much toxic assets have been written up, to levels well above what the banks’ own models say they are worth (and I mean massively above, mind you).

      Josh Rosner and Chris Whalen, who know the financial services industry cold, both think the picture painted by bank balance sheets is FAR more rosy than their true condition.

      The data points that keep coming to me from credible sources are negative. So it’s more likely to be sample bias.

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