Is Enough Enough?
What Bank Reserves Tell Us About Future Performance
By: James S. Still
Managing Director
With the stock market up by 18.9% percent through the end of November and “signs” of recovery on the horizon, financial institutions throughout the world continue their quarterly, if not monthly, chore of estimating loan loss reserves during the most challenging times in recent economic history. Estimating these reserves is analogous to determining the exact arrival time of a cross country flight dealing with head winds and thunder storms. In the United States alone, the largest lenders undertake this chore in a climate of unprecedented government intervention, recessionary conditions, and a daily barrage of possible new regulations.
Why are bank loan loss reserves important? These metrics assist stock analysts and the investing public in the process of estimating current and future bank performance for investment purposes. The degree to which a bank reserves against “bad loans” has a visceral impact on their willingness to extend capital in the future e.g. whether or not they will provide fuel in the form of debt capital to a struggling economy.
The metrics play a larger role, however, in helping to determine the level of capital a financial institution is required to maintain from a regulatory standpoint. According to John Greenlee from the Federal Reserve in November 2009, “Higher loan losses are depleting loan loss reserves at many banking organizations, necessitating large new provisions that are producing net losses or low earnings. In addition, although capital ratios are considerably higher than they were at the start of the crisis for many banking organizations, poor loan quality, subpar earnings, and uncertainty about future conditions raise questions about capital adequacy for some institutions."
According to published reports in the Wall Street Journal, the New York Times, and the Financial Times, a series of metrics can be used to determine the “appropriateness” of bank loan reserve levels.
The first metric is a simple dollar basis: how high or low are the actual dollar levels of reserves as compared to historical levels. Over the past 12 months, loan loss provisions took $157 billion out of earnings at the six largest financial institutions in the country by asset size: Bank of America, J.P. Morgan Chase, Citigroup, Wells Fargo, PNC Financial and U.S. Bancorp. That is roughly $120 billion more than they might annually set aside in a healthy economy, or approximately 3.5 times normal reserve levels.
A second metric is the percentage of bank loan loss reserves to total loans. Normally in the range of 3-4%, the current level at JPMorgan Chase is 4.74% of all outstanding loans and at Citi is at 5.85%. These are two of the higher reserve levels for the six largest institutions in the country.
A final, more subjective measure is one provided by research analysts at Sanford A. Bernstein. Calculated as a percentage of “expected losses” by Bernstein, this measure compares loan loss reserve levels to projected losses. Sanford Bernstein estimates that J.P. Morgan’s buffer is equivalent to 116% of estimated chargeoffs over the next 12 months, putting it second behind “market leader” PNC at 130%. Citi is estimated to be at a level of 109 percent of chargeoffs, placing it third in line, with Wells Fargo (104%) and Bank of America (90%) next in line.
An obvious moving target, loan loss reserve levels are evaluating and monitored on a frequent basis. In early December, U.S. Bancorp CEO Richard Davis provided information to analysts that the Minneapolis based bank will continue to add reserves at a steady rate in order to meet its loan loss requirements. In the third quarter alone, U.S. Bancorp increased reserves by 9%, a level that Davis indicated would likely occur in the fourth quarter of 2009 as well. This compares to a 32% increase in loan loss reserves by Wells Fargo in the third quarter 2009.
The increase in loan loss reserve levels is occurring in a climate where refinancing of existing debt is being largely satisfied not by traditional lending mechanisms but my high-yield debt. On a year-todate basis through the end of October, approximately $123 billion of high-yield debt has been issued in the United States alone. This level of high-yield debt issuance compares to only $48 billion on a comparable calendar basis in 2008 and at a level that threatens to exceed the record $143 billion that was issued in fiscal year 2006. While the availability of the high-yield debt is an encouraging sign for a market void of traditional debt vehicles, experts contend that the highdebt issuances are almost exclusively for renfiancing rather than for expansion debt. This does not portend well for an economy that is searching for signs of growth.
It remains unclear “how long the window will stay open” for weaker companies to borrow, said Barclays Capital restructuring chief Mark Shapiro. “Six months ago, no one thought that many of these companies could access the high-yield market.” For the time being, he said, it’s helping a lot of companies avoid “bankruptcies that would have otherwise occurred in the next year.”
For the lending community, the confluence of increased reserves and highly conservative lending creates a paradigm of activity that drives short-term strategy. For many institutions, the most important issue is to “protect” currently written down asset levels through good faith work with clients as these clients work to improve operational performance during trying economic times. In addition, however, the banks need to expand the scope of their relationships and solidify existing ones in order to provide a platform for growth moving forward. While the recent consolidation of the industry (Wells Fargo/ Wachovia; Bank of America/Merrill Lynch; PNC Bank/National City) has caused the larger institutions to increase market share, it is not clear that the impact of these mergers has resulted in increased lending activity through fiscal year 2009. The access to high yield debt, traditionally not the domain of the largest financial institutions, has in some ways masked the challenges facing the industry as it seeks to recover from the worst economic downturn since the Great Depression.
At MainStream Management, we view the challenges our financial partners face as both a need to protect and an opportunity to create value. Now, 18 months into this challenging economic recession, our view is that banks have recognized a considerable amount of “pain” through their increased loan reserves and are positioning themselves to maintain and expand client relationships through prudent loan extensions and careful workout arrangements. It is a rare opportunity to both protect the assets under management in a prudent manner while positioning for future growth in earnings and shareholder value.
For more information about MainStream Management, LLC or to discuss this article further please email info@ mainstreamllc.com or call 877.785.6888.