Reserve Releases Must End Soon For Banks

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Includes: BAC, C, FAS, FAZ, IYF, IYG, JPM, SEF, UYG, VFH, WFC, XLF
by: Sean Weston

During the pandemonium of the 2008 crisis large quantities of money were set aside by the nation's largest banks to protect against the threat of bad loans. As conditions gradually improved these reserves have been released, and it flows directly into the company's profits due to accounting rules. Obviously something of this nature can't continue in perpetuity, and when it comes to an end, banks are either going to have to find a way to make up the difference or take a hit to their financial statistics.

3rd quarter numbers show how reliant the banks are on reserve releases:

Bank of America (NYSE:BAC): $1.4 billion/ 29% of pre-tax income

Citigroup (NYSE:C): $.8 billion/ 18% of pre-tax income

J.P. Morgan (NYSE:JPM): $1.8 billion/19% of pre-tax income(disregarding their monstrous litigation expenses incurred during the quarter)

Wells Fargo (NYSE:WFC): $.9 billion/ 11% of pre-tax income

A good sign is that numbers aren't as high as they have been. Three years ago, 3rd quarter 2010 numbers saw banks like Citigroup receive over 90% of their earnings from reserve releases. In fact, of the 18 U.S. banks with over $50 billion in assets, nearly half, 48% of their 3rd quarter 2010 profits came from reserve releases.

Banks still have a sizeable amount left. Allowance For Loan Losses for Wells Fargo, which was in less trouble than others during the crisis, is $15.2 billion while Citi has more at $20.6 billion, for example.

Still, some feel the banks may have overextended themselves. One such critic is Comptroller of the Currency Thomas Curry. He states:

"Too many institutions are continuing to reduce provisions solely to boost earnings....."If provisioning continues at current levels and charge-offs remain constant, the allowance as a share of non-current loans could return to historical lows in just a few years."

As loan books are performing better than anticipated, with Wells Fargo having a loss rate of 0.48 last quarter, for example, less money is being placed aside each quarter to cover bad loans. Using Wells as an example once again, they only put aside $75 million in the 3rd quarter. As the money they set aside is much less than what is going out, reserves could eventually be required to be built back up.

Banks defend themselves, explaining they are simply following accounting rules which require them to release reserves as both economic and credit conditions improve. Critics state, however, that the practice is becoming habit forming among the banks, and there is some ambiguity over whether or not it is truthful that they are obliged to release all they do.

Regulators might become more assertive in taking steps to control loan loss reserves in the future. Industry groups, accounting oversights orgs and regulators have all recently been holding meetings to discuss proper actions for the issue.

This all comes at a time when revenues among the banks are falling near 10% as the refinancing boom comes to an end. Reserves are certainly a convenient source to draw from that can offset this. Regulators are right to worry some might become addicted to using it.

Out of the four banks, as usual Wells Fargo comes out of this looking more attractive. Much like last quarter, they've been relying less on reserve releases than the other three banks. While EPS numbers might have their growth stifled, the shares already have it more than priced in.

Absent from much of the stock market rally since the early summer, Wells Fargo sports a P/E of only 11.6 and trades around 1.5 times its book value. It's rare for a company to have such a healthy dividend of 2.7% with a payout ratio barely over 30%, leaving lots of room for growth. Aligning $1 in earnings to $15 in share price, thereby giving Wells a P/E more in line with its historical mean, yields a price of $57 for Wells. That is about a 30% increase from where it sits currently.

Disclosure: I am long WFC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.