New Threat: Loan Losses

New Threat: Loan Losses

By PETER EAVIS
April 22, 2008; Page C3

The next earnings nightmare for banks has begun.
Until now, losses at many banks have come from multibillion dollar write-downs on toxic debt. But analysts believe the costs of building bad-loan reserves could cause just as much pain -- and for a lot more banks.
Banks establish bad-loan reserves as a cushion against expected losses on defaulted loans. Additions to these reserves, called "provisions," get booked as an expense in a bank's income statement and reduce earnings.
Now, as the economic downturn starts to bite, rising defaults are prompting banks to add larger sums to the reserves, a development that has hurt first-quarter earnings at some lenders.
Bank of America Corp. is the most recent victim. The bank's first-quarter earnings, reported Monday, were worse than expected because of a $6 billion addition to its loan-loss reserve. That expense dwarfed the bank's $1.31 billion of trading-related losses in the quarter -- an indication that reserve building is taking over from write-downs as the newest big threat to earnings.
To be sure, investors have been expecting bank earnings to get whacked by bad-loan reserves. But, as Bank of America's first-quarter numbers show, that expense can cause a lot more pain than the market anticipates. And, if defaults continue to rise, banks may have to make large, earnings-depleting additions to their reserves for several quarters.
"It's a good thing that banks have started to reserve more," says Kevin Fitzsimmons, banks analyst at Sandler O'Neill & Partners. "The bad news is that they are going to need those reserves."
The size of the provisions is based on a bank's analysis of default history and forecasts of the loans on its balance sheet. Provisions build up the reserve, but when a bank decides a loan is uncollectible, the loss on that loan is realized. That realized loss -- or "charge-off" -- is subtracted from the reserve, making it smaller.
So if a bank had a loan-loss reserve of $100 million at the end of the fourth quarter and $25 million of charge-offs, it would need a $25 million provision to take it back up to $100 million.
But if that bank thought loan defaults were going to get worse, it might want to add more than that to take the reserve above $100 million.
While Bank of America shocked investors with a big provision Monday, it may have some benefit if it convinced investors that management is being conservative and taking its lumps when it should.
Two yardsticks make it look like Bank of America is girding itself well amid the credit storm: First, its loan-loss reserve was equivalent to 1.71% of loans and leases at the end of the first quarter, up from 1.33% at the end of the fourth quarter. And its $6 billion provision was well in excess of its $2.72 billion of annualized charge-offs in the period.
If defaults at Bank of America continue to go up, it may turn out to be under-reserved. "Based on what we know today and what we're seeing in the market, we believe our reserves are adequate," a BofA spokesman says.
Wells Fargo reported earnings April 16. Oppenheimer analyst Meredith Whitney argued Monday that Wells Fargo's bad-loan reserve looked too low.
A Wells Fargo spokeswoman declined to comment on the report but referred to the bank's first-quarter earnings statement, which said: "We believe the allowance was adequate for losses inherent in the loan portfolio at March 31, 2008."