Never Mind Good Earnings -- Banks Still Face Dangerous Credit Losses

What might “The Closer’s” ace detective Brenda Johnson glean from what these senior bank officials said this month in discussing their respective companies’ latest earnings?

“I would say consumer charge-offs may be close to peaking in dollar terms around year-end, although we believe it will stay elevated post to peak.” –Ken Lewis, CEO, Bank of America

“We continued to build our allowance for credit losses, totaling $23.5 billion, which included a $700 million credit reserve build in the second quarter.” –Howard Atkins, CFO, Wells Fargo

“Looking to the second half of 2009, we are seeing some signs of moderation in the growth of net credit losses, which in turn could result in lower additions to loan loss reserves.” –John Gerspach, CFO, Citigroup

“We did have the negative trends in the charge-off rate….” –Michael Cavanagh, CFO, JPMorgan Chase

First off, Brenda would notice that our execs are all suggesting that bank “credit,” meaning their outstanding loans (and discounts, technically), continues to be a sort spot. To be sure, the rate at which customers are falling behind on their payments or defaulting altogether is slowing.

But from the bankers’ statements it’s clear these institutions won’t be out of the woods for several quarters, which is why they continue to sock away capital to offset projected losses. That’s best-case scenario, and it assumes economic conditions don’t tank. In making their latest forecasts, some big banks project a 10 percent U.S. unemployment rate, while many economists expect it to rise much higher.

The detective would also zero in on this implicit issue of earnings quality. In gauging how banks will fare over the next couple years, the usual benchmarks of corporate performance — earnings per share, profit margin, revenue growth — matter far less than other metrics. Perhaps the most important of these are the delinquency rates on mortgage, commercial real estate and other loans, along with the risk that the company will have to write them off.

Take Wells Fargo. Obviously, for the bank and investors it’s good news that revenues rose 28 percent sequentially in the second quarter, while net income surged 47 percent from the year-ago period.

No matter how lustrous, though, such figures tell you more about past performance than the perpetually murky future. The company’s results look less shiny if you notice that its level of charge-offs, meaning loans written off as bad debts, increased 35 percent from the first quarter, while its nonperforming assets soared 45 percent. That, in turn, could require Wells to build its cushion against bad debt, which can ultimately crimp earnings.

Girding for such problems, Wells added $700 million in reserves in Q2. The company thinks that’s sufficient to cover a year’s worth of expected losses on consumer loans and 24 months of losses in its commercial and CRE portfolios. But will it be enough? No one knows.

Other big banks exhibit similar symptoms. B of A’s second-quarter earnings fell as losses rose in its credit card and residential mortgage businesses. The company’s commercial loans backing retailers and office properties also continued to suffer. At Citi, net credit losses rose to a hefty $5.2 billion on higher mortgage-related losses.

For these companies — indeed, for the banking sector as a whole — the future depends in part on when charge-offs peak, whether corporate bankruptcies rise and how the job market fares, among other factors.

So can we join the chorus calling an end to the banking crisis? As Brenda might say, no thank yooouuuu.