Jubak's Journal
Has Congress sparked a banking crunch?
Sarbanes-Oxley reforms make it's nearly impossible for banks to prepare for the credit cycle's turn. Banks are forced to cut reserves for bad loans just when they need them.
By Jim Jubak
Remember Sarbanes-Oxley? The act Congress passed in 2002 was intended to prevent accounting fraud like that perpetrated by Enron and WorldCom. In the banking sector, though, the law designed to ensure that companies report numbers that accurately reflect their financial conditions is instead forcing banks to paper over problems they know are coming.
The unintended consequence of post-Enron accounting reform could be a meltdown in the U.S. banking sector.
How do I know? Bankers themselves (and several accountants doing work for banks) have told me so in e-mail responses to my Sept. 9 column, "Do-nothing Fed is dangerously disengaged."
In that column, I took the Federal Reserve to task for talking the talk when it came to blaming consumers for a potential housing bubble, but for failing to walk the walk when it came to banks and other lenders who were relaxing credit quality standards so they could make more and more loans to less- and less-qualified borrowers.See the news
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Many banks were making the problem worse, I wrote, by decreasing the money they set aside to pay for future loan defaults. The Fed's failure to put pressure on banks to toughen lending standards and to reserve more, I continued, meant that when the current easy-money credit cycle turns -- as credit cycles always do -- and the less-qualified borrowers default on their loans in higher numbers, the mess might be bad enough to endanger some banks.
In their e-mails, the bankers took me to task. Not for criticizing the Federal Reserve, but for missing the bigger story: That's the way that the Sarbanes-Oxley accounting reforms have made it just about impossible for banks to prepare for the credit cycle's turn. Accountants and the Securities and Exchange Commission (SEC) are applying Sarbanes-Oxley in a way that forces banks to cut reserves for delinquent and bad loans just when they need to put money aside for the rainy days that will come, these bankers say.
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A rough ride on the credit cycle
The problem begins with the credit cycle. At the top of a credit cycle, borrowers have plenty of cash, make their payments on time and pay back their loans without difficulty. It helps that at the top of a credit cycle, money is plentiful and cheap -- thanks often to the Federal Reserve -- so that borrowers are getting their loans at very low interest rates and have relatively modest interest payments.
In this environment, banks and other lenders see the number of delinquent loans and the number of loans that actually go into default drop. Banks cut their reserves for bad loans and see their earnings rise as a result. Beguiled by this level of loan performance -- and often, at this point in the cycle, with lots of money to lend -- lenders stretch their credit standards and make loans to borrowers that they would have previously rejected as too risky.
But these sunny days don't last forever. Maybe the economy slows so that borrowers have less cash flow to use to meet their obligations. Maybe inflation rises, forcing borrowers to pay higher material prices (if the borrower is a business) or higher fuel and heating costs (if the borrower is a consumer) rather than paying back debt. Maybe interest rates go up, so that the monthly payments on floating rate and short-term debt start to rise. Or maybe all of these things happen at once.
Gradually, the number of delinquent borrowers begins to rise. Gradually, the number of loans in actual default begins to rise.
As that happens, banks increase their bad-loan reserves. They raise the rates they charge to borrowers to reflect the higher costs of doing business -- and the greater risk in a loan. They tighten up their lending standards, now denying loans to potential borrowers they would have gladly approved at the top of the cycle.
At some point, the credit cycle bottoms. Tighter credit quality standards reduce the number of loans outstanding and thus the number of bad loans. Banks, seeing fewer defaults, stop increasing their reserves for bad loans. And they gradually look for more lending opportunities, often first offering their best customers more capital at better terms.
Right now, a number of historical measures indicate that we're near the top of the credit cycle. At individual banks, charge-offs for bad loans have hit historic lows. At KeyCorp (KEY, news, msgs), for example, charge-offs for bad debt in the second quarter were the lowest in the bank's history. According to FIG Partners, the loan-loss reserves at the country's 50 largest banks are now lower as a percentage of loans than at any time since 1990.
So sometime soon, we're due to take a turn from the top of the cycle toward the bottom.
A ban on rainy-day funds
The distance from the top to the bottom of the cycle depends on many things. The general economy, for one. The growth in money supply controlled by the Fed. The number of loans made with lax standards that later go bad. The foresight of banks in putting away reserves while the sun shone at the cycle's top for the inevitable rainy days at the cycle's bottom.
If banks have put away too little at the top, they will have much less ability and desire to make loans at the bottom, when they have to rush to put extra cash into their underfunded reserve funds. If the underfunding was bad enough, a bank or two may even fail, sending a wave of gloom through the banking sector that can deepen the bottom of the cycle as fearful banks refuse to lend.
And that under-reserving at the top of the credit cycle is exactly what my banker correspondents worry is happening right now, thanks to the way accountants and the SEC are interpreting Sarbanes-Oxley.
"In past cycles, we have 'squirreled away' loan-loss reserves in the good times to absorb the impact of the inevitable deterioration in credit quality at the end of the cycle," wrote one e-mailer who has been a bank director for more than two decades. "This is exactly what a fiscally sound business would do. However, 'it's different this time,' for reasons that go right back to Sarbanes-Oxley."
Bank directors and officers want to increase the bank's loan-loss reserve, my correspondent wrote, to keep pace with the growth in the bank's portfolio of loans, but the bank's public accountants won't allow it. The accountants say that the bank can only put aside reserves if it can identify specific loans that will go bad. Putting money aside as unallocated reserves -- reserves that aren't attached to a specific problem loan but are designed to head off a future turn in the credit cycle -- aren't allowed by Sarbanes-Oxley, the accountants have decided. Unallocated loan-loss reserves are an attempt to smooth earnings of exactly the kind that is prohibited by Sarbanes-Oxley.
I'd pass this off as a problem at one bank that has an especially dense auditing firm except for two things: 1) I heard the same story for a number of different banks, and 2) all of these bankers noted that the SEC has come down on the side of the auditors.
There's been a battle inside the banking industry between federal and state bank regulators on one side and the SEC-backed accountants on the other. The bank regulators have argued, from their own experience, that banks must put aside extra reserves at the top of the cycle, while the accountants have argued that putting aside these reserves violates current securities regulations under Sarbanes-Oxley. And recently, after much struggle, according to my correspondents, the bank regulators have given in.
The auditors' big gun
They aren't done grumbling to the banks that their reserves are too low, but for all intents and purposes, banks now have to follow the interpretation on reserves put forward by the accountants and the SEC. The accountants and the SEC also have a very big gun that they can hold to a bank's head: Violate their interpretation of how to account for reserves and get no audit certification. No audit certification, no listing as a publicly traded security.
The accountants and the SEC aren't doing this on a whim: Their position does have a certain logic. The SEC argues that investors don't get a true picture of a bank's financial performance if the bank can tap a large loan-loss reserve anytime a loan goes bad. That would have the effect of preventing a hit to current income. Investors get a truer picture, the securities regulators argue, if they can see a fluctuation in the bank's income statement when a loan goes bad.
I don't find that logic convincing. Taken to its conclusion, you'd have to argue that a bank shouldn't run any loan-loss reserve at all because any loan-loss reserve "hides" income fluctuations from bad loans. It's only honest to show investors all that volatility.
But banks don't have a duty just to investors in their publicly traded stocks. They also have depositors, and loan-loss reserves are designed to protect them from exactly the kinds of fluctuation that the accountants and the SEC want to emphasize. Running a "sound" bank has always meant putting enough aside to cover the losses that the bank can project from its experience as a lender. Jim Jubak's newsletter
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The rules, as interpreted by the accountants and the securities regulators, would prevent banks from using their experience of financial history to protect depositors from the volatility of the credit cycle. And, frankly, given the very limited experience banks and other financial institutions have with new products such as interest-only loans, I think depositors are going to need all the protection they can get.
This isn't the way accounting reform was supposed to work.
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Updates
Sell XTO Energy
Well, XTO Energy (XTO, news, msgs) is not quite at my December price target, but I can't see a reason to hang around for three months to get that final 97 cents a share -- especially since I think we're in for a spot of moderating oil prices. XTO Energy is up 51% since I added the stock to Jubak's Picks on Jan. 28, 2005. At this price, the stock is now more expensive than many of its peers, and I think it's likely to perform no better or worse than the average oil production stock for the next year or so. I'm moving the money from this sale into Dril-Quip (DRQ, news, msgs), a late-cycle oil-service stock that I think will outperform as we run to the peak of this oil cycle, whenever that may be.
Buy Dril-Quip
Dril-Quip gets its biggest surge in revenue relatively late in the oil-drilling cycle, which makes this a good time to buy this stock. As drillers and service companies work through inventory and see their order books fill up, they place more orders for Dril-Quip products such as specialty casing connectors, mud line suspension systems and sub-sea wellhead connectors, where Dril-Quip owns about 30% of the market. The company has doubled its manufacturing capacity since the last peak in the oil-drilling cycle (1998) and now has the capacity to deliver about three times as much revenue as it did in that year. Dril-Quip has just sold its first integrated undersea system, breaking into a $1.2 billion market that further increases the company's revenue opportunities over the next two to three years. I'm adding Dril-Quip to Jubak's Picks with a target price of $51 a share by December 2005. I'd set a stop-loss at $38. (Full disclosure: I will buy shares of Dril-Quip three days after this column is posted.)
New developments on past columns
4 stocks with real value in real estate
On Sept. 14, Rayonier (RYN, news, msgs) announced a 3-for-2 stock split effective Oct. 17. More telling to me, since it’s a vote of confidence in the company's long-term cash flow, the board of directors voted to increase the company's quarterly dividend by 13.7% to a post-split 47 cents a share. (That's equivalent to a pre-split 70 cents a share, up from the current pre-split 62 cents a share.) The increased dividend will be paid on Dec. 30 to shareholders of record on Dec. 9, 2006. (Full disclosure: I own shares of Rayonier.)
6 stocks for a second-half growth rally
On Sept. 7, Komag (KOMG, news, msgs) confirmed its earlier guidance for the third quarter. The company is running at full manufacturing capacity, which will produce third-quarter revenue equal to that in the second quarter and a net margin of 16%, slightly below the 16.6% margin in the second quarter. The company continues to report good progress on its efforts to increase production to 31 million disks by the first quarter of 2006 and to 40 million by the end of 2006, from current capacity of 27 million disks. As of Sept. 16, I am keeping my price target of $48 by December 2005 on these shares and removing my stop-loss. (Full disclosure: I own shares of Komag.)
Editor's Note: A new Jubak’s Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Komag and Rayonier. He doesn't own short positions in any stock mentioned in this column.
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