Bank stocks: important article, describing how banks resort to creative accounting to hide their rapidly mounting loan loss problems. in other good news for the bears, Marshall Acuff has just stated how unwaveringly bullish he is...and he has plenty of company, after all, what's not to like?
fortune.com
Bank Stocks Get Soft
As bad debt looms, banks are using creative accounting to hide their exposure until it's too late. Here's how to avoid getting squeezed.
Janice Revell
The old saying "Things are not always what they seem" has never been more true than in the bank sector lately. Take, for instance, the December bombshell dropped by UnionBanCal, a West Coast regional lender that looked healthy enough—then suddenly announced that greater-than-expected loan losses would all but wipe out its expected fourth-quarter earnings. Or a similar disclosure by Bank of America that an abundance of lousy loans would cause it to miss its fourth-quarter profit forecast by as much as 27%.
Unfortunately, the trend is likely to get worse before it gets better. Under unrelenting pressure these past few years to show earnings growth, U.S. banks have been pushing the envelope, eagerly making loans in situations that required near-perfect economic conditions or else the borrowers would risk default. Now, with evidence piling up that the economy is slowing down, defaults are predictably on the rise, and it looks as if a lot more bad debt could soon come home to roost.
Complicating all this is the fact that banking companies have gotten clever about hiding their problems from all but the most savvy financial sleuths. "Banks have a much greater ability than most industrial companies to manufacture earnings and present the world with whatever picture of reality they want to," says Sean Ryan, an analyst who has worked at both Banc of America Securities and Bear Stearns. After all, says Ryan, "if your product is cars and you're not selling them, then people can see them piling up in your warehouse. But if you're a bank and your primary product is essentially risk, nobody understands it all that well."
A quick lesson in terminology is probably in order here. On every bank's balance sheet is an "allowance for loan losses." That number reflects the liability established on the balance sheet to cover potentially bad loans. Along with that is the "provision for loan losses"—the amount of money the bank adds to its reserve each quarter. The loan-loss provision appears in a different place, as an expense on the income statement. And the higher the provision, the lower a bank's earnings will be. That's why banks trying to pump up their earnings will sometimes skimp on the safety factor.
In theory, a bank's loan-loss reserve should be high enough to cover any current bad debt, plus an estimate of future losses. But reserve ratios—reserves as a percentage of total loans—declined steadily throughout the late 1990s, indicating that many banks were padding their earnings and running the risk of getting thumped by defaults.
That's even more troubling given the timing: Reserve ratios declined even as banks signed up risky commercial loans at a record pace. In October federal regulators reported that "adversely rated" large syndicated loans—meaning problematic loans totaling more than $20 million and shared by three or more banks—had risen to $99.6 billion in 2000, more than double the level in 1998.
"At the very wrong time of a cycle, banks were underproviding for potential losses," says David Stumpf, a bank analyst at A.G. Edwards. The short-term payoff was earnings that looked better than they were, but "you can only play that game for so long before it catches up to you," Stumpf says. And despite the list of banks that have already confessed to looming credit problems, many analysts think the defaults are far from over. "The discovery of credit deterioration is just in its infancy stages," says Charles Peabody, an analyst at Mitchell Securities.
In addition, banks have a few tricks besides manipulating loss reserves, say analysts. "Accounting-wise, we're getting real creative lately," Stumpf says. For example, some banks will simply move their dodgy loans into a different accounting category, known as "held for sale." That removes them from the dreaded "nonperforming asset" classification, which gets scrutinized by analysts and regulators alike. First Union, for example, transferred about $450 million in problem loans that would otherwise have been classified as nonperforming to held-for-sale status during the second quarter of 2000. That cut its nonperforming assets by a third. Not bad for simply moving some numbers around on a financial statement.
To be sure, unloading problem loans can be a sound business strategy. But when those loans are transferred to held-for-sale status, the resulting write-down in value—often significant—typically gets reported as a restructuring or nonrecurring charge, not as an operating item. Maneuvers like that are common, even though they raise eyebrows on Wall Street. "These banks are in the business of lending money," Stumpf says. "That's why they open the doors every day. If you've got a loss as a result of being in that business, it's an operating item." A First Union spokeswoman responds that the moves were clearly disclosed in its SEC filings and in full accordance with accounting rules.
So with all these financial gymnastics going on, what can bank investors do to avoid any unwanted surprises? Stumpf recommends that you read the notes to the financial statements and then do some back-of-the-envelope calculations.
First off, pay close attention to the loan-loss reserve ratio. (Again, you get this by dividing the loan-loss reserve by the total loans outstanding; both numbers are on the balance sheet.) Different banks carry different levels of risk, so it's tough to compare them or to say that a specific ratio—say, 2%—will guarantee safety for all banks in all situations. However, you can use this ratio to measure a bank's present situation against its recent history. If the ratio is declining, it could be an indicator that the bank is cannibalizing its reserve to artificially prop up earnings. For example, Bank of America's reserve ratio at the end of the third quarter of 2000 showed a noticeable decrease from the previous year's. Yet over the same period the total amount of Bank of America's loans increased dramatically.
Second, while they may not make for the most scintillating reading material, the notes to financial statements are worth wading through. It's there that you'll find out whether a bank transferred any problem loans to held-for-sale status, in effect trying to make them disappear. Transfers like that are almost always a bad sign.
Next, Stumpf recommends that you pay close attention to any major restructuring charges. Was there a big nonrecurring item somewhere in the quarter? If so, it could signal an attempt to get rid of a pile of loan-related expenses in one fell swoop and artificially inflate future earnings. "That's what I think banks are guilty of," says Stumpf. "They take these huge restructuring charges, they write stuff down, they lump it in a quarter, and we're supposed to ignore it and then next quarter believe that they reported 10% earnings growth."
But perhaps the most salient piece of advice that investors should heed is to not focus on the price/earnings ratios of any bank stocks right now. They clearly look cheap, given the hammering taken by many of them over the past year—and the fact that Alan Greenspan's recent interest rate cut makes financial stocks more attractive than they were at the end of 2000. But remember, while the P/E ratios for many of these stocks may look enticingly low, it has become painfully obvious that the earnings part of that ratio may be questionable. As analyst Sean Ryan puts it, "All bank stocks look cheap, but only some are inexpensive."
--------------snip---------------------------
comment: this speaks for itself. 100 billion buckaroos in bad loans, and we have barely entered an economic downturn....this is going to turn into a HUGE problem, the proportions of which can currently only be guessed at. private sector debt in the economy runs at a total of $22 trillion approximately, so there is plenty of scope for an apocalypse of debt destruction. someone will pay this debt, and if the borrowers don't, the lenders will.
in the meantime, don't forget to buy the dip.... |
