See also

Everything You Need to Know About Regional Banks, Part 1: Earnings

After two banks recently rocked the market by reporting dramatic increases in bad loans, financial institutions' second-quarter results are being sliced and diced to gauge whether they are suitably protected against similar credit-quality problems.

Last month,

Wachovia

(WB) - Get Report

and

UnionBanCal

(UB)

had to deduct large

sums from profits to boost protection against rising bad loans.

Last week,

TheStreet.com

looked at

methods the pros use to assess banks' earnings. Here, we examine how they analyze bad-loan accounting to assess whether it's being tweaked to give a false boost to profits.

The Rainy Day

Financial institutions keep money aside in a so-called loan-loss reserve as a shield against increases in bad loans. They add money to this reserve to replace any losses, as well as to cover future bad loans. This addition, called a provision, is reported quarterly. All in all, the loan-loss reserve is like a sea wall: It has to be patched up when it gets damaged, and it may even need to be heightened in a stormy season.

Those are the basic mechanics of bad-loan accounting. But how do these matters affect earnings? Focus on the provision, because this is subtracted from profits. A lower provision means higher earnings, and vice versa.

Tips for Bank-Stock Investors
Loan losses and provisions

*Note whether interest rates are heading higher or lower.

*Determine whether the economy in the bank's operating area is growing or shrinking.

*Check if the bank is heavily involved in any lending that may be increasingly speculative.

*Assess whether charge-offs rose or fell from previous levels.

*Compare the provision with charge-offs.

*Calculate the loan-loss reserve as a percentage of loans, and note whether that figure rose or fell from previous levels.

*Examine whether the reserve as a percentage of nonperforming loans rose or fell.

*Call investor relations if you have questions or need clarification.

Of course, bank management will never admit to underprovisioning, claiming instead that the reserve is correct for the economic environment and the type of loans on the books. And sometimes management is right: Reserves do need to be lower when the economy is booming -- as it has been for some time. Therefore, when confronted by a weakening reserve, or a low provision, investors need to have ways of telling whether it's OK.

The Barometer

The first steps in this process have nothing to do with accounting. It's necessary to keep a close eye on the economic and interest-rate context. When the economy slows, or when interest rates go up, as they have recently, firms and individuals will find it harder to pay back loans. Bad-loan levels don't immediately deteriorate, so a bank should be protected in advance if rates are trending up or an economic slowdown beckons.

Chris Marinac, an analyst at Atlanta-based

Robinson-Humphrey

, believes that at the moment, banks should be building up their reserves more than they are. The problems at Wachovia and UnionBanCal "are not necessarily isolated incidents," he says.

Moreover, even if rates are not going up and the economy remains strong, investors need to check if a bank has much exposure to a type of lending that has recently gotten too hot and is vulnerable to a sharp cooling-off period. For example, banks such as Wachovia and UnionBanCal are now experiencing the nasty consequences of a recent speculative boom in syndicated loans, which are large credits to companies made by several banks at once.

When dealing with the quarterly numbers, investors should initially check if loan losses, also called charge-offs, have risen a great deal. If so, listen to the earnings conference call or ask the bank's investor relations staff what sort of loans are going bad and why.

Looking Outside

The next step is to compare the size of the quarterly provision with the amount of charge-offs. If the provision is less than charge-offs, the overall size of the loss reserve will drop. At the moment, many analysts would be very disturbed by that.

Banks which do match charge-offs with provisions still could be letting their guard down if the loan-loss reserve falls as a percentage of loans.

First Union

(FTU)

, which in June announced a deep

restructuring that included higher provisions, had diligently matched for several quarters. Even so, its reserve fell to 1.3% of loans in the first quarter, from 1.41% in the year-earlier period. Why? Loans were growing faster than the reserve.

But just looking at the path of the reserve-to-loans ratio is not enough. For instance, at Wachovia this ratio was 1.17% in this year's first quarter, unchanged from the year-earlier period. However, 1.17% was well below peer levels, and it was probably too small for a bank that does a lot of commercial lending.

Moreover, the inadequacy of Wachovia's reserve could have been seen when using another metric: the ratio of the reserve to nonperforming loans, credits the bank believes might not get paid back. At Wachovia, the reserve was 263% of nonperforming loans in the first quarter, down sharply from 379% in the year-earlier period.

The Slicker

Perhaps it's helpful to glance at a bank that has superb credit quality and doesn't appear to be taking any chances:

FifthThird

(FITB) - Get Report

, which reported earnings Friday.

Charge-offs were 0.27% of loans in the second quarter, down from 0.4% a year earlier. Its $26 million provision in the latest quarter was nearly $10 million higher than charge-offs in the period. The reserve-to-loans ratio has stayed more or less constant, at a solid 1.47%. What's more, reserves jumped to a super-safe 483% of nonperforming assets from 398% in the year-ago period.

Finally, investors ought to be aware that the

Securities & Exchange Commission

, the federal agency that oversees public companies' accounting, opposes the

practice of building up large reserves when such reserves might not be necessary. The SEC fears that banks may tap into overly large reserves to goose earnings when things get slow.

But the bank regulators are thought to oppose the SEC's stance, fearing that it could be misused by some financial institutions. Some banks are citing the SEC's opposition to high reserves as the reason for their low provisions -- perhaps disingenuously.