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Here Come the Reserves!

America's biggest banks are tapping into huge earnings potential by reversing the buildup of loan loss reserves.



) - The big theme among U.S. banks this earnings season was the boost to the bottom line from the release of loan loss reserves. That trend is likely to accelerate as credit measures continue to improve.

Over the three years ended Dec. 31, 2009,


(C) - Get Citigroup Inc. Report


Bank of America

(BAC) - Get Bank of America Corp Report

quadrupled their loan loss reserves, while

JP Morgan Chase

(JPM) - Get JPMorgan Chase & Co. (JPM) Report


Wells Fargo

(WFC) - Get Wells Fargo & Company Report

more than tripled theirs.

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U.S. Bancorp

(USB) - Get U.S. Bancorp Report

-- the fifth-largest domestic bank holding company by total assets - reserves more than doubled.

During the second quarter, four of the five largest holding companies reported net charge-offs - loan losses less recoveries - exceeding provisions for loan loss reserves. This "releasing" of reserves directly affects earnings, and for Citigroup, the second-quarter reserve release was more than half of net income.

U.S. Bancorp bucked the trend, as the Minneapolis lender continued to build loan loss reserves.

During a discussion with


on the prospects for the largest banks over the next few quarters, Jamie Cox, managing director at Harris Financial Group in Colonial Heights, Va., said "the reserve reduction provides enormous earnings power going forward."

Cox thinks that with the uncertainty created by financial reform softening the market, "this is a fantastic time to accumulate," adding that JPMorgan is his favorite pick as a long-term play. He also disclosed personal holdings in Citigroup and Bank of America, with a shorter-term outlook.

The following is a summary of reserve growth, coverage and loan loss activity for the group of five.

Citi's second-quarter net charge-offs totaled $8 billion, down from $8.4 billion for both the previous quarter and the second quarter of 2009.

The company's annualized ratio of net charge-offs to average loans declined to 4.49% from 4.57% in the first quarter and 5.09% a year earlier according to

SNL Financial

, with reduced loan delinquencies for the consolidated company as well as within its credit card operations.

Loan loss reserves covered 6.67% of total loans as of June 30 -- way ahead of the pace of charge-offs. This historically high level of reserve coverage bodes well for an accelerated release of provisions and higher earnings over the next two years.

Shares closed at $4.05 Thursday, below the June 30 tangible book value of $4.19 reported by Citigroup. Shares closed at 12.2 times the 2010 consensus earnings projection of 33 cents a share among analysts polled by

Thomson Reuters

. Moving out on the earnings projections, the price-to-earnings ratio drops to 9.3 based on the 2011 consensus projection and a low 7.2 for 2012.

Atlantic Equities analyst Richard Staite has an "Overweight" rating (the equivalent of a buy) on the shares, with a 12-month price target of $6.00, saying in a report on Tuesday that his firm recommends "switching from JP Morgan and Bank of America into Citigroup given its better emerging markets growth prospects."

JPMorgan reported second-quarter net charge-offs of $5.7 billion, down from $7.9 billion the previous quarter and $6 billion a year earlier.

The net charge-off ratio for the second quarter was 3.24% and was greatly exceeded by the reserve coverage, which was 5.12%.

JPMorgan's shares closed at $39.35 Thursday or 1.4 times tangible book value and 12.6 times projected earnings for 2010. The P/E ratio based on 2011 consensus earnings projections was 8.4 and 7.1 based on the 2012 earnings projection.

Cox said JPMorgan shares were likely to pop once the company decided to restore a significant dividend payout, since many institutional investors will shy away until that time.

Keefe, Bruyette & Woods analyst David Conrad has an "Outperform" rating on the shares, which translates to a "Buy." His 12-month target for JPMorgan is $57.00.

Bank of America's second-quarter net charge-offs totaled $9.6 billion, down from $10.8 billion during the first quarter but up from $8.7 billion during the second quarter of 2009.

Reserve coverage was well-ahead of the pace of loan losses, although to a lesser degree than Citigroup and JPMorgan. The net charge-off ratio for the second quarter was 3.81% and loan loss reserves covered 4.55% of total loans. .

Shares closed at $13.66 Thursday or 1.1 times tangible book value. The ratio of price to projected 2010 earnings was 15.6, moving down to 8.3 and a very attractive 5.8 based on earnings projections for 2011 and 2012.

Wells Fargo Securities analyst Matthew Burnell rates Bank of America "Outperform," with a "valuation range" of $17 to $19 a share, which was reduced from a range of $23 to $26. Burnell also lowered his 2011 earnings estimate to $1.75 from $2.40, citing "slower reserve releases and higher regulatory reform costs than previously expected."

Wells Fargo reported second-quarter net charge-offs of $4.5 billion, declining from $5.3 billion in the first quarter but ahead of the $4.4 billion in net charge-offs during the second quarter of 2009.

The net charge-off ratio for the second quarter was 2.22% and loan loss reserves covered 3.04% of total loans.

Shares closed at $27.39 Thursday or 1.9 times tangible book value. The P/E ratio based on 2010 earnings projections was 14, dropping to 9.5 for 2011 and 7.5 for 2012.

Guggenheim Securities analyst Marty Mosby rates Wells Fargo a buy, and raised his firm's 12-month target to $39 from $35 after the second-quarter earnings release, saying his firm expected Wells Fargo to eventually "trade at 10x our normalized earnings power of $4.50, and we forecast WFC can hit that number by 2012. That's quite a rosy forecast.

U.S. Bancorp was the only bank among the largest five to continue building loan loss reserves during the second quarter. The $1.14 billion provision for reserves slightly exceeded $1.11 billion in net charge-offs for the quarter.

The net charge-off ratio for the second quarter was 2.34% and reserves covered 3.04% of total loans as of June 30.

Shares closed at $23.66 Thursday or 2.8 times tangible book value according to


, by far the highest valuation by this measure among the largest five domestic bank holding companies.

The ratio of price to the consensus earnings estimate for 2010 was 14.9, declining to 10.6 times projected 2011 earnings and 8.7 times the earnings projection for 2012.

Collins Stewart analyst Todd Hagerman has a Hold recommendation on the shares and a 12-month target of $26, noting that U.S. Bancorp's second quarter earnings improvement was driven by "better than expected revenue growth" and improved credit quality, but also saying he expected revenue growth to decline amid regulatory uncertainty and slow loan demand.

He also said that while U.S. Bancorp's "profitability levels remain well above peers and internal capital generation remains robust," the likelihood of the company returning excess capital to shareholders in the near future was "slim."

"We continue to wait for a cheaper entry point to get more aggressive," he said.


Written by Philip van Doorn in Jupiter, Fla.

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Philip W. van Doorn is a member of TheStreet's banking and finance team, commenting on industry and regulatory trends. He previously served as the senior analyst for Ratings, responsible for assigning financial strength ratings to banks and savings and loan institutions. Mr. van Doorn previously served as a loan operations officer at Riverside National Bank in Fort Pierce, Fla., and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a bachelor of science in business administration from Long Island University.