Provisions for Loan LossesOver the past several quarters, many of the largest U.S. banks have seen a direct boost to earnings through the release of loan loss reserves. This is no surprise, since the obvious reaction to a souring loan portfolio is to sock away extra reserves. Then, after working through a significant portion of the problem loans, most of the large players have found that they had more reserves than they needed. Each quarter, a bank will typically add to its allowance for loan losses by making a provision for loan loss reserves, which lowers its earnings. If the provision outweighs a bank's net charge-offs -- its loan losses less recoveries on previously charged-off loans -- its allowance for loan losses increases. Since messing with the quarterly provision is an obvious way for banks to manage earnings, regulators frown upon banks "over-reserving" when the economy is strong. This, of course, is counter-intuitive, because a period of strong economic growth is when a bank will be better prepared to build reserves. No matter. What happens is they scramble to build reserves in the midst of a recession, thus front-loading their net losses, leading to the large release of reserves we are seeing now. During the second quarter, JPMorgan Chase ( JPM) reported net income of $5.4 billion, partially fed by a $1.2 billion reserve release.
Troubled Debt RestructuringsA troubled debt restructuring -- or TDR -- is a loan for which the lender has granted concessions to a borrower, in order to avoid a possible foreclosure or charge-off. The lender is supposed to write-down the TDR, and sometimes regulators come in and force additional write-downs.
Mortgage Servicing RightsFor most banks originating fixed-rate mortgage loans, the best practice is to underwrite the loans under standards established by Fannie Mae or Freddie Mac and immediately sell the new loans to the government-sponsored mortgage giants, while continuing to service the loans. This way, the banks typically make a quick profit while selling the loan, and then enjoy continuing servicing fees from the GSEs. The mortgage servicing rights -- or MSRs -- for these loan portfolios are carried on a bank's books as an asset, and banks typically reassess the MSRs once a year. In a declining rate environment -- or a seemingly eternal low-rate environment like this one -- it's quite likely for banks to write-down the value of their MSRs, because of the higher likelihood of mortgage refinancing. Bank of America reported $14.9 billion in MSRs as of December 31, declining from $19.5 billion a year earlier. Ouch. The company said those numbers reflected a $3.8 billion "impact of customer prepayments," including home sales and refinancing, "other changes in MSR fair value" of $4.3 billion, and net MSR additions of $3.5 billion.
Deferred Tax AssetsBanks that have booked losses will carry deferred tax assets on the books in the hope of offsetting them against future earnings. The problem with this is that if you don't return to profitability quickly enough, you might need to write-down the deferred tax assets. One of the ways that the Basel III agreement tightens banks' capital measures is to exclude deferred tax assets from capital ratios. This is one reason investors focused so heavily on banks' levels of tangible common equity during the credit crisis. Bank of America reported "disallowed deferred tax assets," -- referring to their exclusion from regulatory capital -- of $8.7 billion as of December 31, rising to $16.6 billion as of June 30. That's quite a potential padding for the company's future earnings, if it can get past the endless mortgage headline risk sooner rather than later. Otherwise, there be write-downs ahead.
Deposit StructureOur last area for bank accounting red flags is deposit structure. A heavy reliance on deposits gathered from outside an institution's home market, brokered CD deposits and deposits gathered through a listing service, could potentially lead to a liquidity squeeze for a bank, making funding more costly and compressing net interest margins. This is because the out-of-area deposits tend to be "flighty," unless the bank continues to pay top dollar for them.
Philip van Doorn. To follow the writer on Twitter, go to http://twitter.com/PhilipvanDoorn.