Credit Improvements Still Boosting Bank Profits (Update 1)

Updated from 11:17 a.m. ET with afternoon market action and comment from FBR analyst Paul Miller.

NEW YORK ( TheStreet) -- Second-quarter earnings season has been strong for most the nation's biggest banks, but it's always good to look beyond the headline numbers, which are still seeing a boost from the release of loan loss reserves.

Banks follow a counterintuitive practice when it comes to setting aside reserves to cover loan losses. The quarterly addition to loan loss reserves is called the provision for loan losses.

Since the provision directly affects pretax earnings, banks can manipulate their quarterly results by making outsized provisions for loan losses, or by allowing their loan loss reserves to decline. So during times of strong credit quality, banks need to be careful not to "over-reserve," because this might be seen as an attempt to smooth out earnings increases over extended periods.

So reserves are relatively low during good economic times, and must be quickly boosted during a severe recession, just when banks may be feeling the revenue squeeze in all business lines.

All of the nation's large banks that reported second-quarter results through Friday released loan loss reserves during the second quarter, with the exception of State Street ( STT), which doesn't count lending as a key business activity.

Wells Fargo ( WFC) reported record second-quarter earnings of $5.5 billion, or 98 cents a share, increasing from $5.2 billion, or 92 cents a share, in the first quarter, increasing from $4.6 billion for 82 cents a share, a year earlier. The earnings improvement was driven by strong growth in investment banking, wealth management and retail brokerage.

According to data supplied by Thomson Reuters Bank Insight, Wells Fargo released $567 million in loan loss reserves during the second quarter. That compares to releases of $349 million in the first quarter and $532 million in the second quarter of 2012. So for Wells Fargo, the reserve release didn't drive the year-over-year earnings beat. It did, however, help feed the sequential earnings increase.

To better compare operating results from quarter to quarter, investors can use a quick back-of-the envelope calculation of pre-provision net revenue. Pre-provision net revenue is a bank's tax-adjusted net interest income, plus its noninterest income, less noninterest expenses.

Wells Fargo's pre-provision net revenue rose to $9.170 billion in the second quarter, improving from $8.877 billion the previous quarter and $8.887 a year earlier, underlining just how solid a quarter the bank had.

Here's a look at reserve releases and pre-provision net revenue growth for the rest of the "big four" U.S. banks, with all showing welcome increases in pre-provision net revenue:
  • JPMorgan Chase (JPM) reported second-quarter earnings of $6.496 billion, or $1.60 a share, increasing from $6.529 billion, or $1.59 a share the previous quarter, and $4.960 billion, or $1.21 a share, a year earlier. The company released $1.396 billion in loan loss reserves during the second quarter, increasing from a release of $1.156 billion in the first quarter, but declining from a release of $2.080 billion in the second quarter of 2012. The company's pre-provision net revenue rose to $10.086 billion in the second quarter from $9.699 billion the previous quarter and $6.718 billion a year earlier. So once again, the sequential increase in the reserve release provided a boost, but the large decline in the release year-over-year, underlined a pretty solid quarter for JPM, especially for fixed income trading.
  • Bank of America (BAC) reported second-quarter earnings of $4.012 billion, or 32 cents a share, increasing from $1.483 billion, or 10 cents a share, in the first quarter, and $2.463 billion, or 19 cents a share, during the second quarter of 2012. The company restated its first-quarter results to reflect a $1.6 billion settlement with bond insurer MBIA (MBI). The year-over-year bottom-line improvement also reflected a decline in expenses. Bank of America's earnings benefited from a $1.206 billion release of loan loss reserves, which was considerably less than the $1.738 billion released the previous quarter and the $1.923 billion release a year earlier. The company's pre-provision net revenue rose to $6.438 billion in the second quarter from $6.049 billion in the first quarter and $5.723 billion a year earlier.
  • Citigroup (C) saw its earnings rise to $4.182 billion, or $1.34 a share in the second quarter, from $3.808 billion, or $1.23 a share, the previous quarter, and $2.946 billion, or 95 cents a share, a year earlier. The company's second-quarter earnings benefitted from a $2.147 billion release of loan loss reserves, which was much higher than releases of $1.728 billion the previous quarter and $1.409 billion a year earlier. But Citi also followed the positive trend for the big four, with pre-provision net revenue growing to $8.392 billion in the second quarter from $8.036 billion the previous quarter and $6.286 billion a year earlier.

"Given the improving economic environment and declining risk offuture reps/warranties claims, it is to be expected that banks would normalize their reserve bases over time," according to FBR analyst Paul Miller.

In a note to clients on Monday, Miller wrote that the second-quarter boost from earnings releases "could be the beginning of a significant wave of credit-related earnings benefits, as major institutions like JPM, BAC, and WFC benefited significantly from reserve releases across multiple asset classes."

The analyst added that "while these are certainly near-term benefits, we would caution investors that some institutions that appear to be earning their cost of capital may not be absent these benefits."

Of note amongst our universe, BAC, JPM, and WFC had the most outsized credit improvements relative to their peers in the quarter. And in the case of JPM and BAC in particular, headline ROEs would have been significantly weaker, though still decent, absent them," Miller wrote.

Bank stocks on Tuesday afternoon were mostly higher, with the KBW Bank Index ( I:BKX) up 0.6% to 66.46. Out of 24 index components, all but four were up for the session.

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-- Written by Philip van Doorn in Jupiter, Fla.

>Contact by Email.

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 TheStreet.com 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.

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