Bank of America Faces Major Earnings Dip When Reserve Releases End

NEW YORK (TheStreet) -- Large-cap bank have seen a major boost from the release of loan-loss reserves over the past several years, and a return to typical provisioning for reserves could have quite a negative effect on earnings.

Banks typically set aside money for loan loss reserves each quarter based on their loan-loss expectations. For commercial loan portfolios, provisions are decided upon on a per-loan basis. Banks take a statistical approach for mortgage loans and other types of consumer loans. The trend -- it's human nature really -- is for banks to under-reserve during "good times" and over-reserve during and immediately after recessions.

This is in part because regulators don't want banks to use their reserve provisioning activity to smooth out earnings increases, and have traditionally frowned upon high levels of loan loss reserves when net charge-off rates are low. Investors also frown upon high levels of reserves, because they lower banks' returns on equity.

But this counterintuitive habit makes the bad times really bad, as we saw in 2008 and 2009 at the height of the real estate crisis, when banks really took it on the chin while adding to reserves.

During the fourth quarter of 2013, Bank of America's (BAC) provision for loan loss reserves -- the amount added to reserves, thus lowering pretax earnings -- was $336 million, while the company's net charge-offs -- loan losses less recoveries -- totaled $1.582 billion. So the company saw a $1.246 billion boost to pretax earnings from setting aside less for reserves than it charged-off for nonperforming loans. This is appropriate at this stage of the economic recovery, considering that the bank's annualized ratio of net charge-offs to average loans was 0.68% during the fourth quarter and its $17.428 billion in loan loss reserves covered 1.88% of total loans as of Dec. 31.

Bank of America has plenty of excess reserves right now. But the reserve releases can't go on forever, and at some point the bank is likely to return to making provisions for reserves at similar amounts to its loan losses.

With this in mind, KBW's analyst team put together two sets of numbers to estimate what effect "normal" provisioning levels would have on earnings for 11 large-cap U.S. banks. Based on fourth-quarter numbers, if the banks were to make provisions for loan loss reserves matching median levels for the past 23 years, Bank of America would see its earnings lowered by 37 cents a share, or 37% of its core fourth-quarter earnings of a dollar a share.

With the understanding that the above analysis could be overly aggressive, KBW put together another set of numbers showing the effect on earnings if the banks made provisions for loan losses that matched their fourth-quarter net charge-offs. In this case Bank of America's fourth-quarter core earnings-per-share would decline by 31%.

The big bank that would see the second-largest declines under the first scenario is JPMorgan Chase (JPM), with KBW estimating an earnings decline of $1.04 a share, or 19% of core fourth-quarter EPS of $5.60. Under the second scenario -- provisions for reserves matching fourth-quarter net charge-offs -- JPMorgan's earnings decline would be 91 cents a share, or 16% of core EPS.

Regions Financial (RF) of Birmingham, Ala., ranked sixth under the first scenario, with fourth-quarter EPS declining by 12 cents, or 15% of core EPS of 80 cents, but Regions ranked second under the second scenario, with estimated core EPS down by 33 cents, or 28%, if the bank were to make a provision for reserves matching its net charge-offs.

"BAC and JPM test especially weak in our analysis. However, both banks could have potentially greater offsets than the others," KBW analyst Christopher Mutascio wrote in a note to clients on Tuesday. Examples he cited of offsetting factors for the two banks include the eventual "normalization of BAC's legacy asset servicing costs from the 4Q13 level of $1.8 billion to $500 million per quarter," which could boost EPS by 32 cents.

"In addition, JPM incurred $1.1 billion in after-tax legal costs in 4Q13, which represents an annualized hit to EPS of $1.16. This more than covers the impact to EPS if the loan loss provision expense were to increase to the levels highlighted in our analysis," he wrote.

"We are not suggesting the BAC's legacy asset servicing costs normalize immediately or that JPM's legal costs go to $0 in the near term. However, it appears to us that these two companies may have greater potential cost offsets over time to rising loan loss provision expense than might be assumed by investors or implied by our static analysis," Mutascio added.

Of course, those "offsets" would be present anyway, since Bank of America and JPMorgan are keen on maximizing their profits no matter what the circumstances. The KBW analysis is quite useful to investors who need to keep in mind that the reserve-release gravy train is cyclical.

The bank that would see the smallest decline in core earnings if it were to make a provision for reserves matching the 23-year median, would be U.S. Bancorp (USB) of Minneapolis, with core EPS declining by 18 cents, or 6% of core fourth-quarter EPS of $3.04, according to KBW. USB would also fare best under the second scenario, with EPS down by just 6 cents, or 2%, if the bank made a provision for reserves matching its actual net charge-offs.

U.S. Bancorp has been a bastion of stability over the past ten years, remaining profitable through the credit crisis and consistently posting the best returns on assets and equity among the top 10 bank holding companies in the United States.

The following table shows the outperformance of USB against Bank of America, JPMorgan Chase, the KBW Bank Index (I:BKX) and the S&P 500 over the past five years:

USB Chart data by YCharts

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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 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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