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As Earnings Season is Here, I Reiterate My Warning That Big Banks Will Pay for Optimism Driven Reduction of Reserves

Submitted by Reggie Middleton on 10/13/2010 10:52 -0400

As those that follow me know, I have been bearish on US banks since
2007. That bearish outlook resulted in massive returns ensuing years,
just to have nearly half of it returned due to rampant shenanigans and
outright fraud. Needless to say, it pissed me off – but it did much more
than that. It created a re-bubble before the bubble that was bursting
had a chance to fully deflate. As a result, what we have now is one big
mess that is getting messier by the minute.

On Friday, July 16th, 2010 I posted “After
a Careful Review of JP Morgan’s Earnings Release, I Must Ask – “What
the Hell Are Those Boys Over at JP Morgan Thinking????”. The impetus
of such was that this bank that all seem to be in awe of was taking a
big risk in order to pad accounting earnings for a quarter or two. Below
is an excerpt of my thoughts:

Trust me, the collateral behind many
more mortgages will continue to depreciate materially as government
giveaways and bubble blowing for housing fade!

The delinquency and NPA levels
drifted down a bit, but they are still at very high levels. Charge-offs
came down but the reduction in provisions has been quite
disproportionate bringing down the allowance for loan losses. In 2Q10,
the gross charge- offs declined 26.6% (q-o-q) to $6.2 billion
(annualized charge off rate – 3.55%) from $8.4 billion in 1Q10
(annualized charge off rate – 4.74%). But the provisions for loan
losses were slashed down 51.7% (q-o-q) to $3.4 billion (annualized rate
– 1.9%) against $7.0 billion (annualized rate – 3.9%) in 1Q10.
Consequently, the allowance for loan losses declined 6.2% (q-o-q) from
$35.8 billion from $38.2 billion in 1Q10. Non performing loans and NPAs
declined 5.1% (q-o-q) and 4.5% (q-o-q) respectively. Thus, the NPLs and
NPAs as % of allowance for loan losses expanded to 45.1% and 50.7%,
respectively from 44.6% and 49.8% in 1Q10. Delinquency rates, although
moderated a bit, are still at high levels. Credit card – 30+ day
delinquency rate was 4.96% and the real estate – 30+ day delinquency
rate was 6.88%. The 30+ days delinquency rate for WaMu’s credit impaired
portfolio was 27.91%.

While the lower provisioning
was able to beef up the bottom line in this quarter, the same is not
sustainable in the future as JPM cannot afford to reduce its allowance
for loan losses substantially. This is a one shot, blow your wad and go
to sleep deal! There is no margin for error in the future, and one
can only assume that the reason this was done was to pad accounting
earnings and to take advantage of the extremely short term, and
obviously naïve, memory of the financial media and retail/institutional
investor. Given the high charge-off rates and delinquency levels, the
provisioning will probably need to be bolstered again in the not too
distant future.

Listen, even US Economic
Cheerleader and Propaganda-in-Chief Ben Bernanke said it will be
several years before growth and employment resumes. Sooooo…. What the
hell are the boys (and girls) at JP Morgan doing????

Well fast forward three or four months and we get to see whether or
not I had a point. You see, JP Morgan swallowed WaMu (who I warned would
face peril in 2007) at a discount that is all but eaten up already as
asset values continue to fall, and they swallowed Bear Stearns (whom I
warned would fail in January of 2008) with government guarantees.
Combine these with their own lending and you have a lot of potentially
rotten assets smelling even more rotten. Now that the fraud which was
mortgage paper keeping, transfer and assignment has come to light, it is
just a matter of time before the even more material overstatement of
values discussion becomes both commonplace and the subject of enough
litigation to last several presidencies. Reference
“The Robo-Signing Mess Is Just the Tip of the Iceberg, Mortgage
Putbacks Will Be the Harbinger of the Collapse of Big Banks that Will
Dwarf 2008!”

You see, JPM (and not to pick on them, so let’s include their big
bank brethren as well) so early stage delinquencies ameliorate, and as a
result padded the lack of oomph in trading, asset management, core
banking and I-banking with the release of accounting reserves. Either
they purposely were looking to deceive or the honestly didn’t look at
the amelioration in the larger context (or of course, I could just be
wrong – but I seriously doubt so). If you remember, I issued an explicit
warning regarding watching price without regard to economic activity in
The Truth Goes Viral, Pt 1: Housing Prices, Economic Sales and the State of Depression as well as paying heed to those who have vested interests in Pay Attention to the National Association of Realtors and Their Chief Marketing Agent At Your Own Risk!.

Below is a chart which illustrates the folly of excluding economic sales activity from your real estate based decision making. More...

Well, the big banks which include JPM that released reserves and provisions just did the same thing. They saw this…

… and apparently believed that a) this positive trend would continue
(unrealistically optimistic, but possible), b) collateral values will
not collapse, c) this improvement was caused by organic means/economic
growth and not government bubble blowing (and I am sure they knew better
than that) and d) nothing else would or could go wrong. Well, all they
had to do was to take a holistic view of the market before reducing
provisions and they could have seen that although the credit metrics had
improved slightly right after the government induced buyers to jump
headfirst into a plunging housing market with suppressed mortgage rates
and tax incentives, that the real world credit metrics were actually
worse than they have been throughout this entire crisis due to the fact
that economic housing sales have plummeted in relation to the
deteriorating metrics, causing an increasingly large pipeline of bad
assets to pile up on banks books. Just as an increasing price is
misleading if you look at it in a vacuum, so are improving credit
metrics. The NPA pipeline for the banks is not only getting longer, its
the longest it has been since I can recall the data. This is a very bad
thing.

Let’s break this down…

The end result… Banks are becoming the country’s largest REITs, sans
the tax exempt trust part, and sans the expertise in managing
properties.

As I anticipated way back in 2007, banks are becoming the largest homeowners in the country. Reference “Would you buy Countrywide if all of its bad mortgages were magically wiped off the books?” from December of 2007:

I know I wouldn’t. I believe there
are better investments out there from a risk/reward perspective.
Countrywide is in a bit of a jam, and it is not just from bad loans on
the books. Looking at the Countrywide Foreclosures Blog (yes, there
actually is one), I found this article:14,196 Homes Offered For Sale on Countrywide Financial’s Website.
I browsed through some of the site, and the small sample of numbers
that I looked at seemed accurately reported. It also seems to mesh with
Housingtracker.net. Browsing through the comments, someone noticed
that the bank and trust offerings were not included. I looked, and at
first glance, it seemed like he had a point. Now,it is a lot of work to
verify all of this, but if it does pay out (and it looks like it
does), Countrywide has nearly 100% of it market capitalization
outstanding as REOs – in a market where houses just aren’t selling and
property values are falling fast. This is totally discounting each and
every under performing and underwater mortgage asset they have on
their books.

Held by Countrywide Mortgage Co.	$ 2,910,876,468
Held by Countrywide Trust and Bank	$ 2,969,067,322
Total	$ 5,879,943,790

CFC Market Capitalization	$ 6,180,000,000
% market cap held as REO	95%

Just some food for thought.

Now, fast forward roughly 3 years, and after Countrywide and WaMu
collapse (as we at BoomBust anticipated back in 2007), and you find the
biggest and most respected banks in the country are suffering from THE
EXACT SAME PROBLEM!!!

Banks balance sheets are getting stuffed faster than ever
with bad loans and foreclosures because the bad loans and foreclosures
are occurring faster than the market is absorbing them. This means that
the REOs are building up on the banks balance sheets (whether they
properly disclose this or not) and it also means that the Fraudclosure
issue will significantly exacerbate the problem, and it also means this
problem will get much worse as housing activity AND prices are on the
downturn again.

These factors should have been taken into consideration before even
thinking of reducing risk provision measures. Of course, then you have
FraudclosureGate, which delays the foreclosure process, further stuffing
the pipeline. The result of FraudclosureGate will be the mad dash to
put fraudulent loans back the originator. None of these occurrences will
be good for the banks, particularly those banks that swallowed the
NINJA loan mills.

Look here for some more sobering views…

As of last quarter (when the effects of .GOV bubble blowing just
started to wear off) housing related NPAs (or what will become housing
related NPAs with honest accounting) have SIGNIFICANTLY outstripped
housing sales in both growth rate and amount.

If you have read this far, then you undoubtedly have an interest in
the mortgage and commercial banking space. I will be releasing to paying
subscribers updated bank valuations and quarterly earnings opinions
that FULLY reflect the data above, plus much more that I didn’t have
time to delve into today. Stay tuned for analysis of JP Morgan, Morgan
Stanley, Goldman Sachs, PNC Bank, Well Fargo, and Sun Trust Bank. Others
may follow. Subscribers can scan the subscription archives for previous
quarterly opinions, stress tests and full forensic reports of all of
the aforementioned bank (click here to subscribe).
As a subscriber, you also have access to all of the data and analysis
used to create these charts, in addition to a more granular
application, by state in the SCAP template and by region in housing
price and charge off templates – see

Delinquency and foreclosure inventory – blog edition 10-2010 (used for this post)

See the following posts for an extensive background on the topics discussed in the video:

The full JPM Q2 review can be downloaded by subscribers (click here to subscribe) here: JPM 2Q10 review

Subscribers should also review our forensic valuation reports, which
have (thus far) proven to be right on the money in terms of JP Morgan:

The JP Morgan Professional Level Forensic Report (subscription only)

The JP Morgan Retail Level Forensic Report (subscription only)

Those that don’t subscribe still have a lot of BoomBustBlog JPM
opinion and analysis to chew on, including a free, condensed (but still
about 15 pages) version of the forensic analysis above. You can find it
below this pretty graphic from “An Unbiased Review of JP Morgan’s Q1 2010 Results Yields Less Roses Than the Maintream Media Presents“…

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Wed, 10/13/2010 - 11:36 | 646201 Panafrican Funk...

Does this strike you as a signal that the Fed intends to purchase substantially more MBS? Tactically it seems like this would be the only path left. The key trick of course being that the Fed balance sheet is largely opaque when it comes to the details.

Wed, 10/13/2010 - 11:50 | 646276 tom

Not very likely. Total GSE and agency net issuance is negative, and seems likely to go deeper negative as a result of the foreclosure mess (if you can't foreclose it, you don't sell it, you don't generate that new mortgage, you don't generate that new MBS).

But perhaps QE2 will include some buying of MBS, just to slow the pace at which the Fed's current GSE/agency holdings are being shrunk by early redemptions.

Wed, 10/13/2010 - 15:42 | 647060 Panafrican Funk...

I'm thinking possibly new issuance where the banks more or less package up their remaining book and dump it on the Fed at par, and chase yield elsewhere.

I honestly don't see any other way for them to get out of this shit.

Wed, 10/13/2010 - 11:16 | 646078 Rogerwilco

Who needs reserves when Uncle Sugar has your back? Seriously, these bastards don't care anymore, and short of Armageddon, they will "beat" the numbers every quarter.

Wed, 10/13/2010 - 11:44 | 646241 tom

Almost true, except that they can't fake profits by de-provisioning indefinitely, as they are quickly running out of provisions.

As Earnings Season is Here, I Reiterate My Warning That Big Banks Will Pay for Optimism Driven Reduction of Reserves

The end result… Banks are becoming the country’s largest REITs, sans the tax exempt trust part, and sans the expertise in managing properties.

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The end result… Banks are becoming the country’s largest REITs, sans
the tax exempt trust part, and sans the expertise in managing
properties.