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Tuesday, 12 October 2010 19:35

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

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

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

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

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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“…