(BN) Bankers Bet Jobs on a Roaring V-Shaped Recovery: David Reilly

July 24 (Bloomberg) -- The country’s biggest banks are doubling down on a bet that the economy will improve in the latter half of the year. If they’re wrong, and borrowers don’t pull out of a tailspin, bankers and their investors will take a beating.
That’s because banks will have to rebuild diminishing reserves that they set aside for soured loans, which results in charges that lower profit.
Signs that big banks are hoping to draw the equivalent of an inside straight on an economic rebound emerged in second- quarter results. Figures from the country’s seven largest commercial banks by assets, including banks like Wells Fargo & Co. and Bank of America Corp., show they went easy on increasing loan-loss reserves in the quarter.
That followed a similarly light buildup in the first quarter. Such moves help bolster bank profits.
If loan losses slow during the next six months because, say unemployment levels off and housing stabilizes, banks will win big with this bet. They will have pumped up profit today while allocating sufficient reserves for the rest of the year.
At some point in every economic cycle, wagers like these pay off for banks as loan losses peak and provision charges ebb.
Timing is everything, though, and there are reasons to worry banks are making their recovery play too early.
Economists forecast unemployment to rise higher than 10 percent. While there are growing signs housing may be near a bottom -- yesterday’s announcement of June existing home sales beat expectations -- it is doubtful prices will rebound soon.
This means foreclosures will persist.

Bernanke’s Warning

Plus, commercial real estate loans are a growing threat.
U.S. commercial property prices have declined 35 percent since their peak, Moody’s Investors Service said in a recent report, while Federal Reserve Chairman Ben Bernanke warned Congress this week that defaults in this sector may pose a "difficult"
challenge for the economy.
Meanwhile, banks’ credit losses aren’t showing signs of slowing. At J.P. Morgan Chase & Co., these charge-offs increased to $6 billion in the second quarter from $4.4 billion in the first three months of this year.
Wells Fargo saw charge-offs rise to $4.4 billion from $3.3 billion in the first quarter. Yet as those losses rose, Wells increased its reserve by only $700 million compared with a $1.2 billion buildup in the first quarter.
Unless loan losses soon slow, Wells "will have to start materially increasing its provision expense, which will put pressure on earnings and valuations," Paul Miller, a bank analyst at FBR Capital Markets, wrote in a report this week.

Sour Loans

Wells isn’t alone in dragging its feet on bulking up reserves. Of the seven biggest banks by total assets, all but Citigroup Inc. saw the growth of nonperforming assets -- mostly loans likely to result in a loss -- grow at a quicker pace than the increase in the bank’s loan-loss reserve, according to my calculations.
Additionally, all the banks except Citigroup saw reserves as a percentage of assets fall in the second quarter.
Citigroup’s reserves increased to 128 percent of nonperforming assets compared with 119 percent in the first quarter.
Of the other banks, JPMorgan has the highest reserves ratio at 170 percent and SunTrust Banks Inc. had the lowest at 47 percent. Bank of America’s ratio fell to 116 percent from 122 percent, while US Bancorp’s declined to 114 percent. Wells saw its reserve ratio fall the hardest, dropping to 128 percent from
181 percent.

Nervous Shareholders

While banks don’t have to keep reserves as a percentage of potentially dud loans at a specific level, investors are likely to get antsy if this nears a one-to-one ratio at bigger banks.
That makes it more likely the banks will have to add more money to their reserves if the economy doesn’t rebound as planned.
Investors tolerate ratios below 100 percent at smaller banks because they tend to have less debt tied to credit cards and automobile loans that can result in higher losses.
That said, SunTrust’s ratio is looking uncomfortably low.
And PNC Financial Services Group Inc.’s results released yesterday showed its ratio of reserves fell to 101 percent of nonperforming assets.
The dilemma for banks is that keeping reserves at a higher level can wipe out profit. If PNC, for example, had wanted to maintain its reserve at the first-quarter level of 124 percent, it would have had to add about $1 billion to its reserves. Doing so would have wiped out the $207 million net profit it reported in the second quarter.

SunTrust’s Loss

A move to keep the reserve at an equivalent first-quarter level at SunTrust would have likely doubled what was already a
$183 million net loss for the second quarter.
For the moment, markets are tolerating the slower reserve buildups, trusting along with banks that an recovery is at hand.
After all, lower charge-offs help buoy profits and that lifts share prices.
If the economy deals the wrong set of cards in the second half, though, optimistic bankers may find themselves out of jobs while investors face a new round of losses.
(David Reilly is a Bloomberg News columnist. The opinions expressed are his own.)