Banks Still Underestimating Scope of Crisis

This post first appeared on Minyanville.

Certain American banks, it appears, didn’t get a very important memo: Losses tend to rise, not fall, during a recession.

The Wall Street Journal reports some large banks, contrary to what seems logical in an economic slowdown caused by massive amounts of bad debt, aren’t raising loan-loss reserves as fast as their loans are souring.

Loan-loss reserves represent a bank’s expected losses on its loan portfolio. They don’t set aside actual cash, but any increase in their reserve reduces profits. This allows executives to manage expectations, giving investors a heads-up about future losses. Eventually, when they get around to selling or otherwise disposing of bad debt, there shouldn’t be any surprises.

Just one catch: Though there are guidelines, standards and principles that govern how banks determine loan-loss reserves, the final number is ultimately subjective. If in September, for example, bank executives felt the credit crunch was waning, and that things were returning to normal, one would expect to see reserves fall.

In recent third-quarter earnings releases, Suntrust (STI), Bank of America (BAC) and BB&T (BBT) actually saw the ratio of reserves to non-performing loans decrease. In other words, these banks thought it prudent to set aside fewer dollars for expected losses for each dollar of impaired loans.

Whether the levels were manipulated to manage earnings, or simply the result of honestly incompetent miscalculation, it’s a troubling trend. Either the folks at the helm of some of our largest financial institutions just don’t get it, or they’re still trying to cross their fingers and hope things get better, despite their continued failure.

By contrast, JPMorgan (JPM) and Citigroup (C) raised the percentage of bad debt on which they expect to experience losses. This is what one might expect of a shrewd financial institution, and is an indication that management expects conditions for their borrowers to worsen. But at least they’re dealing with and acknowledging the problem, rather than continuing to sweep it under the rug.

Now that taxpayer funds are being pumped into troubled banks, continued mismanagement of loss expectations cannot be tolerated. It’s one thing for investors, of their own volition, to take on risk by buying bank stocks. It’s an entirely different story, however, when we don’t get to choose the institutions to which we’re hitching our collective cart.

Limiting executive pay makes for nice headline copy, but it's a weak mechanism for imposing accountability where it’s sorely needed. Until more banks own up to the real exposure lingering on their balance sheets, the true impact of the financial crisis will remain unknown.

Investors don't like uncertainty. Banks would do well to (finally) come clean.