Monday, April 19, 2010

Hussman Weekly Market Comment: Earning More by Setting Aside Less

Meanwhile, it is notable that the "favorable" earnings reported by J.P. Morgan and Bank of America in the first quarter were due to reduced provisions for credit losses - charges that are largely discretionary. In the fourth quarter of 2009, J.P. Morgan charged $8.9 billion against earnings to provide for credit losses, but in the first quarter of 2010, it charged $7.0 billion. Thus $1.9 billion of the $3.3 billion in earnings reported by JPM reflected reduced provision for credit losses. Likewise, the main factor driving Bank of America's earnings was a reduction in loss reserves. Indeed, the provision for credit losses was $3.6 billion lower than it was a year ago (when delinquency rates and credit losses were running at a fraction of current levels).

The reduced provision for credit losses might be reassuring were it not for the fact that delinquencies, foreclosures, non-performing loans, commercial mortgage strains, and actual charge-offs reported by various sources have been either unchanged or accelerating. Bank of America, for example, reported that 30-day delinquencies on residential mortgages hit a new record of 8.5% in the first quarter (though the surging FHA-insured portion will allow them to pass some of the consequent losses off onto the American public). Moreover, provisions for credit losses are again falling short of net charge-offs, which is what we saw in 2008 before banks got into trouble (see the June 2, 2008 weekly comment: Wall Street Decides to Close Its Ears and Hum). For example, actual net charge-offs at Bank of America were $10.8 billion during the first quarter of this year (versus $6.9 billion a year ago), exceeding the provision of $9.8 billion that was deducted from earnings in the first quarter. In effect, the Bank reduced its reserve for future losses by about $1 billion, which had the effect of boosting reported earnings accordingly. This accounts for the entire improvement in earnings from the fourth quarter of 2009, and then some.

Overall, the current data presents at best a mixed picture of credit conditions. My impression is that investors should not be surprised by a significant second-wave of credit strains. Still, as we've anticipated for months, we have now entered the window where those strains would be expected to begin, so I won't maintain this view if the data don't increasingly support it. Some evidence is consistent with fresh deterioration, but not nearly to the extent that we would consider decisive. Meanwhile, indications of improvement are also extremely thin. It seems unwise for investors to celebrate variations of a few basis points in delinquency rates. It seems equally unwise to celebrate "favorable" bank earnings reports that are exclusively driven by reduced loan loss provisions, particularly when the volume of impaired loans has not declined proportionately. Keep in mind that Enron and Worldcom were able to report outstanding earnings for a while by adjusting the manner by which revenues and expenses were accrued. I suspect that the U.S. banking system has become a similar breeding ground for innovative accounting.