Stock Traders Blog

I read many articles that talk about loan loss reserve, loan loss provision and net chargeoffs. I don’t really understand what they mean and all of a sudden I want to spend sometime to dig into their meanings. One thing I am clear is that loan loss provision, is like cost of good sold on income statement, should be subtracted from revenue to calculate net income. I did some research and find the following from A Loan Loss Reserve Primer: Beyond Simplistic Ratios

The loan loss reserve (or allowance for loan losses) is a contra-asset account on a bank’s balance sheet that is netted against gross loans. Each quarter the loan loss reserve rises by the amount of the loan loss provision (an expense item;) and reduced by the level of net chargeoffs.

I still remember this general accounting principle: Asset = Liability + Owner’s Equity. So loan loss reserve can be viewed as negative asset sitting on the asset side. The increase of loan loss reserve will decrease the total asset value. And this loss of asset value is reported on income statement as loan loss provision. Loan loss reserve on the balance sheet is similar to the stocks a company holds. Its value can fluctuate from time to time. But the stocks a company holds is normal asset type and the increase of stock price creates a gain item on income statement whereas the decrease of stock price creates a loss item on income statement. Loan loss preserve may go down and when it happen it will create negative loan loss provision and bring up net profit. It can happen when the management decides that they are over reserved for loan loss. It was the number 4 arguing point of the quote in this post The Reasoning Behind Bank of America’s Upgrade. I think he really means BOA has over 100 billion loan loss reserve(not provision) and at some point in the future when the economic turns around Bank of America may find it is over reserved. We can see loan loss preserve is a pretty flexible item where every banks can make its own decision to increase it or decrease it base on its own view on its own loan portfolio although some general guidelines apply

Net chargeoffs are loan amounts considered absolutely not collectible. It shouldn’t change the total value of asset as far as my understanding. People can look at net chargeoffs to evaluate whether loan loss is over or under reserved.

I came across some of the old articles that talked about Meredith Whitney, Goldman Sachs analyst Richard Ramsden and Second Curve Capitals Analyst Tom Brown’s opinion on Bank of America last August. After reading them I find Meredith Whitney is admirable but Richard Ramsden and Tom Brown are laughable.

Bank Of America (BAC) A-OK, Says Goldman: No Capital Needed

Wachovia (WB) and BOFA (BAC) Have Bottomed; Meredith Whitney Missed Boat

Maybe you will feel the same after reading them. Whoever was able to predict this financial meltdown was basically seen as hero in the financial community. Meredith Whitney was right last year and I tends to believe she is going to be right again because she has more power now and her call will effect the sentiment of the market. She just updated her view on financial sector. I quote some her lines here to remind myself of her opionion.

We believe we are on the onset of changes impacting the mortgage market that could meaningfully influence earnings of the banks over the near to medium term. Accelerations in loan modifications will materially change how loss reserves are measured, which will result in lower loss provisioning and higher earnings over the near term

the U.S. government increased allocated incentives to mortgage companies by a fifth to modify home mortgages, while total incentives to servicers now stand at $18 billion and could climb higher. This is not the only incentive to banks. Modifications “cure” past dues and shift delinquent loans to current loans. As banks’ loss provisions are based upon past due or delinquent loans loss provisions will decline as modifications rise.

The clear risk here is timing as current recidivism rates range 22-46% on modified loans. Banks may take advantage of a timing arbitrage, which could benefit near-term earnings

“As we continue to believe the bank sector faces numerous challenges, we are most comfortable with stock valuations close to tangible book per share levels,” Whitney said. Pointing to Bank of America, JPMorgan Chase, Wells Fargo and Citigroup, she expects future increases in tangible book value, except for Citigroup.