The $ 33 billion credit loss warning on four megabanks is causing confusion

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The country’s largest lenders saw huge losses in the second quarter – all without a wave of customer defaults or foreclosures.

That is on purpose. New accounting rules that went into effect in January are forcing banks to record losses before those losses surprise them. In a time of 11% unemployment, rising coronavirus cases, but government stimulus money propping up the economy, banks are preparing for the worst, even if it hasn’t happened yet.

The Credit lossaccounting The revision should make it easier for analysts to understand the future prospects of banks. But the mix of doomsday scenarios and yet few on-site losses makes for a confusing earnings season as banks struggle to make estimates with the conflicting information they have.

“People are just guessing,” says Paul Noring, executive director of the Berkeley Research Group. “That has to do with math and people try to model and look at things, but the traditional methods they came up with just don’t work.”

The four largest financial institutions – JPMorgan Chase & Co., Wells Fargo & Co., Bank of America Corp. and Citigroup Inc. – at first glance saw a worst-case scenario and put together a whopping 33 billion US dollars with impending losses. However, these loss forecasts are based on different data from the institutes.

‘Explosion’ models

The current Accounting Standard for Expected Credit Loss (CECL), published as the Financial Accounting Standards Board’s main response to the 2008 financial crisis, requires companies to look to the future, consider past experiences, and assess current conditions to identify potential Expecting losses rather than waiting for customers to miss payments in order to post them.

This pioneering accounting method made its unfortunate debut during a global pandemic. The first quarter was tough for the banks, which closed their books on March 31st, March 31st, and spent about two weeks with widespread stay-at-home orders. But this quarter, with even more uncertainty about the future, was even more challenging.

Banks have spent years preparing to implement the standard. Many of the models banks have developed to estimate future losses use factors such as unemployment to gauge what will hit the market.

When people lose their jobs, they typically fall behind with auto payments and mortgages. But economic controls, government corporate loans, and increased unemployment benefits have averted that financial pain.

“Right now, we are not seeing anything that is consistent with an 11% employment rate in actual consumer payment history,” said Brian Moynihan, CEO of Bank of America Corp., on the bank’s conference call on July 16.

During the quarter it became clear that factors such as unemployment and gross domestic product would not help banks determine expected losses. These models “started to blow up,” said Reza van Roosmalen, CECL head of accounting advisory services at KPMG LLP.

“If you were really just using unemployment or GDP growth as the main driver, the real reserves would actually be exponentially higher than they are today,” said van Roosmalen.

Judging by nature

While the FASB and regulators have repeatedly warned that credit loss estimates shouldn’t be a best-case or worst-case scenario, but rather a best estimate using all the evidence available, an inherently judgmental rule has leeway.

“Some companies will take a conservative view, some an aggressive view, and some a down-the-middle view, all of which are acceptable under the standard,” said Jeffrey Johanns, senior accounting lecturer at the University of Texas McCombs School of Business.

In some cases it pays to be conservative. When a bank overestimates losses, it diminishes profits in the short term, but its reserves absorb the losses when they occur. If these losses do not pay off, the bank can reduce this pot of money or “release” it as profit.

“If you give the market a surprise, you want a positive one,” said Johanns.

The reserves banks set up to cover losses affect income and the numbers matter.

When a bank increases its retirement provision, it sends important details about how pessimistic or optimistic it is about the future, said Saul Martinez, managing director of UBS.

“It helps us think about how banks view potential results and potential losses,” Martinez said. “Whether they’re right or wrong, who the hell knows.”

JPMorgan Chase & Co. posted a provision of $ 10.5 billion, more than $ 2 billion more than the previous quarter. The bank’s executives told analysts on the July 14 conference call that they are weighing a variety of scenarios but relying heavily on the downside results to determine their number. CEO Jamie Dimon said the bank has taken a more conservative approach to what the Federal Reserve and others believe is the “baseline” scenario that ultimately gets out of hand.

“If the base case occurs, we may be overbooked. I hope the base case happens, ”said Dimon.

Investors need to be on their guard in the coming quarters to see earnings growth driven by banks adjusting their forecasts and releasing reserves, Martinez said.

“It’ll be interesting in ’21 or ’22 if that takes effect and profits are really backed and backed by reserve releases,” Martinez said. “Will investors rate this investment flow with a high multiple? Or are they viewed as lower quality income? “

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