Banks pull more of their earnings out of a bag of tricksOctober 17, 2013: 10:36 AM ET
Accounting moves boosted bottom lines at the biggest banks this quarter. How long can this last?
FORTUNE -- Even as Washington is adding doubts to the recovery, investors have taken comfort in bank earnings. Perhaps they shouldn't be.
On Wednesday, Bank of America (BAC) said it netted $2.5 billion in the third quarter, up from basically breaking even a year ago. Shares rose, as they have at the other banks, even before Washington had a deal. JPMorgan Chase's shares were up on Friday, despite the fact that the bank disclosed a loss on a huge litigation charge. Without the charge, though, JPMorgan (JPM) said it would have earned close to $7 billion in the three months that ended in September.
BofA's report seemed to round out another strong quarter for bank profits. Collectively, the nation's four largest banks earned nearly $11 billion, which was pretty good considering it included JPMorgan's $9 billion charge.
The problem is the profits banks are reporting might not be as good as they appear.
As sales have stalled, banks have increasingly turned to an accounting maneuver that has drawn criticism from analysts and a top regulator. In the aftermath of the financial crisis, banks loaded up their loan reserves -- the rainy day fund lenders use to cover losses.
Now banks are saying that they don't need as much in those accounts. That's become a big boon for bottom lines. Accounting rules state that any money that comes out of those accounts can go, after taxes, straight to the bottom line.
Of course, it make sense that banks might not need as much in those accounts as they once did. The economy is improving, and fewer people are likely to fall behind on their loans. But the problem is the earnings from the reserve releases have grown much faster than the banks' regular profits. In the third quarter, for instance, as much as 37% of the profits of the four big banks, which includes Citigroup (C) and Wells Fargo (WFC), as well as JPMorgan and BofA, came from reserve releases. That's nearly up from 20% in the second quarter, which was already larger than typical. The fear is that the reserve releases are masking the underlying weakness in bank earnings, and that when banks have pulled as much as they can out of their reserves bottom lines will drop.
"Everyone is looking at this," says Moshe Orenbach, a bank analyst at Credit Suisse. "At some point this runs out."
In September, Thomas Curry, who is the Comptroller of the Currency and one of the banking industry's chief regulators, said in a speech at an industry conference that while some reserve releases make sense, he was worried banks were dropping their reserves faster than they deserved just to boost earnings.
In the most recent quarter, for instance, at BofA, its reserve release of $1.4 billion equaled more than half of the bank's bottom line. That's up from 23% in the second quarter. BofA got more than any of the other big banks. JPMorgan took a $1.1 billion benefit from the same maneuver. Although the comparison is a little bit of apples and oranges because the loan reserve benefit is pre-tax and BofA's $2.5 billion bottom line is post-tax.
There's no preferred method for testing whether a bank is reserving less than it should. But BofA took just under $300 million in provisions for future loan losses in the quarter, down by $900 from the second quarter.
Charge-offs of bad loans were down as well, but only by less than half as much. At the same time, BofA said an additional $2.5 billion in loans that the bank made to individuals were delinquent, meaning consumers had missed one or more interest payments, in the third quarter alone. That was up from $2.3 billion in the second quarter. So the bank's credit problems seem far from over.
"We expect to see uniformly strong risk management, including prudent allowances practices consistent with [accounting] and regulatory guidance, in our banks, and especially in our largest institutions," Curry said at the industry conference. It's not clear the big banks are listening yet.