Credit costs are falling, but credit expenses are on the rise. Huh?
It's a distinction with a difference — at least that's what the heads of BB&T Corp., Wells Fargo & Co. and Huntington Bancshares Inc. said in selling their stories to investors at a New York banking conference this week.
The pitch was cerebral to say the least: Though the industry's go-to barometer for measuring credit costs for the last two years — provisions to cover future losses — are falling, other problem-loan expenses are elevated or getting higher.
These include the costs of selling foreclosed properties or adding loan workout specialists to the payroll. There are new allowance pools to cover the cost of home-loan lawsuits as well as the costs of buying back bad mortgages from investors.
These items contributed to a surprise yearend surge in big bank expenses and underscore two things that make it hard for investors to be bullish on banks right now: The twisted logic of big bank accounting, and the long way banks still have to go to fully recover from the fall of 2008.
"I think we're going to have these expenses for awhile," said Christopher Marinac, managing principal and director of research at FIG Partners LLC. "The credit cycle is not over."
The higher credit-related expenses going forward "could be a source of investor disappointment," he added. "People expect it to be significantly better, and it takes a lot longer for these things to come down."
The cost of dealing with a bad loan for the past two years has almost entirely been tracked on the "provision" line of bank balance sheets, which shows how much money a bank is essentially socking away in a rainy-day fund for future losses. Those funds are essentially being reclassified as profits these days, and credit headaches are migrating to other lines of the expense docket.
An important one: the efficiency ratio, which is essentially expenses divided by revenue. What's happening is that bank expenses are on the rise while even the best banks are treading water when it comes to growing revenue. A lower efficiency ratio is good: It indicates that a bank is controlling expenses while doing things to make more money. Right now efficiency ratios are rising.
Wells Fargo's was 62.1% in the fourth quarter, up from 58.7% three months earlier. It was up to 72.0% from 71.6% at Regions Financial Corp. Barclays Capital on Wednesday said in a report that median expenses rose 4% quarter-to-quarter at the 27 large and midsize institutions it tracks. Revenue grew 1%.
"Expenses came in much higher than projected [last quarter], a trend we will have to watch more closely as 2011 progresses," the report said. "This trend began to emerge in (the third quarter), though we thought it would taper off."
Some of that can be attributed to banks spending more money on growth initiatives after years of belt-tightening. But bankers who spoke Tuesday and Wednesday at the Morgan Stanley conference said credit-related expenses were an issue, too. It's a problem that isn't going away any time soon either, they said.
"There are just a lot of expenses embedded in our run rate today that are credit-related. We tend to talk about provisioning, but it just bleeds through the whole income statement," Kelly King, chairman and CEO of the Winston-Salem, N.C.-based BB&T, said on Wednesday. "You have not only (foreclosed-asset) expense, you have heightened professional expense. You know, you have heightened expense in terms of additional staffing. So there are just a lot of areas that are absolutely correlated to the level of nonperforming assets."
BB&T's efficiency ratio rose to 55.3% from 54.1%, largely due to securities gains. It was weighed down by a huge loss from disposing nonperforming loans as well as elevated foreclosure expenses.
Wells Fargo, in turn, has been among the most forthright banks in addressing how the credit crisis could keep expenses elevated for years even as losses keep falling.
"While credit quality continued to improve" in the fourth quarter "we still have higher than normal costs associated with loan resolutions and loss mitigation, including both personnel and foreclosed-asset expense," John G. Stumpf, the president and CEO of the San Francisco company, said in his presentation on Tuesday.
Every key area of credit quality kept moving in the right direction: Provisions have fallen for five quarters to their lowest point in at least two years, and nonperforming loans fell more than $2 billion during the last three months of the year. That has enabled it to wind down its credit allowance in the form of profit-boosting reserve releases that amount to about $2 billion over three-straight quarters.
Offsetting those gains are non-provision-related credit expenses that just won't go away: It spent $86 million more dealing with foreclosures, which contributed to $827 million in what Wells classifies as "loan resolution/loss mitigation" costs. That was up from $750 million in the prior quarter.
Stumpf told investors that resolution costs could range from an average $600 million to $775 million per quarter in 2011, and $550 million to $650 million in 2012.
"We expect those to be lower if the credit environment continues to improve in the coming years," Stumpf said.
The story was slightly different at Huntington Bancshares Inc., a Columbus, Ohio bank that had big problems with subprime home loans that is has mostly — though not entirely — moved past.
Provisions fell $32 million last quarter, along with delinquent loans and chargeoffs. But some expense-line items show that it's not entirely free of its past: total noninterest expense rose $7.3 million, reflecting $4.1 million it had to set aside to repurchase bad mortgages from investors.
Still, Stephen Steinour, Huntington's CEO said credit quality showed "outstanding improvement" last year, and that falling provisions and problem loans will drive profits in 2011. Expenses should increase, he said, but that is because Huntington will be spending more money on people, products and services in pursuit of more customers across the Midwest. The other big driver of expenses last quarter was $3.1 million spent on growth initiatives.
"We are gaining share of wallet and we are taking market share," Steinour said. "And the results are being seen in growth of our customer base."
Jim Sinegal, an equity analyst at Morningstar Inc., said that even though credit metrics are improving, they are doing so at a slow pace.
"If you look at the decreases in nonperforming loans, they weren't very large," he said. "We've seen kind of a little bit of an improvement now for several quarters, but it doesn't look like there's been major improvements anywhere."
As a result, credit-related expenses are going to remain elevated over the next two years, he said.
