Releasing loan-loss reserves may be a form of fake earnings — "ink on paper" that means "nothing" as JPMorgan Chase & Co. Chief Executive Jamie Dimon put it in July. Nevertheless, such moves accounted for giant fractions of shareholder returns in the second quarter.
Reductions in loss cushions — or the amount by which allowances are not replenished when quarterly chargeoffs exceed provisions — accounted for about a third of earnings per share at JPMorgan Chase and Bank of America Corp., assuming a 35% tax rate (see charts below). At Citigroup Inc., reserve releases were equivalent to a bit more than its profit of 9 cents a share.
What appears to be a decisive turn in the performance of credit card portfolios drove much of the attrition in defenses. At JPMorgan Chase, for example, a $2.4 billion drop in set-asides for bad card loans from the first quarter was equivalent to about 65% of the reduction in the company's total allowance.
But releases of reserves for commercial loans were also large. Wells Fargo & Co., which has a relatively small credit card business, cited improving trends in its consumer and commercial portfolios in its decision to draw down the allowance by $500 million before taxes, a move that explained about a tenth of Wells Fargo's earnings per share.
(Wells Fargo is also getting a big lift from better-than-expected performance in pools of impaired loans it acquired when it bought Wachovia Corp., including the reclassification during the second quarter of about $1.8 billion in expected losses on option adjustable-rate mortgages that it now expects to flow through as income over the remaining life of the loans.)
Among the very largest domestically owned commercial banking companies, U.S. Bancorp was alone in building its allowance in the second quarter, a move that helped increase it 12 percentage points from the first quarter as a portion of nonperforming loans to 168%. But during the company's earnings call, CEO Richard Davis said that U.S. Bancorp might release reserves in the future, a possibility it did not expect a few quarters ago. (U.S. Bancorp said that better delinquency trends had been offset by concerns about the economy in the most recent period, steering it to hold its reserves about steady.)
As a portion of nonperforming loans, Wells Fargo's reserves continued to fall in the second quarter, dropping 4 percentage points from the first quarter to 88%. But the company highlighted a deceleration in the growth of nonperforming loans — which it said were close to peaking — and said that a lengthy process for home mortgage modifications and foreclosures was slowing the pace at which it drained the pool of such assets.
Wells Fargo said further reductions in its allowance were likely "absent significant deterioration in the economy."
While releases of reserves may be poised to continue to prop up earnings in the coming periods, attenuated buffers mean that banks could also be forced to swing back to builds if loan performance worsens. In any event, reserve releases are ultimately an exhaustible resource.