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Bank Earnings 102: The Best of Times, The Worst of Times


At the top of a credit cycle, the income statement for a financial institution shows "the best of times", but buried in the balance sheet is "the worst of times" to come.

Minyan Peter, who has become quite popular around the 'Ville with readers and professors alike since his first letter, A Bird's-Eye View of the Credit Conundrum, here continues his informative series on banks that began with Bank Earnings 101.

In Bank Earnings 101, I provided an overview on the key drivers of bank income statements. Again, I can't emphasize enough the importance of understanding the basics of how banks make money. They are the largest sector in the S&P 500 and a strong banking sector is a prerequisite for a strong economy.

At the same time, however, I am now going to ask you to ignore the net income figures that are announced by financial services firms at the end of this quarter. As much attention as they will get, in the bigger scheme of things, their net incomes this quarter don't matter. And they don't matter because of one simple rule for financial services firms:

The income statement is the past. The balance sheet is the future.

Let me repeat it again. The income statement is the past and the balance sheet is the future, especially now.

At the top of a credit cycle, the income statement for a financial institution shows "the best of times", but buried in the balance sheet is "the worst of times" to come.

To explain:

First, this particular quarter truly is the best of times and worst of times for financial services firms. Literally half of the quarter (through August 16) was "Goldilocks LaLa Land" and the other half was God-awful. Trying to extrapolate this quarter's earnings into any kind of meaningful projection will be all but impossible. And even when pressed, I doubt you will see too many firms highlight their monthly trends within the quarter to help you. (Although watch who feels compelled to share their month-to-month earnings. This is a great tell as to who may be experiencing the most funding pressure.)

At least to me, this quarter's results will be scrambled eggs: banking analysts looking for yolks will see one thing, and analysts looking for whites will see another. There is too much good and bad mixed into this quarter to make clear decisions based solely on net incomes. But you can be sure that CNBC will be filled with debates as to who met or missed expectations.

To be clear - it doesn't matter. History repeatedly reveals the ability of highly profitable banks to go down in flames. How many of you remember Texas Commerce Bank – AAA at the top, but gone at the bottom of a severe credit cycle?

Second, one quarter does not complete a credit cycle. We are at the beginning of a material economic change. Remember, we have only just seen the first month of employment decline. Loan loss provisions are predicated on the present economy, not on possibly better or worse future economies. This quarter's provisions are likely to be relatively light based on the strength of our current economy. Similarly, any funding cost increases are just beginning to impact net interest margin.

Go back and read the 3Q '05 financial results for a few homebuilders and you will get my point. Few reveal any clues to their future demise– particularly the potential for balance sheet writedowns. And I expect the same this quarter for many banks. Unless they were hit directly by credit issues related to sub-prime mortgages or liquidity issues around the mortgage or asset-backed commercial paper markets, you probably won't see much.

But in much the same way as the housing industry has taken one-time write down after one-time write down for land values, I anticipate that we will see increasing loan loss provisioning by banks as the economy continues to weaken. Remember, the loans have been made. The only questions now are how severe the downturn will be and how many borrowers will be affected. If the housing industry's forecasting prowess is any indicator, I would suggest we have a long way to go before we see the bottom of this cycle.

Finally, and thanks to GAAP accounting, not all gains and losses flow through bank income statements. While I am not an accountant, my understanding is that all foreign currency translation adjustments, minimum pension liability adjustments, unrealized gains or losses on available-for-sale investments, net unrealized losses on SFAS 133 derivatives and even some securitization related items skip the P&L and are reported directly as adjustments to shareholders equity.

So, even if you look, you won't find them in bank income statements and they don't touch earnings per share. To find out what these items are you will need to read something called the "Comprehensive Income Statement".

And that is where I intend to start. I don't know about you, but to me one of the most important figures I am going to be focused on this quarter is "unrealized gains or losses on available-for-sale-investments". For financial services firms with large trading positions, my guess is that there is a lot paper sitting in inventory. The Comprehensive Income Statement will reveal the level of pain associated with it.

In a follow up piece, I'll help you do some detective work in a bank's balance sheets. That is where most of the clues about the future will be found.
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