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Managed Earnings: Still a Terrible Idea


Beating estimates at any cost is what got us into this mess.

Several Minyanville professors -- along with Warren Buffett -- have argued that bank nationalization can be avoided if we just allow the major banks to amortize (write off) the bad loans on their books a little bit every quarter over the next several years.

While part of me feels like that would be akin to letting retailers write-off the markdowns on last season's green bell-bottomed pants over the next 5 years, I have a more fundamental opposition to the idea: You had your chance and, with all due respect to the man, Arthur Levitt blew it for you.

You see, back in the late 1990s, when Mr. Levitt was chairman of the SEC, he went on a very visible crusade against earnings management and banks' and corporations' use of, as he put it, "cookie-jar reserves."

I encourage you to read the 1999 Fortune article by Carol Loomis entitled Lies, Damned Lies, and Managed Earnings, which contains the following Dirty Harry-like line: "The crackdown is here. The nation's top earnings cop has put corporate America on notice: Quit cooking the books. Cross the line, you may do time."

One specific cookie-jar item that Chairman Levitt and his team focused on was bank loan-loss reserves. Specifically, Mr. Levitt felt that banks were adjusting their assumptions on how far behind their reserves were each quarter in order to meet or beat analysts' estimates. And he wanted that to end.

So, to make one bank an example: In the fall of 1998, the SEC blocked SunTrust's (STI) acquisition of Crestar Financial until SunTrust agreed to reduce its existing loan-loss reserves by $100 million and restate prior-period earnings.

Well, as you might imagine, the banking industry went nuts, saying that it was unfair for the SEC to punish a bank for holding excess reserves at a time when banking regulators were urging them to bolster reserves.

While ultimately the SEC backed down on its restatement request, the loan-loss reduction stuck. And -- notwithstanding an attempt on the part of the Federal Reserve, the FDIC, and the OTS to water down the SEC's demand to a more "reasoned assessment of losses" -- the message to bank CEOs and CFOs was clear: Reserves should reflect losses under the most likely economic circumstances over the next 12 to 18 months - or else. (And to be clear, "or else" in the eyes of Mr. Levitt and his agency meant fines and/or jail sentences.)

And so, rather than use these past 10 years to build reserves sufficient to cover losses during this economic downturn, banks brought a lot of those reserve dollars into earnings. Worse, most used those earnings to buy back their own common stock at the top of the market. (And in this regard, I would highlight a slide from last week's Bank of America (BAC) annual meeting, in which the company noted that, during 2006, it used over $19 billion of its $21 billion in earnings that year to repurchase stock or pay dividends.)

The good news, in all of this, if there is any good news, is that regulators around the world now recognize the loan-loss reserve and capital shortcomings which we had in place going into this crisis. And the Group 30, an association of global central bankers and regulators, has proposed "counter-cyclical" capital requirements, effectively mandating the establishment of oversized reserves in good times - which can then be used to cover losses during downturns.

But to those who argue that this crisis' oversized losses should now somehow be rolled through future bank earnings, I would offer this: Not only has the time passed when these losses should have been reserved for in the first place, but writing down the existing loans in the future won't be economically possible. This is because future bank earnings will likely be significantly depressed as banks begin to build what I hope will be far more adequate reserves for the next economic downturn - one which will, no doubt, inevitably occur.
No positions in stocks mentioned.
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