What the Heck Are Loan Loss Reserves and Why Are Banks Making Money From Them?

A key theme in the recent earnings releases from some of the nation's big banks has been the reduction in an accounting item called the loan loss reserves. Although this sounds like mere book keeping at first, loan loss reserves have contributed hundreds of millions to bank profits recently and thus are nothing to shrug off.

Accounting Mechanics

Banks make loans; that is the business of commercial banking. However, some loans end up being defaulted on or have to be restructured at a cost to the banks. Because banks have an idea of the amount of loans that are set to sour, they can estimate this amount. And since financial reporting is supposed to be about clarity, accounting rules require banks to expense this amount now and create an account that represents this expected loss.

During the financial crisis, loan loss reserves increased due to the fact that banks expected more loans to sour. As people lost jobs and companies went bankrupt, the number of non-performing loans increased and banks financial statements were adjusted to represent this.

Related: Citigroup's Nathan Sheets Makes Sense Of Bernanke's Moves.

Boosting the Bottom Line

The reduction in loan loss reserves at some of the nation's biggest banks has been seen in the few bank earnings that have already been released and should continue to be a theme for others. In fact, for five of the largest banks that have already reported, reduced loan loss reserves have supplied about $2.8 billion in pre-tax profits or 15.25 percent of the $18.273 billion in net income these banks have earned.

Here is a breakdown on a per bank basis:

• J.P. Morgan Chase JPM reported net income of $6.5 billion with $1.5 billion in pre-tax profit coming from reduced loan loss reserves, or 23.08 percent of net income.


• Wells Fargo WFC reported net income of $5.5 billion with $500 million in pre-tax profit coming from reduced loan loss reserves, or 9.09 percent of net income.


• Citigroup C reported net income of $4.2 billion with $784 million in pre-tax profit coming from reduced loan loss reserves, or 18.67 percent of profit.


• Goldman Sachs GS saw no reduction in loan loss reserves in its net income of $1.93 billion.


• Comerica CMA reported net income of $143 million with $3 million in pre-tax profit coming from reduced loan loss reserves, or 2.1 percent.

Who's Next?

Looking ahead, Bank of America BAC is expected to report second quarter results before the bell Thursday, July 17. The bank is expected to report EPS of $0.25 vs. $0.19 a year ago on revenue of $22.79 billion vs. $21.97 billion a year ago. Moshe Orenbuch, bank analyst at Credit Suisse, sees Bank of America releasing $750 million in reserves in the quarter on $2.695 billion in net income, or 27.8 percent of net income.

U.S. Bancorp USB is also expected to report second quarter results Thursday before the bell and is expected to have to expense more provisions, rather than see the boost from a reduction in loan loss reserves like its peers. U.S. Bancorp is expected report second quarter EPS of $0.76 vs. $0.71 a year ago on revenue of $5.00 billion vs. $5.07 billion a year ago. Credit Suisse sees the bank expensing $399 million in new credit provisions in the quarter, less than the $403 million in the first quarter and $443 million in the fourth quarter of 2012.

The point is that banks "profits" can be boosted by accounting items that may not be real and it is important for investors to learn how these numbers actually work. Bank earnings can be some of the hardest to digest due to these phenomena and thus understanding the dynamics is crucial. And for trading, markets can overreact to headline numbers that don't appreciate these single lines on the income statement and balance sheet and can create short-term arbitrage opportunities to profit on.