Dwindling Loan Loss Reserves (by Runedge)

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The major banks have reported this week and have exceeded on the bottom line (top line for the most part was down Q4 2010 versus Q4 2009).  The reason for the bottom line beat is they reduced their provision for credit losses.  In fact each quarter since at least Q4 2009 they have continually dropped the total allowance for loan losses as a percent of total loans outstanding.

Chris Whalen said it best referring to JPM's earnings "Jamie Dimon is making a bullish bet on housing." What happens if asset prices do not rebound but rather fall?  What happens if the foreclosure process extends further with all that is going on in the industry?  What happens if mortgage cram downs occur? What happens to second tier liens?   

At some point should asset prices fall the banks are not prepared from an earnings standpoint to take the hit to their balance sheet.  Rather than lower the provision for credit losses they will need to ramp them back up and take a major hit to bank earnings.  Banks are also talking about raising their dividend (good luck finding the cash for that) in the coming year.  

The data below supports the theory that their "bullish bet on housing" is the wrong side of the trade. Perhaps there is a strategic reason for them to kick the can down the road right now from a reporting standpoint to build confidence in their equity.  In some sense why do the right thing now when there is a chance (albeit slim) that asset prices will rise and total allowances are at adequate levels.   

As traders we know prices ALWAYS over correct.  Whether it be to the downside or upside, the market never gets it right initially.  Looking at this chart below which looks at historic home values the argument can be made that home prices will depreciate possibly as much as 30% more.


The Case-Shiller Price Index below is also showing a double dip in home prices.  Many argue that since this index does not measure the entire market that it in fact lags and still it is showing a drop in home prices.

The chart below shows sales activity in 25 major metropolitan areas.  There are no "bids" in this market. How can prices rise when supply outweighs demand?


Lastly Lender Processing Services recently reported the following 

"Foreclosure inventories also continued to rise for the fifth straight month as delinquent accounts are referred for foreclosure, but the sale of foreclosure properties declined. When compared to January 2008 levels, the foreclosure inventory of jumbo prime loans is nearly seven times higher; the inventory of agency prime loans is nearly six times higher; and the foreclosure inventory of option adjustable-rate mortgage loans is approaching five times the inventory in January 2008."

The banks may argue that falling asset prices does not mean increased balance sheet risk as they hold to maturity or higher delinquency rates.  Perhaps that is their bullish bet.  There is plenty of data that counters that argument and clearly shows the less financial interest a homeowner has in their asset the far greater chance they will strategically default.  

Submitted by Runedge.  If you would like to follow my blog please visit - Ultra Trading