Banks: Pain Now, Profits Tomorrow

Although investors have grown more confident about banks, earnings still look weak. The third quarter marks the 11th straight period in which the industry has delivered worse results than the previous year. Overall profits are expected to drop 28% from the same period in 2008, according to investment bank Keefe, Bruyette & Woods.

When will profits perk up? Despite the drumbeat of dire warnings about commercial real estate and consumer credit, the banks may be due for better earnings next year.

Much of the recent woe stems from banks recording the cost of losses before their loans completely rot. Fourth-quarter earnings likely will remain in the doldrums for the same reason. But the caution could pay off. By taking so much pain now, banks may be limiting the lumps they have to take in 2010. "I think they're going to be aggressive about recognizing problems so they won't have that drag on earnings [next year]," says Chris Kotowski of money management firm Oppenheimer.

Big banks are accounting for hefty losses, a process known as building up reserves. Kotowski figures Wells Fargo (WFC), which was slated to report earnings after BusinessWeek went to press, will rack up $6 billion of expenses in the third quarter for problem loans, more than double the amount a year ago. The company was expected to earn 38 cents a share, down from 48 cents last year. JPMorgan Chase (JPM), Citigroup (C), and Bank of America (BAC) are adding to their piles of reserves as well. Kotowski figures reserves at the five largest U.S. banks will amount to 3.4% of their outstanding loans at the end of the fourth quarter—roughly twice the norm.

Thanks to the magic of accounting, the growing stash of reserves may eventually help juice banks' profits. That's because even if more loans go bad next year, banks won't necessarily have to build reserves to cover them. By the end of this year, they may have enough to deal with a lot of future losses. Assuming that's the case, earnings will look stronger in 2010.

AN ABOUT-FACEIn the past regulators have raised eyebrows at such preemptive moves. The Securities & Exchange Commission and accounting rulemakers have discouraged banks from taking losses until they had real evidence—such as a history of delinquencies—that their loans wouldn't be paid in full. In 1998 the SEC forced SunTrust Banks to reverse $100 million in reserve-related expenses. The federal regulator was concerned the Atlanta-based bank was effectively dipping into current profits to make future periods look better, a practice known as cookie-jar accounting.

But the economy has changed since then. Now regulators, fearful of unanticipated losses lurking in loan portfolios, are urging banks to fatten their reserves. President Barack Obama and other leaders of the Group of Twenty nations formally called on regulators to allow bankers to be more "forward looking" in counting "expected losses." And the International Accounting Standards Board is currently drafting rules to do just that.

Of course, the question remains how much of the losses will ultimately materialize. Mortgages, credit cards, and other consumer loans are showing signs of stabilizing, although JPMorgan CEO Jamie Dimon warned on Oct. 14 that he expects consumer credit costs to "stay elevated for the foreseeable future." For many banks the biggest concern is commercial real estate, which analysts figure may not hit bottom for at least another year. But given just how much banks underestimated their losses at the beginning of the crisis, it's not improbable to think they would overestimate them toward the end of it.

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