Top U.S. banks will get billions of dollars of extra profit this quarter from the money they set aside in tougher times to cover bad loans.
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Banks including JPMorgan Chase & Co, Wells Fargo & Co and Bank of America Corp said this week that more borrowers are paying their loans on time, which allows the lenders to keep less money on hand to cover loan losses.
Dipping into the money they had previously set aside - known as "releasing reserves" - is entirely legal, and banks have been doing it for some time. But it will be particularly handy for banks this quarter. Mortgage lending has slowed down, cutting into a key source of income growth for the banks.
Meanwhile, overall loan growth has been tepid, Federal Reserve data shows, signaling that there are few obvious sorts of income growth to replace mortgages, and litigation costs for many banks are rising.
"We are in a better quality environment that still is not a growth environment," said Nancy Bush, an analyst at NAB Research in Annandale, New Jersey.
JPMorgan is expected to release around $1.5 billion in the third quarter from areas including credit card loans and mortgages, finance chief Marianne Lake said this week at a conference hosted by Barclays Capital. These reserve releases will allow the bank to set aside more money to cover litigation expenses, Lake said.
Wells Fargo expects to release more reserves in the third quarter than the $500 million in released in the second, Chief Financial Officer Tim Sloan said at the conference. He did not provide a specific number, and a spokeswoman for the San Francisco company declined to comment further.
Bank of America finance chief Bruce Thompson did not provide an estimate of the bank's expected reserve releases when he spoke this week, but he did say that much of its worst loans have been written off, and he said in July that he expects "continued reserve releases, particularly in its consumer real estate portfolios."
Richard Staite, an analyst at Atlantic Equities in London, estimated in a report on Thursday that the bank could release $1.6 billion in the third quarter. He added that the Charlotte, North Carolina, bank could reduce its $22 billion loan loss reserves by 27 percent and still have enough to cover double the amount of expected net loan losses.
Citigroup Inc, the third-largest U.S. bank, has not given any guidance about reserve releases, but research firm Portales Partners estimates that the 16 major banks it follows have $14.7 billion of reserves that could be funneled into earnings. A third of that is in residential real estate portfolios, and another third is in commercial real estate, said Portales research director Jennifer Thompson. The rest is in areas including corporate loans and auto loans.
Banks do not have carte blanche to release reserves. They have to point out that credit has improved enough such that those reserves are no longer necessary. The reserve releases boost pretax income, and regulators watch them closely to make sure banks are not manipulating earnings.
Because the releases are not necessarily repeatable in the future, some analysts are suspicious of them.
"It's not quality earnings," said Charles Peabody of Portales.
Executives at JPMorgan, Wells, and Bank of America highlighted the strong performance of their loan books when discussing their reserve releases. JPMorgan's credit card loans are experiencing "20-year lows for delinquencies across the industry," CFO Lake said at the conference.
Loans are also performing better because banks tightened their underwriting standards after the financial crisis. The mortgage loans Wells Fargo extended after 2008 "have virtually no losses," CFO Sloan said.
Reserve releases were an important contributor to banks' strong second-quarter results. They accounted for 14 percent of JPMorgan's second-quarter earnings, 6 percent of Wells Fargo's and 16 percent of Bank of America's, according to a September report from Bernstein Research.
However, reserve releases can offset lower revenue for only so long before banks have to find ways to make up the difference, NAB's Bush said.
"The industry is in this transition period, but transitioning into what? You hope it's into better growth, better margins, and all the stuff that goes into that, but it doesn't feel that way yet."
JPMorgan, Wells Fargo and Bank of America will report third-quarter earnings in mid-October.