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Among the less visible worries in the cornucopia that have angered investors of late are S&P 500 Financials -19.9% ​​YoY earnings in the first quarter of 2022 – a highly unusual development over the past a period when most economic indicators are up and the vast majority of sectors are experiencing earnings growth.[i] The culprit, as The Wall Street Journal examined last weekend, is both simple and complex: a relatively new accounting rule seriously distorts profit calculations. Interestingly, unlike the last time an accounting rule change skewed bank earnings, US financials are holding up better than the S&P 500 as a whole. This is a change from 2007 – 2009, when another accounting rule destroyed bank balance sheets, triggering the global financial crisis. In our view, understanding the differences between the rules can help investors better understand the past and the present.

The rule in question is known as Expected Current Credit Loss, or CECL. As the name suggests, it requires banks to recognize all reasonably expected losses in their loan portfolio based on current economic conditions. Prior to CECL, banks had to recognize and provision loan losses only when they were imminent. Although this system worked well for decades, following the financial crisis of 2007-2009, some industry critics argued that banks were late in recognizing problems in their loan portfolios. In our view, they misinterpreted the havoc wrought by another accounting rule – FAS 157, the mark-to-market accounting rule, and its illogical application to illiquid, hard-to-value assets that banks never had intend to sell. But cool heads rarely prevail in these areas, so regulators decided the best way to bolster banks’ defenses would be to require them to provision for all expected credit losses over the lifetime of a loan.

This means, in practice, that banks must constantly adjust the probability of default of a given loan, usually based on current economic and financial conditions – and the assumption that these conditions will last indefinitely. This has led to wild swings in bank profits, swings that do not fully reflect real economic reality. In early 2020, at the height of the lockdowns, this led banks to increase their default projections and bolster their loan loss reserves accordingly. This was a major contributor to the decline in bank profits at the start of the year, as these provisions are essentially paper losses. But a year later, with more open economies and an alphabetical soup of fiscal and monetary aid programs in place, expected defaults have plunged, allowing banks to reduce their loan loss provisions – a gain on paper. . Today, high inflation and rising interest rates are raising default projections again, contributing to the fall in S&P 500 bank earnings of -30.7% in the first quarter of 2022.[ii] At some point in the future, this will reverse again, giving earnings a paper boost.

Before the CECL took effect in early 2020, bank earnings rarely deviated significantly from total S&P 500 earnings – the main exception was in 2015-2016, when falling oil prices destroyed earnings of energy, distorting the total downwards. But since CECL entered the fray, divergence has become the norm, as shown in Exhibit 1. Note the amplified swings during and after lockdowns, sending S&P 500 results exploding up and down.

Exhibit 1: CECL bank profit bias

Source: FactSet, as of 06/09/2022.

To understand why these swings represent less than ideal side effects of the new rules, we’ll have to use a tiny bit of jargon. When it comes to bolstering banks’ balance sheets, beneficial measures are usually what industry insiders would call “counter-cyclical” – banks would build up reserves for rainy days in good times and reduce them in bad times. bad times. This is the purpose of a buffer: it is a cushion against illiquidity and insolvency in the event of a crisis. This is what all the bank capital changes applied globally after the financial crisis have sought to accomplish. The CECL, on the other hand, is what eco-types call “pro-cyclical”: it releases reserves in good times and adds them when conditions get tough. As a result, it makes net income very good in good times and very bad when things go bad.

FAS 157 was also pro-cyclical. It required banks to value every asset on their balance sheet at the most recent market value of comparable assets, regardless of how difficult it was to value those assets and whether or not the banks intended to sell. So when hedge funds and other banks sold illiquid mortgage-backed securities at knockdown prices, it forced all banks to write down similar assets on their balance sheets at similar discounts. This destroyed bank capital, forcing some banks to sell their own mortgage-backed securities in the blink of an eye, triggering more writedowns, then more fire sales, then more writedowns. Lather, rinse, repeat – with some institutions failing, others bailed out and chaos reigning on Wall Street and Main Street until regulators suspend the rule’s application to held-to-maturity assets. This is the vicious circle that took hold at Lehman Brothers in September 2008.

Both CECL and FAS 157 had outsized impacts on bank profits. So why did FAS 157 cause a crisis while CECL mostly generated sighs and annoyed phrases from bank CEOs? On the one hand, as mentioned earlier, FAS 157 wiped out banking capital. This is not the case for CECL – it is a paper loss reflecting an increase in cash reserves to protect against expected future defaults. Second, loan losses were not at issue in the global financial crisis. According to former FDIC chief Bill Isaac, who analyzed the numbers in his excellent book on this period, senseless panic, total loan losses at that time were only about $200 billion. It’s important in a vacuum, but not important enough to crush the global economy. But FAS 157 amplified that figure to nearly $2 trillion in overstated and unnecessary write-downs – it was a punch. It destroyed bank capital used to support lending capacity. Credit frozen. CECL simply does not compare.

Overall, we are inclined to agree with JPMorgan Chase CEO Jamie Dimon’s assessment of the situation. When he announced exceptional results in the first quarter of 2021, largely related to the release of loan loss provisions made under CECL rules during the shutdowns, he said bluntly: “We do not consider not this as a profit. It’s ink on paper.[iii] In our view, the markets see it too. In 2008 and 2009, the fire sales and writedowns were a giant shock to a critical aspect of banking operations. So did the government’s haphazard attempts to manage the situation, which fueled further uncertainty. But under CECL, markets are pretty good at determining how banks’ models will extrapolate current conditions into expected defaults. They can also distinguish between real and paper profits and losses, and they know that CECL does not wipe out capital in tough times.

Be careful, we don’t think CECL is the smartest rule ever applied. In addition to its procyclicality, it essentially forces banks to forecast future loan losses by extrapolating current economic and financial conditions into perpetuity. The fluctuations of the last two years show the folly of this situation, as rapidly changing conditions have led to rapid changes in CECL provisions. Additionally, a number of variables can affect a borrower’s risk of default over the life of a loan. Distant developments like this are simply unknowable.

So it’s a pretty useless rule. But thanks to the efficiency of the markets and some key differences from FAS 157, it is not inherently destructive. This is primarily an academic curiosity that we encourage investors to consider when evaluating bank earnings.

[i] Source: FactSet, as of 06/09/2022.
[iii] “How a new accounting rule is causing bank revenues to explode”, David Benoit, The Wall Street Journal06/03/2022.