A number of major financial institutions are reporting 2nd quarter earnings this week. Actually, to say these institutions are truly reporting earnings would be a misnomer. To a large extent, these institutions are releasing managed earnings reports. What does that mean? Let’s navigate this ever important sector of our economic landscape.
In simplistic fashion, earnings are revenues less expenses. While financial analysts may want us to take reported earnings on face value, there is a lot more to it than that. What are the quality of the earnings? Are revenues increasing or decreasing? Are expenses increasing or decreasing? Are net margins of profitability increasing or decreasing? Are earnings a function of a growth in revenues or more a reduction in expenses?
In regard to a financial institution’s earnings, the greatest expense is typically compensation and benefits. On Wall Street, the expense associated with personnel usually runs between 50-55% of overall expenses.
On the revenue side of the ledger, earnings are broken down by division. How much revenue is produced from fee-generating business units and is repeatable versus how much is generated from volatile trading businesses and is thus more risky. Fee generating revenue is considered to be of higher quality. As such, the market attaches a higher multiple to the earnings from those business units.
In my opinion, the most opaque component of earnings and income statements revolves around valuations of assets held on the financial institution’s books. This component of an earnings statement is truly where the financial wizards on Wall Street get most creative. The assets to which I refer are:
1. Securities positions, that is, the variety of different bonds, stocks, and derivatives held by the institutions. While plenty of these assets are very liquid, easily evaluated, and thus easily marked, others are much less so. For a wealth of toxic assets (different types of mortgage assets, CDOs, and the like), these institutions were blessed by the FASB (Federal Accounting Standards Board) to mark them at levels which they deem appropriate versus where the assets may actually be trading in the marketplace. In the process, these institutions are sitting on hundreds of billions of embedded, yet unrealized, losses. How and when may those losses be recognized? When the underlying loans backing these securities default. Let’s move to that aspect of ‘managed earnings.’
2. All of these financial institutions have a mix of different consumer or corporate lending businesses. As such, they all have exposure to consumer and corporate loans. These loans are experiencing an ever increasing level of delinquencies, defaults, and foreclosures. As such, financial institutions should be aggressively increasing their levels of reserves against these loans. In the 1st quarter, virtually every financial institution underreserved in an attempt to report better than expected earnings.
By underreserving, these institutions are front end loading the actual earnings while simultaneously postponing the losses and chargeoffs associated with loans which will continue to default at higher rates.
Will the financial institutions ‘manage’ to play this charade once again? In my opinion, they will. Why? The analysts in the industry along with the financial media have been and will continue to be largely compliant in this ‘managed earnings’ game as opposed to demanding real transparency and integrity in the process.