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The following is a guest contribution from Annaly Capital Management.  They eloquently show how bank earnings are still in dire capital positions and that their profits are nothing more than a mirage.  There are many hurdles ahead for the banks:

“Earnings Register Modest Improvement” states page one of the FDIC’s Quarterly Banking Profile for the period ending 9/30/09.  We love this data-rich report, and sometimes a line or two from the summary will jump out that demands attention.  For example, the quote below:

“The third quarter [provision for loan loss] was $11.3 billion (22.2 percent) higher than a year earlier, but it was $4.8 billion (7.1 percent) less than the amount that insured institutions set aside in the second quarter.” (emphasis ours)

Indeed, this quarter’s provision was $62.5 billion versus $67.3 billion in the previous quarter.  If we had improving (or at least steady) credit performance, or a banking system that was already adequately reserved, falling provisions wouldn’t be a red flag.  But we don’t.  The chart below is an old favorite of ours, one you’ve seen before and one you’re likely to see again.

It confirms that credit performance continues to deteriorate and the coverage ratio is certainly not what we’d call adequate for any scenario other than a rosy one.  As non-performing assets and net charge-offs climb unabated, a lower loan loss provision (one that is lower than 2 of the previous 3 quarters) cannot be justified.  If banks had held their coverage ratio steady at 63.6%, where it was in the previous quarter, this would have called for an additional provision of $12.9 billion, which more than wipes out the $2.8 billion in “profits” for this quarter.  Instead, to produce those headline profits, the coverage ratio drifted further south, to stand at only 60.1%.  It’s impossible for outside observers to say what level of reserves is adequate to cover future losses.  After all, if a loan is collateralized, losses won’t total 100% of the loan.  We can’t say what the “correct” amount of provisioning is, but it isn’t 60%.  The average coverage ratio in the nearly 15 years before the crisis began is roughly 140%.  The current coverage ratio won’t do, not when credit continues to deteriorate (and not if you want an active and lending banking system).  John Hussman has become a lone voice in the wilderness, crying out about the coming second wave of option-ARM and Alt-A mortgage resets, and we would suggest you listen to him.  The significant issues in commercial real estate have also seemingly been forgotten during the ripping rally in risk assets, but they have not gone away.  Why then, with the old issues still worsening (prime mortgage delinquencies hit a new record in Q3) and these new challenges in the offing, would banks be lowering their provision simply to show a mirage of profit?

More importantly, why would the regulator allow it?

Source: Annaly Capital Management