There is an increasing need for credit analysts in high yield and convertible bond/preferreds markets to look under the hood of the nation’s banks.
This paper is meant to help summarize and guide analysts’ work in looking at banks from an investment perspective.
We have seen some financial institutions (e.g. CIT) enter into subinvestment grade territory. This means their bonds are subject to inclusion in high yield indices and thus part of the high yield universe. Ignoring these names by portfolio managers and credit analysts constitutes a structural short of the banking sector relative to high yield indices. Further, there are more banks on the precipice of a downgrade into sub-investment grade, so some analysts might be looking to ready themselves for possible cross-over names. So analysts are going to be forced to turn some attention towards the banking sector.
But a more important reason to roll up the sleeves and look under the hood of the nation’s banks is the investment value that can be uncovered. “Normal” credit analysis does not cut it when it comes to looking at banks. Debt to EBITDA is meaningless. Cash flows are important, but the key to understanding credit risk is in tearing down the balance sheet. Capital ratios referencing the Tier 1 level or the tangible equity level can be useful indicators, but there is more in the balance sheet than equity cushion. It is important for the credit analyst to dig into the valuation and accounting of loans and other interesting earning assets. Accounting policy varies from company to company. For example, merely comparing loan reserve levels for two banks ignores differences in how each might have written off loans before even needing to provide reserves. To high yield and convertible market investors, this “newness” of analyzing banks means mispricing opportunities and the chance at finding solid returns without commensurate risk.
Analysts can get lost in the different accounting names and definitions. Here are some key terms:
Loan Loss Reserve
This is a contra asset account on the balance sheet used to offset problem loan balances without directly writing off the loan. An estimate. A way to effectively mark loans to market. Could be allocated or unallocated to specific loans. Unallocated reserves are essentially a rough estimate of problem loans based on some assumptions by mngt.
Opening Loan Loss Reserve
+ Loan Loss Provision
- Net Charge offs
= Closing Loan Loss Reserve
Loan Loss Provision
This is a P&L expense item. As loan loss reserves are built up, this is the related expense. This can turn to a credit/income on the P&L as the economy recovers and banks reverse their reserves.
Net Charge offs
A more direct way of reducing loans. All or part of the loan is directly written off (cr) and either the loan reserve is reduced or if the loan not already provided for then is expensed through the P&L (dr). Use the word “net” because gross charge offs can be reduced by any recoveries. Loans are charged off when they are deemed uncollectible.
Non accrual loans
Loan that is over 90 days overdue. The bank stops accruing interest income and only records income when cash is received. When cash does come in, the bank can chose to recognize this as a reduction in the loan balance or book it as income. This is one category of “non performing loans”. Not all loans categorized as “non accrual” get the FAS 114 impaired loan accounting treatment as below.
Restructured loans
The original terms of the loan are changed because of deterioration in credit quality. The modification is usually a reduction in the principal of the loan or the interest to be received is modified. Extending the maturity at the same rate is NOT a restructured loan. These loans are shown separately. A restructured loan should be accounted for as an “impaired loan” as set out below. This is one category of “non performing loans”.
Non-Performing Loans (NPL)
The sum of Non Accrual Loans and Restructured Loans.
Deliquent Loan
Behind in payment. These may or may not be provided and reserved for.
Impaired Loans – FAS 114
Rather than booking a general provision to increase reserves, a bank can write loans down directly with a charge off and no provision therefore is set up. “A loan is impaired when it is probable (ie likely to occur) that a creditor will be unable to collect all amounts due” as scheduled. The FASB provision states that the loan is valued at one of:
1) NPV of expected cash flows discounted at the loan’s effective rate, or
2) An observable secondary market value of the loan or
3) The fair value of the loan’s underlying collateral
The discount rate is the “effective rate” which is the actual stated interest rate of the loan. If the loan is restructured, you use the original rate. Banks can use discretion if the loan is based on LIBOR in order to fix the rate for discounting.
Some banks use FAS 114 more than others. More direct charge-offs of loans means less use of reserves as a contra account to the loan asset. You can see how comparing reserve levels across banks without understanding propensity of a bank to use FAS 114 can lead to distortion of comparatives. Using NPV usually is harsh and results in a big write-down.
These are just some of the jargon a credit analyst encounters when looking under the hood of banks.
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