From John Hempton:
There have been some mathematical corrections to this post discussed in the comments. My pencil notes had the numbers right. By the time I got to writing it out errors had entered. Sorry.
Fannie Mae just put out awful looking results based primarily on massive (and increasing) credit loss provisions. Indeed their provisions this quarter were the largest thus far in the cycle.
Its worth looking a little closer because – like it or not – all Americans are owners of Fannie – both the downside (their current book) and the upside (if any) through taxpayer ownership of the common stock.
The nature of credit loss provisions
Each quarter almost every financial institution takes some charges when loans they have made settle at less than 100c in the dollar. At the moment charge-offs are at historic highs.
Every quarter a company makes an estimate of future losses – a “provision” if you will.
Provisions by definition are estimates – whereas charge-offs are real and mostly final.
The difference between provisions and charge-offs goes to a “reserve for future losses” or more commonly just “reserves”.
Most financial institutions are taking more provisions than charge-offs – in other words they are building reserves. This is necessary because there are a lot of delinquencies and a lot of loans in the foreclosure process and – just frankly – a lot of loans that common sense tells you will end in charge-off.
Most institutions build reserves relatively slowly. Bank of America for instance – in broad numbers – has had 13 billion of provisions per quarter for the last three quarters and charge-offs of 6,8 and 9 billion respectively. If the charge-offs skyrocket (say to 20 billion) at bank of America then it will find itself under-reserved – and will wind up having to report very big losses. However if charge-offs slowly level off around 13 billion per quarter then BofA will – ex-post – look OK.
The honest answer in the case of BofA is that we really do not know where charge-offs will wind up but we can make educated guesses. In the last conference call BofA thought charge-offs would peak about the first quarter of 2010. If they are right then their current reserving is right and BofA is probably a steal as a stock right now. If however charge-offs continue to rise for another 18 months peaking out at say $35 billion per quarter then BofA will need to be recapitalised further and may wind up as government property....MORE at Bronte Capital