1 Big, Fat Yellow Flag for Bank Stocks

It would not surprise me in the least if you have never heard of First Financial Northwest (Nasdaq: FFNW  ) of Renton, Wash. First Financial is a small bank with $1.2 billion in total assets and is currently valued at less than $100 million. And if you've never heard of First Financial, you obviously didn't catch the bank's second-quarter earnings report.

Lucky for you, I did. And I'm going to draw your attention to a particular section of First Financial's press release. It involves the company's loan-loss provision -- the money banks set aside to cover bad loans -- and reads:

The amount of the provision is determined by management's analysis of various quantitative and qualitative factors affecting loans to provide reserves adequate to support known and inherent losses within the portfolio. One component of our provision calculation utilizes a weighted-average, look-back period, which is common practice within the industry. Actual loan loss history incurred by the Bank was significant during 2009 and 2010, although loan losses were minimal in years prior. As a result, as quarters with minimal losses roll off and are replaced with quarters that contain higher loan losses, the provision may continue to increase even though the credit quality of our loan portfolio may continue to significantly improve and the amount of our delinquencies and the size of our total loan portfolio may continue to decrease.

That's a brainful. But in plain English, it's much simpler. Basically, the bank partially bases its loan-loss reserves on past experience. This led to low provisions as the bank entered the credit crisis because its system assumes that current loss experience will be similar to past loss experience. And, of course, saying that credit-crisis-era losses would resemble pre-credit-crisis loss experience is like saying that Hurricane Katrina was like a gentle spring rain shower.

Now why is this an issue? Well, at the end of the quarter, allowance for loan losses as a percentage of nonperforming loans was 44.8%. Prior to the credit crisis, the bank had barely any nonperforming loans to speak of, and allowances were a multiple of nonperforming loans.

My assumption, then, is that the bank will have to build that back up. Part of that will come from better credit quality and lower nonperforming loans -- between the first quarter and the second quarter, nonperforming loans fell 26%. However, some of it, as we discussed above, will come from using credit-crisis loss experience to determine loan loss reserves, which will lead to higher loss allowances. Despite the drop in nonperforming loans between the first and second quarter, the allowance for loan losses rose 33%. And that contributed to the sequential drop in earnings.

But you don't own First Financial and don't give a hoot about it, so why should you care? Because First Financial isn't the only bank that has a low allowance for losses in relation to its nonperforming loans. Interestingly, many of the big banks that investors still seem a bit wary of have a healthy level of reserves -- Bank of America (NYSE: BAC  ) is at 115%, JPMorgan Chase (NYSE: JPM  ) , 239%; and Wells Fargo (NYSE: WFC  ) , a not-too-shabby 91%.

On the other hand, Hudson City Bancorp (Nasdaq: HCBK  ) is at 29%, New York Community Bancorp (NYSE: NYB  ) is at 31%, and Doral Financial (NYSE: DRL  ) is at 18%. Perhaps the management teams have really good insight into the nature of the nonperforming loans and have good reason to believe that losses will be low. (Some of New York Community Bancorp's loans are covered under a loss-sharing agreement with the FDIC.) Or a continued build of loss reserves could provide a drag on the earnings for these banks in the quarters ahead.

If you're investing in a bank, you're probably going to want to dig up a good answer for that.

The Motley Fool owns shares of JPMorgan Chase. The Fool owns shares of and has opened a short position on Bank of America. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or Facebook. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 27, 2011, at 5:52 PM, xetn wrote:

    (Some of New York Community Bancorp's loans are covered under a loss-sharing agreement with the FDIC.) Or a continued build of loss reserves could provide a drag on the earnings for these banks in the quarters ahead." That means backed up by taxpayers. The FDIC has no money of its own, just what it can steal from the member banks and the taxpayers. Ultimately, it all comes from the citizens that earn money.

  • Report this Comment On July 27, 2011, at 6:03 PM, cmfhousel wrote:

    ^ Almost all *states* require banks have FDIC insurance. It's not a federal policy.

    From the FDIC: "States are the ones who decide whether or not to require FDIC insurance."

  • Report this Comment On July 28, 2011, at 2:14 AM, shoemaker17 wrote:

    you had me at Renton, WA. If there was ever a West Coast Detroit, Renton would be it...

  • Report this Comment On July 28, 2011, at 3:23 PM, getitstraight wrote:

    The PROVISION is what increased 33%, the ALLOWANCE actually decreased by 16%. Makes me wonder if you really know what you're talking about.

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