With the calendar turned to July, the second quarter is officially in the books. And with earnings season just around the corner, there is one thing investors must watch when Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC) announce earnings.
What is it? If they report increased income, make sure the banks -- and not only these three -- actually did just that.
The vital number to watch
Without diving too far down into the numbers, banks are remarkably simple. They earn net interest income -- what they take in from loans minus what they pay out on their borrowings -- and noninterest income, which are those fees charged to customers. And they of course have expenses, which are paid out to keep everything running smoothly. Add the first two together, and subtract out the expenses, and boom, you have their pretax income.
While banks like Bank of America, Citigroup, and Wells Fargo are absolutely massive -- with nearly $5.5 trillion in combined assets -- at their core, they're quite simple.
But the thing is, there is one number that has a massive impact on the bottom line of the banks, but all too often it goes undiscussed, known as the provision for credit losses.
Understanding the number
The provision for credit losses is what a bank expects to lose on the loans it has written. While banks do their best to ensure they won't write loans that will go bad, ultimately they understand some will.
As a result a bank will do its best to calculate what those losses may be and in turn place that money into its loan loss reserve to help insulate itself, if -- or regrettably, when -- some of those loans go bad. And this is one expense a bank recognizes each and every quarter.
While there is a wide variety among what the banks expect to lose -- that is another story for another day -- you can see Bank of America, Citigroup, and Wells Fargo all saw their provision for credit losses decline dramatically through the first three months of the year:
Combined, they expected to lose an astounding 40% less -- or $2.1 billion -- through the first three months of this year relative to last year. This is undeniably good news for these banks.
But the thing is, it's also critical to remember this is just an estimation, and it doesn't represent any actual difference in the earning capability of the businesses underlying the banks. But since it is considered an expense, a reduction in this number translates to the income rising.
And as you can see, while the bottom line results improved significantly at these banks, in the case of Citigroup and Wells Fargo, the gains were entirely the result of a reduction in this one line item:
That's not to say these banks didn't show improvement, as a reduction in losses undeniably benefits shareholders, but the gains weren't necessarily an indication of improved operations and increased income as a result.
Of course, it must be noted too the first quarter of last year saw a massive boom in refinancing, and in many ways that too was an anomaly. After all, Wells Fargo saw its mortgage banking income drop by 46%, from $2.8 billion to $1.5 billion in the first quarter.
The key takeaway
With these banks just weeks away from announcing results from the second quarter, in order to truly understand the performance of their operations, make sure when you are gauging the earnings, you also take a look after excluding the provision for credit losses. While it is a very real benefit, it is one that can't be recognized forever.
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Patrick Morris owns shares of Bank of America. The Motley Fool recommends Bank of America and Wells Fargo. The Motley Fool owns shares of Bank of America, Citigroup, and 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. The Motley Fool has a disclosure policy.