This is a big week for the banking sector. America's four biggest banks by assets -- JPMorgan Chase (JPM -0.39%), Bank of America (BAC -0.25%)Wells Fargo (WFC -0.58%), and Citigroup (C -0.77%) -- all reported first-quarter earnings this week, setting expectations for the next few weeks and the quarter ahead as regional and smaller national banks follow with earnings of their own.

And while in many ways America's big four reported results that were in line with expectations, investors and analysts were caught off guard by a single metric that caused their earnings to fall sharply from last year and set the stage for what could prove an incredibly painful second quarter of the year and beyond. That metric: loan loss reserves.

Between them, the four banks above took a massive $22 billion in credit costs and loss provisions in the first quarter, preparing their balance sheets for what could be a massive wave of defaults in the months ahead as tens of millions of Americans lose their jobs or see their income fall, and then fall behind on their debt payments. 

Couple with worried expression looking at computer screen.

Image source: Getty Images.

Putting the numbers in proper context

First, what does this mean? In short, banks are required to carry provisions on their balance sheet to account for potential defaults. This is a way to offset the assets listed under accounts receivable, that the bank estimates may not come in as borrowers default. So these moves are designed to offset future cash flows that the banks estimate are at risk of default.

The best way to think about the massive increase in reserves the big four added to their balance sheets is to compare it to the year-ago quarter. Last year at this time, the economy was plugging along. Jobs growth was strong and people were feeling confident. Lending was improving and getting even more profitable for banks as the Federal Reserve raised interest rates. But even with rates up from the prior several years, both consumers and businesses were able to take advantage of historically cheap rates. 

And under those conditions -- a strong economy and steady demand for lending from qualified borrowers -- the four took a combined $2.6 billion in credit costs and provisions. That's less than 12% the size of this week's bolstering, and a pretty clear indicator that bankers have a poor outlook for the rest of 2020. It also comes after the Federal Deposit Insurance Corp. asked the Financial Accounting Standards Board -- which sets GAAP, the accounting standards for U.S. companies -- to delay the implementation of a new loan loss standard in late March. In other words, it's possible the loss provisions could have been even bigger.

Expecting big losses, even with unprecedented intervention

It makes sense that banks would start preparing their balance sheets for the months ahead. We have already seen a record number of people file for unemployment -- the past three weeks have each broken the record for most new filers -- and it's expected that the nearly 15 million who are newly unemployed could double by this summer. An enormous portion of the economy has been put in park, with hundreds of thousands of businesses closed to limit the spread of the deadly novel coronavirus that causes COVID-19. 

As a result of the hard-and-fast halt to the economy, the federal government has taken unprecedented action. In addition to the massive $2.2 trillion in direct support being sent to individuals and businesses, the White House has instructed the Small Business Administration to backstop almost $350 billion in lending, and the Federal Reserve has implemented more than $4 trillion in monetary and lending support to keep the financial system flowing.

So yes, a 90% increase in credit loss provisions and other reserves is a clear indication that banks are preparing for a severe recession.

It's still not 2008-2010 all over again

The next several quarters could be brutal, and banks will face tens of billions of dollars in losses as borrowers fail to meet their debt obligations. Add in the near-zero-interest-rate environment, and an environment where new lending for homes and automobiles is falling sharply, and this is a terrible environment to be a banker. 

But even with the reality that the rest of 2020 will be ugly, the banking sector is much stronger now than it was about a decade ago, around the time of the Great Recession. Lending standards have been higher for years, and regulations have forced banks to retain more capital even in a healthy banking environment so they'd be more prepared for these kinds of shocks.

What's an investor to do?

Bank of America, JPMorgan Chase, Wells Fargo, and Citigroup's moves to bolster their balance sheets and offset the at-risk parts of their accounts receivable make it pretty clear that it's going to be a turbulent couple of quarters ahead. And that is likely to mean a lot of volatility for their stock prices, and even a decent chance shares fall even further. That's particularly true if we see state "stay-at-home" orders get pushed into May and even further, limiting and pushing back the economic recovery.

But that's not to say investors should necessarily sit on the sidelines, particularly with JPMorgan, Wells, and Bank of America. Today's prices look very attractive, based on the kinds of earnings they have proven capable of generating in a healthy economy. JPMorgan trades for 1.2 times book value, while Wells and Bank of America trade for 72% and 81% of book value, respectively.

Yes, parts of their lending assets are at risk right now, potentially inflating those book values a portion, but looking out three or more years into the future, today's prices are likely to prove a real bargain. And if they fall more in the months ahead as the severity of the recession becomes more apparent, I would likely put them high on my list of stocks to buy more of.