It's a good rule of thumb to avoid bank stocks during a recession; investors should wait until the period of writedowns is over before stepping back into the sector. The big question today is whether we are at that point -- or at least at the point where banks' provisioning for loan losses is sufficient to cover the expected writedowns.

Bank of America (NYSE:BAC) has been increasing its loan-loss provisioning at an aggressive clip, yet we aren't seeing similar increases in asset writedowns for non-performing loans. Is Bank of America being overly conservative? Or is there another shoe that has yet to drop?

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Ready for a big jump in defaults

In the first six months of 2020, Bank of America reserved $9.9 billion to cover potential credit losses. That's equal to just about 1% of its $998 billion loan portfolio. Total provisioning for credit losses stood at 1.96% of the portfolio at the end of June. The company's common equity tier 1 (CET1) ratio as of June 30 stood at 11.4%, which is 1.9 percentage points above the bank's regulatory minimum. This works out to a $28 billion capital cushion.

It is important to distinguish between provisions for credit losses and charge-offs. Provisioning basically represents the amount of losses the bank expects to eventually book from its loan portfolio. In other words, it's a forecast of potential losses. Charge-offs are the actual write-offs of debt -- which the bank does with loans it has concluded will never be repaid. The banking system is also adapting the current expected credit loss (CECL) format, which requires institutions to forecast losses over the entire economic cycle.

Still waiting (and that's a good thing)

While Bank of America has been building up its loan-loss provisioning, net charge-offs have been steady. In the first half of the year, the bank added $10 billion to its provision for credit losses. It actually wrote off just $2.2 billion. In other words, the bank has been preparing for delinquencies and defaults that -- so far -- haven't been occurring. It is important to note that this isn't necessarily a bad thing. since it gives the company more flexibility in the future if things turn out better than expected. Still, the reason for the provisioning is something investors should understand. 

On the second-quarter earnings conference call back in July, CEO Brian Moynihan noted that federal stimulus checks, enhanced unemployment benefits, and other assistance out of Washington had been helping borrowers get through this tough period, and that delinquencies were much lower than the unemployment rate, then at 11%, would suggest.

Interestingly, distressed-debt collector PRA Group noted the same thing: People are paying their debts despite the lousy economy. The question is what will happen now that those extra unemployment benefits have stopped coming and the stimulus checks have largely been spent.

Non-performing loans (i.e., those that are in default) increased only slightly from the first quarter to the second, from $4.3 billion to $4.6 billion. This is another instance where we are not seeing evidence of major problems in the loan portfolio. When asked about the relatively small increase (compared to Bank of America's peers), Moynihan attributed it to the fact that his bank has less commercial real estate exposure than it used to, as well as to an elevation in non-performing assets in the natural gas sector that it booked during the first quarter. If that is the case, then does the bank expect more credit problems in the future?

Warren Buffett is betting big on Bank of America

Warren Buffett's Berkshire Hathaway added to its already large Bank of America position in late July and early August, purchasing 13.6 million shares at an average of just under $25 a share. Buffett has always liked the financial sector, and Bank of America has a decent dividend, yielding 2.8% at Thursday's close. It's too early to say whether he's making a statement about banks since he recently cut his position in Wells Fargo (after trimming other bank holdings in the second quarter). That said, Buffett must see something in Bank of America -- Berkshire now owns roughly 12% of it. And while the Oracle of Omaha sometimes gets it wrong, it pays to watch closely when he presses his bets.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.