Monday, August 22, 2005

What would Pangloss Say?

As we all well know, earnings are meant to be manipulated, at least that's what many public companies would have you believe. Now comes word that many members of the banking industry appear to be united in believing that loan quality has gotten so much better that they can set aside smaller amounts for possible loan losses. Of course, setting aside smaller loan reserves improves today's earnings and, in the world of Wall Street, today's earnings are really all that count.

In fairness, it must be admitted that the percent of loan loss reserves to problem loans is at its highest since 1999. That's a good thing.

However, the question is the definition of problem loans. Whether they are loans that are in trouble today or likely to be in trouble tomorrow is crucial. In 1999 the number of interest-only loans was miniscule and there were very few variable rate mortgages. Today, I think the quality of credit is not what it was only a few years ago. Plus, we have a housing bubble in many states.

Today, the ratio of loan-loss reserves to total loans is at its lowest in 19 years. That, I think, is a bad thing. Just look at what happened to Japan when its banks pursued a policy of low quality loans.

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