An interesting part of a bank’s financial statements is what is called the Loan Accounting Framework or LAF. In normal times, this is glossed over but we live in strange times indeed.
Accountants get paid for recording the figures. Analysts get paid for reordering them. We are Analysts.
This section discloses several important accounting policies, namely which US GAAP policy applies to the loan (there are only 3: Held For Investment, Held For Sale, At Fair Value), how the loan is recognized on the balance sheet and how the bank recognizes interest income.
For example, JP Morgan has this disclosure when it comes to credit card loans, of which its outstanding loan amount was $154.0B as of Mar 31, 2020, which is accounted under the Held For Investment category. This was down from $168.9B in Dec 31, 2020, a reduction of $14.9B. Of course, many observers will be surprised as to why this figure went down, considering that as the United States is facing the worst economic crisis since the Great Depression, there would be a tendency for stressed borrowers to draw down on their credit card lines.
In order to understand this, we have to first understand how credit card loans are accounted for as disclosed over here:
The key facts
- JP Morgan’s allowance for loan losses increased $13.5B to $23.2B, mostly due to an increase in allowances for Credit Card
- All cards remain on accrual status until charged off. This means the firm can continue to recognise income until they finally call the loan a bad loan. Then they have to reverse all the interest income they claimed but was not paid.
- Accrued interest on receivables increased from $72.9B to $122.0B
Let’s unpack both these accounting policies. As of 4Q19, JP Morgan’s Allowance for Loan Losses, or ALL for their credit card portfolio was $5.2B. As of 1Q20, the ALL for their credit card portfolio was $14.95B, an increase of approximately $10B. So the reduction of $10B of the reduction from 4Q19 to 1Q20 was not due to Customer’s repaying their loans but because JP Morgan took an allowance against the outstanding loan amount of about $10B, which reduced the carrying amount of this loan. (The customers are still on the hook for the same amount regardless of the allowance. So if you had $10,000 of Credit Card debt and JP Morgan took an allowance of $5,000, you still are on the hook for the $10,000 credit card debt. )
Of course, several questions are pertinent, namely was this allowance conservative enough, meaning will JP Morgan sustain a credit loss of greater than the $10B they provided for?
Historically, for the last 2 years, JP Morgan took an average charge-off of $4.5 – $4.8B, so the additional $10B for their credit card portfolio could be seen as taking an additional 2 years worth of credit losses. ($5B of this additional allowance was due to the introduction of the CECL accounting requirement in the US, also known as IFRS 9 to the rest of the world).
Furthermore, the 30+ delinquency rate, which measures the proportion of all credit card loans overdue by more than 30 days was at 1.96% or slightly higher than 1.85% in Dec 31, 2019. So definitely, based on the data that JP Morgan had at the end of 31 March 2020, the additional allowance for the Credit Card portfolio at $10B seemed reasonable.
There are several things working in favor of JP Morgan and not in favor of borrowers. Credit Card debt can be rolled over at the Minimum Payment per month so in effect, borrowers can still be considered to be current on their loan payments by just making the minimum payment sum, no matter how financially stressed they are. The revenue rate for Credit Card loans was about 10.68% These loans continue to accrue interest until they turn bad.
The most troubling of this entire disclosure – this entire increase of $50B recognized under Accrued Interest and Receivables. Reading further it consists of several components
- Unbilled interest on credit card loans
- Margin loans to brokerage clients in CIB and AWM that are collateralized by assets maintained in the clients’ brokerage accounts (e.g., cash on deposit, liquid and readily marketable debt or equity securities
Summary and Conclusion
So over the last 50 days since JP Morgan reported their results, the US Unemployment rate climbed from 4.4% to 14.4%. Whilst JP Morgan took an additional $5B allowance for their Credit Card portfolio (of the $10B, $5B was due to CECL as of Jan 01,2020 without #CCPVirus), only an additional $619M was taken against its other Residential and Auto portfolio and $1.7B for its wholesale portfolio (meaning the loans to large corporates like Boeing). The outstanding amounts of these loan portfolios were $293.8B and $565.8B, for a total of $859.6B. It would not surprise me if the net charge off against those loans amounted to 2% over the next several months, for an incremental credit cost of $17B. Total credit losses for 2020 would probably be in the range of $20 – $25B, or about 4x its 2019 provision of $5.5B.