Schafer: It's OK for banks to make money, if it means their customers are doing well

It was fun to read through the Wells Fargo & Co.'s latest earnings release, although Wells Fargo making a lot of money is rarely much of a feel-good story.

The part that stood out was Wells once again getting a pop in profitability by taking back some of what had been set aside for future loan losses.

Other banks are doing this, too, large and small. It's both a great sign of a continuing recovery in the economy and also how the economic pain of the pandemic recession didn't turn out to be nearly as bad as once had been feared.

It's even a little more evidence that the banking system, so wounded in the last big recession, worked pretty well during the pandemic year.

Even bankers might not pay much attention to credit loss accounting, like boosting the allowance for loan losses, unless a big swing affects their pay. But it's a key measure of banking health.

If done correctly, banks don't lose a lot of money when loans go bad, because the bankers were supposed to anticipate these losses and regularly account for them upfront.

Other businesses have to pay attention to this kind of stuff too, including manufacturing companies that must assume some bills they've sent customers might not get paid.

Even common sense suggests bumping up the provision for credit losses, the expense line you see on a bank's quarterly income statement, when making new loans. There are, of course, rules for how to do it.

The big banks adopted a new methodology at the beginning of last year, called current expected credit loss, or CECL. Smaller banks and credit unions will eventually use this approach as well.

Reading through the details of how CECL works will bring a sharp pain to the temples, so it's enough to note that banks are supposed to analyze the potential for losses over the whole life of a loan.

This rule is just another outcome of the experience of the financial crisis and Great Recession of the late 2000s, as regulators concluded banks don't reserve enough for loan losses.

Most banks and bankers had nothing to do with the practices that precipitated the 2008-2009 financial crisis, of course, things like originating home mortgages no one bothered to actually underwrite. But banks large and small had to live with the slumping asset values and deteriorating loan quality that followed.

Once it became clear last spring that the COVID-19 outbreak wasn't going to be small and passing, thoughts quickly turned to how bad the recession was going to get.

Wells Fargo is a big company, so it's going to report some big numbers when it makes its moves, yet it was still attention grabbing that it booked a more than $9.5 billion expense by adding to the allowance for loan losses in last year's second quarter.

It had recorded just a $503 million expense in the same period of 2019. The big move last year dropped the quarterly results to a big net loss.

What you would have expected from this, over the following few quarters, was loan after loan going bad. In fact net charge-offs of bad loans peaked in last year's June quarter, at $1.1 billion. The amount of failed loans charged off has since declined steadily, to $381 million in the quarter that just got reported.

At U.S. Bank the loan losses followed a similar trajectory, although for U.S. Bank the peak of loans charged off was in last year's third quarter, at $515 million. In the June quarter, the bank had net chargeoffs of just $180 million.

While U.S. Bank didn't make nearly as big of a one-time move to add to the allowance for loan losses in the second quarter last year at Wells Fargo did, it released more than $1 billion of reserves in the first quarter and backed out a smaller amount in the most recent quarter.

Bremer Financial just did its first reversal of loan-loss reserves, explained Keith Ahrendt, St. Paul-based Bremer's chief credit officer.

As a smaller, privately held bank, Bremer hasn't yet adopted the new way of reserving for loan losses, but the story Ahrendt told is what you'd expect. Their best estimate last spring of how borrowers would fare in the pandemic turned out to be too pessimistic.

The hospitality sector is one example he cited, as hotel properties that had been reporting 70% occupancy rates or better before the pandemic seemed headed for single-digit occupancy rates. But unless the borrowers served a lot of business customers, he said, they "seemed to bounce back in a reasonably good way."

Conditions improved for Bremer's customers in agriculture last year, he said, and the bank's portfolio of residential real estate loans "performed much better than expected as well."

A booming housing sector is one of the surprises of the COVID-19 era, as there's normally no such thing as a recession with a strong housing market. By this spring housing starts had reached a level last seen in 2006.

While companies like U.S. Bank have backed out reserves in each of the first two quarters of this year, allowances for loan losses are still bigger in the industry than before the pandemic, although part of that can be explained by the change in accounting rules.

Bankers also don't really know how the economy is going to go or how their borrowers will fare, and it may yet take some time for businesses hurt by the pandemic to stop making loan payments.

Federal support programs like enhanced unemployment benefits will sunset come fall, too, and a new wave of COVID-19 infections seems underway now as a lot of people haven't been vaccinated.

"There's less uncertainty than, say, a year ago," Bremer's Ahrendt said. "Now we've been through it and experienced it, and we have a little history to fall back on. We know how maybe the government and how businesses will respond. And we are better prepared to respond ourselves."