The trick that turns banking losses into profits - MoneyWeek Investment Tutorials

so in today's video I'm going to talk about a neat little trick that allows banks and other organizations to turn losses into profits it sounds like financial alchemy and is it's a great example of the rules intending to solve a problem and actually creating a much bigger one now here's a statistic you might find a little bit scary I certainly do if I asked you to guess what proportion of Bank of America's last four quarter profits were generated by accounting sleight of hand about nothing to do with cash flow and nothing really to do with their core operations what would you guess well the answer is 46% so call it half and if you look across the other big three banks reporting in the third quarter this year anywhere between twenty and fifty percent of their profits come from the little trick I'm about to show you and this trick enables banks to almost make up their profit figures for example without this little trick Bank of America would have recorded something like a 2.3 billion dollar loss in the third quarter with it it reported more like a three hundred and forty or so million dollar profit so whatever is it's a pretty neat trick it's not just used by banks but banks are the current big users of what I'm about to describe so here we go what is it it's called loan loss reserve adjustments now don't switch off the video right away because the jargon conceals something quite simple in a way here it is you're a bank okay here's how you go about it you're a bank and your objective like most companies reporting to the market is to show a nice smooth profits you want your profits to go steadily upwards no shocks for investors no nasty surprises so you're going to use a little accounting trick to make sure that happens and here is the trick okay as a bank imagine you have lent a million pounds ten dimes to slightly artificial situation this some people living in the same part of the town who want to buy a house all right so they've got help and basically bought million pounds at the current market valuation using million pound loans from your bank and there are ten of them alright so as a bank you blamed ten million pounds now that ten million pounds is a receivable as the bank you expect to get that money back at some point so it's it's is a nice 10 million pound asset on your books all right ten million pounds owed by hopefully mortgagees who in the meantime will pay interest that's how you make profit as a bank all the ten million and will also pay you back something goes wrong six months later or one of the people you lend a million pounds to starts to not repay interest okay so now as a bank you'll get nervous whenever one of those ten mortgages is starting to not perform and then a few months later okay in trouble I think lost their job that person turns around and says I can't pay the mortgage anymore I don't gotta sell the property I'd imagine they sell what was a million pound house in a difficult market for half that amount five hundred thousand pounds all right so suddenly as a bank you've got one in ten of your mortgage ease not paying interest am i able to pay you back so the property sold and realizes in my little example only half of the mount it was supposed to be worth when you created all alone in the first place now you might have to live artificial but I wanna make a point here what do you do next all right well you're gonna have to write off as a bank half of that mortgage debt alright because your man who's got the mortgage ain't gonna pay you back okay so there's an actual loss a hit okay that's gonna involved writing down the original 10 billion asset by about half a million let's say taking a hit through profits but that's not what I want to get to all right that's the obvious bit what do you do with the other nine people very very similar who went through similar credit checks have still got million pound loans are still paying the interest at this point what do you do okay do you revise your view of their creditworthiness and therefore the value of the remaining asset on your books of saying they're at nine million okay so do you make some sort of adjustment for the remaining asset in your books for those other nine mortgages okay do you ignore the problem do you just say well the chap who couldn't pay his mortgages at one off so we'll deal with him and ignore the others all right you treat him as what they call an impaired load and the others is non impaired and just leave them sitting in your books okay or do you do something the middle do you say well hang on it one in ten of the people we lent money to a struggle so maybe we need to provide for I don't know ten percent twenty percent of all loans are books just in case okay now that process sounds quite sound okay so I'll banks sitting down going through its loan book and saying there are some problem loans all right loans remember in a bank's book are assets they're expecting the money to come back in at some point okay so what they're doing sounds perfectly sensible they are going to make some kind of provision set aside and owned against the possibility that they don't recover all the money they're expecting to the way that would work is as follows if you've got a ten million pound let's say it's asset in your books that's you know in my first example ten mortgages worth 1 million pounds each and you decide that actually given the economic conditions and so on a proportion of those are not going to be recovered all right then in very basic terms you might say well I'll make some kind of provision I'll knock let's say 2 million 20% provision off my asset to bring it down to more like 8 million in the books and that reduction in the value of an asset okay it's a hit to profits of 2 million right now you might be saying well so far so what all sounds very prudent sounds like banks are doing their best to work out who's gonna pay them and charge profits with any amount they don't expect to recover in the future here's the trick okay here's the trick if it turns out you've been a bit too cautious here later you can reverse effectively what I've just done here so turns out but having charged profits okay taken the hit of the 2 million loan loss provision as it's called any turns out a few years later you're a bit over cautious you know basically weapons is no there's no problem with these mortgage loans in fact they're all paid back clean or you estimate there's no longer a problem to these mortgage loans you can actually write back the 2 million okay oh I go to the technical accounting way that's done you can basically say well actually we're about overcautious here so the asset really is worth more like 10 million and we can put 2 million back through profits as a credit or as income all right now the objective is sound enough what these banks have start doing in theory is saying in the bad times I need to make provisions against the fact that people won't press back and if it turns out we were a bit over cautious a few years later will write back those unnecessary charges to profit back through our income statements you might be thinking well it sounds ok so far but here's the scope for playing around with the numbers right here's the sort of thing the banks can get up to and it ultimately is then the decide subjects and accounting rules how much they provide against problem loans problem assets and how much they write back later so imagine here is your situation let's just do three years one I'm making up numbers here two three and here's your profit before your loan loss provision LLP all right and now I'm gonna put a lone loss provision in it and you'll see the scope for playing around with profit numbers here so let's say a bank is looking at a profit number in year 1 of 150 million dollars or sterling okay profit in year two of a hundred million and a profit in year three this is before we do any of that messing around I mentioned with problem loans problem assets problem receivables and a few million that's not looking good all right our core operations are gradually slowing us down 150 200 280 so how could I what I just said to reverse the picture literally reverse it turn declining profits into the opposite is what I do like convinced can I convince investors and the auditors and regulators and so on the Lani's do is put a lone loss provision of 50 million in year one which reduces the overall profit that's the funny little symbol to a hundred million now this was happening during the credit crisis okay banks was they all could be careful okay all these loans we've made all these mortgage you to make whole load that we're not going to come back we're not gonna get a hundred percent back so we need to start making provisions okay we need to start writing them down okay taking hits to profits being prudent being cautious to looking ahead okay and then of course what happens is so you've got you've got that booked lambs is you know couple years later the banks lasting well actually we were bear over we are bit over cautious don't really need a lot 15 billion provision you know it turns out not as many mortgages are underwater as he thought they would be more Pacific in space back than we thought so here's what you do maybe maybe you think well actually we don't need the 450 hit profit so we'll reverse 10 million orbit into year two which creates an overall reported profit 110 million then we'll reverse the other forty back into profits in year three which brings out up to 120 million and hey presto as if by magic having played around with your loan loss provisions you've turned falling profits into rising profits right and this line here has nothing to do with cash flow no cash is coming in or out of the business the relates to these numbers okay and it's got very little to do with your core operations which is what's happening here all it does is allow a bank and it's not just banks companies can do this with stock provisions receivables and so on but I won't go to that here it allows them to change the face of the profit loss account will it really change the view taken away by an investor how much money they're making and in the case of Bank of America in the third quarter they actually turned there would have been a massive loss into a profit simply by reversing yeah but much we're talking sort of million to billion worth lot the forty million over here simply by reversing out previous provisions gets dodgy loadings alright so doesn't invest to do about this I mean you have to follow the the minutiae why I've been saying or why debate they're counting rules but what do you need to do as an investor and the answer is watch cash flow right because you can't play around with cash flow like this okay this is all profit and loss account injuries while it's tempting to look at profit statements profit announcements that's what the bank wants you to focus on the takeaway from this video and I cover it in another video what is cash flow okay but the takeaway is always check the underlying cash flow statement make sure you're happy with the quality of the firm's profits and that is the extent to which they're backed by cash okay because otherwise you're a bank investor or an investor in companies that play around with their provisioning you can be duped into thinking the picture is rosier but it actually really is to download this free video to your favorite mobile device find us on iTunes by searching for money week and the entire video archive is also available free just visit manu ich komm

Channel: MoneyWeek

Views: 36,481

Keywords: ratios, Forex, losses, Hedging, inflation, bank, payments, system, German, claims, successful, Dividend, stocks/shares, Cashflow, Overtrading, firms, profit, loss, trading, Bid, offer, spreads, MoneyWeek, Tutorial, Currency, credit, 'stock, market', investments, tutorials, Trading, Stocks, Analysis, Trade, to, tax, Tax, avoidance, evasion, How, does, work?, trade, economy, whiteboard, tim bennett, Loan, reserves, Banking, profits, Q3, results, Accounting, tricks, Bank, of, America, Mortgage, do, banks, use

Id: tXh01L6mLqs

Length: 12min 33sec (753 seconds)

Published: Thu Nov 08 2012