The Wall Street Journal has an article this morning detailing how banks are boosting earnings by releasing reserves to counter loses from bad loans.

Mike Mayo, the well-known bank analyst at Credit Suisse, is none too pleased. 

Mayo accuses banks of papering over the deteriorating performance of their businesses:

The [reserve] releases are "masking some horrible operating performance," said Mike Mayo, a banking analyst for Crédit Agricole Securities. "The bottom line is your earnings power is decreasing."

Why is Mayo so upset? Banks hold reserves against potentially bad loans on their books. That's nothing new or nefarious. As banks officially write of loans as uncollectable, they release their reserves to cover those losses.

But what the Journal article investigates and Mayo is so agitated about is something slightly different: banks are releasing reserves that are greater in value than the bad loans they are writing off.

This boosts earnings in the short-term, but is by definition unsustainable and banks must eventually set aside additional reserves. However, if they economy improves along with loan performance, the amount of the new reserves may not need to be as great as they were immediately following the financial crisis.

The article notes that the "top 10 U.S.-owned commercial banks released $4.3 billion in reserves in the fourth quarter...boosting after-tax earnings by $3.5 billion."

Banks counter that "reserve releases are justified by declines in bad loans and the economy's improvement" and are fully acceptable under accounting guidelines.

But analysts feel differently:

"It's cotton candy," said Matt McCormick, a portfolio manager and banking analyst with Bahl & Gaynor Investment Counsel in Cincinnati. "It looks good, but it's not going to be substantial for you."

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