My most sincere apologies: A mistake was made over the earnings report excerpt. The correct excerpt is now in place with the correct by-line.

Taking a quick interlude to my momentum article research here to jump in with something kind of topical. There’s an accounting practice that is of particular importance during recessions and economic downturns: it’s called the write-down. The write-down is a funny thing actually, it involves ‘provisioning’ for a loss, essentially setting up reserves for potential losses.


JP Morgan Chase Earnings Report - Note the strong Write-Backs across the group

Now here’s the thing: the losses don’t always just disappear. Though in some cases an economic entity might well actually take the item off its books entirely, this does not necessarily mean that the item is no longer ‘owned’ by the bank. Without wanting to get into too much accounting details here, I would rather jump right ahead and see what happens in the period post the write downs once the write backs come into the picture.

Yep, you guessed it, its the time of the write-back, that is writing back on the books items which are recoverable or which basically are still real in terms of ongoing financial value. And surprise, surprise, we are at the times of the write-backs, meaning back-up on the balance sheet, meaning one-off items popping up on balance sheets and quarterly earning reports and boosting bottom line performance.

You can find more about this by looking up the fundamental analysis literature out there: this area is known as balance sheet analysis, special provisioning analysis and, most importantly, is a field quite specific to each geography (different regulatory and accounting rules tend to appear governing the process). Fundamentally, analysts should always be taking these into account when reviewing the prospects of a company. Occasionally they get this right and, yes, occasionally, they can also get it wrong.

Interestingly enough, in the lead up to the crisis and in its early stages, some commentators noted that fundamental analysts missed out on quantifying the long-tail inherent to some of their valuation models. Admittedly, this criticism of statistical valuation models was extended far beyond just analysts, and also covered a lot of the risk management processes also in place through out the private sector. But coming back to the issue of loss provisioning (most topically: loan loss provisioning), the criticism surrounded the issue of kurtosis: that the far left end of the ‘recovery’ tail wasn’t properly accounted for its ‘fatness’.

So now that the write downs were doubled downed to cover this analytic risk, the question then becomes, what about the write-backs? Have the ‘up’ values also been valued using the same ‘low’ kurtosis or thin tail models? Are we maybe in potentially for a bit of a surprise?

p.2 [group wide] Key performance highlights for the year included: (…) Lower loan impairment expense, reflecting a continuing improvement in portfolio quality;
p.4 Institutional Banking and Markets (…) Lower impairment charges were the main driver of the result supported by moderate growth in operating income
p.4 Wealth Management’s: (…) This outcome was driven by improved investment experience (…) and the non- recurrence of impairments encountered in the prior year.
CBA Media Release 2010 Full Year Results

Well, JP Morgan just started writing back just today, ahead of estimates… Oh, and in case you were wondering, in Australia (that sort of provisioned for a financial crisis without actually really getting one) the big financials all ended up writing back up their previous downs fairly significantly, ie in the $bn range.

This week should see a fair amount of activity on the financial side with most other US majors coming out with their own results.

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