On the Brink

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Banks Most in Need of a Rescue

Philip van Doorn

You can find more stories like this in our On the Brink series.

Many of the nation's largest banks could have really used that bailout Monday.

After the House of Representatives voted down the bill, sparking a 778-point drop in the Dow Jones Industrial Average, lawmakers adjourned until Thursday, leaving the $700 billion rescue plan in limbo.

Of course, it was almost impossible to predict what immediate effect the bill would have had if it had been passed, since the initial funding would have been only $250 billion, and the Treasury Department's purchase program left so many questions unanswered.

Community bankers wondered if Treasury would be purchasing any nonperforming construction loans. Banks large and small, domestic and foreign, were wondering how they would get in line to sell assets to the Treasury.

Then again, any steps to remove distressed assets from bank balance sheets or boost the market value of mortgage-backed securities, would free up some capital.

A list of the 20 largest banks with the highest nonperforming assets ratios offers a telling scorecard of which ones needed the bailout the most.

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Out of the 20 banks and S&Ls on the list, 10 are (or were) federally-chartered thrifts supervised by the Office of Thrift Supervision. Washington Mutual Bank, of Henderson, Nev., was by far the largest charter supervised by the OTS, with $307 billion in total assets, or approximately 20% of assets under the agency's supervision. It was closed down on Sept. 25 and sold to JPMorgan Chase (JPM Quote - Cramer on JPM - Stock Picks). The next largest OTS shop is Countrywide Bank FSB, which Bank of America (BAC Quote - Cramer on BAC - Stock Picks) continues to operate as a separate entity.

Treasury Secretary Henry Paulson's plan to streamline the regulation of financial institutions (remember that?) recommended doing away with the federal thrift charter entirely, and merging the OTS into the Office of the Comptroller of the Currency, the regulator of national banks.

Of course, we don't know if JPMorgan Chase or Citigroup (CORS Quote - Cramer on CORS - Stock Picks), which purchased Wachovia's (WB Quote - Cramer on WB - Stock Picks) banking subsidiaries (with a nice loss backstop from the FDIC) will maintain any of the thrift charters.

Getting back to the current disaster, there are several different ways to measure bank and thrift asset quality and reserve coverage. They include:

• Nonperforming assets percentage: This is simply the ratio of nonperforming loans (those past due 90 days or more, less government-guaranteed balances) divided by total assets. There's no simple answer as to what represents a good or bad ratio. For example, a bank that's in the factoring business may routinely carry a lot of nonperformers. Then again, it would likely maintain a high level of capital.

  The listed institution with the highest level of nonperforming assets as of June 30 was Downey Savings and Loan (held by Downey Financial (DSL Quote - Cramer on DSL - Stock Picks)). Downey Savings & Loan had a nonperforming assets ratio of 14.16%. As we have pointed out previously, Downey's nonperforming assets ratios include restructured mortgages still considered "performing." If these were excluded, the nonperforming assets ratio would have been 11.16% as of June 30. Downey reports interim monthly asset quality numbers, and reported that nonperforming assets (excluding the restructured performing loans) comprised 11.45% of total assets as of Aug. 31.

  Downey hired CEO Charles Rinehart on Sept. 22. This followed a Sept. 5 cease and desist order from OTS, requiring Downey to maintain leverage and risk-based capital ratios of 7% and 14% at the end of each quarter. Downey's ratios exceeded these levels as of June 30. Ordinarily, these ratios need to be at least 5% and 10% for a bank or thrift to be well-capitalized under regulatory guidelines.

  When announcing the regulator's order, Downey also said it had raised its regulatory capital by about $176 million through real estate sales and a dividend kicked up from a subsidiary of the thrift.

• Loan loss reserves/nonperforming loans: It sure is nice to have 100% coverage, but nonperforming mortgages are secured by real estate that has some value, so the bank or thrift will recover the residual value of a repossessed home. This is why mortgage lenders (and secondary market loan purchasers, like Fannie Mae (FNM Quote - Cramer on FNM - Stock Picks) and Freddie Mac (FRE Quote - Cramer on FRE - Stock Picks)) traditionally required borrowers to make 20% down payments when purchasing homes, or purchase private mortgage insurance to cover the lenders.

  That 20% provided the lenders a decent cushion in the event of a fall in real estate prices. Over the past several years, as lenders lowered their credit standards, they found ways to get around the 20% down payment and mortgage insurance requirements, such as issuing simultaneous "piggyback" second mortgages to finance the down payments. Then Fannie and Freddie were brilliant enough to purchase some of these loans, even though they violated their own guidelines.

• Nonperforming loans/core capital and reserves: If a bank has low reserves, but plenty of extra capital, what's the problem? Well, there might not be one, if this ratio is low enough. When we first highlighted the dire loan quality situations at Washington Mutual, National City Bank (held by National City Corp. (NCC Quote - Cramer on NCC - Stock Picks)), World Savings Bank and Countrywide back in August 2007, we were alarmed by ratios of nonperforming loans to core capital and loan loss reserve ratios approaching 20%. In today's environment, those ratios would measure up pretty well on our list.

• Loan loss reserves/total loans and net charge-off ratio: Many of the loans categorized as nonperforming will improve to performing status. The mortgage loans that go through foreclosure processes will often result in a partial charge-off for the lender. A bank or thrift's actual losses, less recoveries, are known as net charge-offs. If we compare a bank's annualized ratio of net charge-offs to its ratio of loan loss reserves to total loans, we get an idea if its provisions for loan loss reserves are keeping pace with its charge-off activity. The bolded institutions on the list will need to increase their reserving if charge-offs continue at their pace for the first half of 2008. This threatens earnings and capital.

  The institution with the lowest capital exposure on the list -- by far -- was GE Money Bank (a unit of General Electric (GE Quote - Cramer on GE - Stock Picks)) with a ratio of nonperforming loans to core capital and reserves of 9.67% as of June 30. Nonperforming assets comprised 2.40% of total assets, but credit card banks tend to charge-off loans, rather than carry them as nonperforming. During the first half of 2008, GE Money Bank was on an annual pace to charge-off 6% of its loans. Since loan loss reserves covered just 4.04% of total loans as of June 30, this institution can be expected to make larger provisions for loan loss reserves over the next few quarters. That being said, the institution was strongly capitalized, with a leverage ratio of 20.53% and a risk-based capital ratio of 17.90%, as of June 30.

• Ratings. TheStreet.com Ratings issues financial strength ratings on each of the nation's 8,600 banks and savings and loans, which take all of the above ratios into account, along with dozens of other measurements of capital strength, asset quality, earnings, stability and liquidity. The ratings are available at no charge on the Banks & Thrifts Screener. In addition, the Financial Strength Ratings for 4,000 life, health, annuity, and property/casualty insurers are available on the Insurers & HMOs Screener.