Banks Face Quality Questions

Recent warnings from several regional banks, including SunTrust Banks(STI Quote) and Fifth Third(FITB Quote), suggest that credit quality could be more problematic as 2007 nears.

SunTrust of Atlanta warned in August that it was reclassifying a $200 million commercial loan to a nonperforming loan. PNC(PNC Quote) plans to sell or securitize $2 billion in residential-mortgage loans that will result in a $50 million charge taken in the quarter.

Fifth Third says earnings will be "modestly lower" from the second quarter. Memphis-based First Horizon(FHN Quote) cautioned that operating earnings could fall by up to $35 million from further deterioration in the mortgage-banking environment.

The health of the mortgage industry also could be a big issue for banks in California, where the housing slowdown has been the most pronounced. For Midwestern lenders, a prime area of concern is loans to the troubled auto industry.

Nancy Bush, an independent research analyst in Aiken, S.C., says, "We've talked for a long time about the secondary impacts about the auto impacts in the Midwest, but now we're going to start hearing the secondary impacts of the residential-construction industry in the East."

Credit quality is not the only looming issue threatening to pressure earnings. Banks are likely to be even more cautious in their tone and outlook going into 2007, as commercial-loan growth starts to stall as many anticipate.

Large-cap banks including Bank of America(BAC Quote), Citigroup(C Quote) and JPMorgan Chase(JPM Quote) are not immune to the worsening credit environment, yet their diversified revenue sources, such as capital markets, investment banking and other fee sources, should offset slowing loan growth and troubles in asset quality. Pure-play regional banks will have a much tougher time offsetting credit problems and slowing loan growth as they are more spread dependent.

CreditSights analyst David Hendler writes in a recent note that the full effects of the cooling mortgage market "have not yet been experienced by the banking sector."