Deteriorating Asset Quality Drives First-Quarter Bank Ratings Lower

When visiting the doctor, many patients are reassured by the various diplomas on the wall. But those pieces of paper don't tell you how well your physician did in school.

And almost as important as your health is your money. While we'd love to be able to rate your doctor, we can't. That's why each quarter TheStreet.com Ratings analyzes the financial strength of all reporting U.S. banks and thrifts -- currently 8,736.

Our Financial Strength Ratings are designed to give depositors and financial professionals a solid indication of an institution's risk of failure.

As part of our approach, we are more conservative than other ratings agencies. Rather than considering only a bank or thrift's current financial solvency, and its ability to weather mild economic adversity, our analysis considers an institution's ability to handle sharp declines in earnings or asset quality.

Our quantitative analytical model assigns a rating, on a letter-grade scale of A (excellent financial security) to F (the institution has been placed under regulatory custodianship). These are measured on the basis of each institution's capital strength, asset quality, profitability, liquidity and stability. Regulatory enforcement actions also are considered in the ratings process.

TheStreet.Com Ratings provides an easy way for a depositor or investor to monitor the financial strength of any U.S. bank or savings and loan. You can quickly look up an institution's rating using TheStreet.com Ratings Screener, which is now updated with ratings based on March 31, 2007 data.

When looking up a rating, if you click the institution's name and select "Download Report," you can also view our free ratings summary, which describes factors comprising the rating, current financial data and several years of ratings history for the institution.

This quarter there was a moderate but clear trend downward for the ratings, as interest rate spreads continued to narrow and asset quality continued to decline.

Top Rated Institutions

This quarter, 63 institutions were assigned an A+ financial strength rating. That is down from 69 the previous quarter, and 82 a year ago.

The following three charts list the largest institutions assigned an A+ financial strength rating based on first-quarter 2007 financial results. In the first two charts, we'll take a look at earnings performance.

During the first quarter of the year, interest rate spreads narrowed to their lowest point in more than 10 years. The flattening of the yield curve that began in 2006 continued as the Federal Reserve's moves to increase short-term rates had little effect on long-term rates.

This began to change late in the second quarter, as the bond market finally started to push long-term treasury prices down, thus increasing long-term rates. There should be a slight improvement in interest rate spreads for the second quarter, with stronger improvement in the third quarter of the year.

Most of the largest institutions with A+ ratings had healthier net interest margins than the national aggregate of 2.95%. The two exceptions were Washington FS&LA, a unit of Washington Federal (WFSL Quote), and Citizens First Bank, of Tyler, Texas. These institutions achieved good earnings performance by maintaining relatively low overhead expenses. This is reflected in their efficiency ratios of 23.22% and 33.29% respectively, compared with the national aggregate efficiency ratio of 58.22%.

The efficiency ratio measures total overhead as a percentage of total revenue, net of interest expense. Lower is better. A 50% efficiency ratio would mean that the institution's overhead expenses were 50 cents for every dollar of revenue.

Capital Strength and Asset Quality

The 20 largest A+ rated institutions all reported a higher level of capital than the national aggregate. Our ratings model places heavy weighting on an institution's entire capital position, including loan loss reserves.

Capital strength is essential in providing a cushion to "weather the storm" if an institution experiences a sudden decline in asset quality or prolonged economic challenges that lead to operating losses.

Source: TheStreet.com Ratings

Industry asset quality continued to weaken during the first quarter of 2007, with the ratio of nonperforming loans to total loans at 0.82%. This is up from 0.79% in December 2006. While this ratio is still not high by historical standards, it does not tell the whole story. More than ever, banks and thrifts can sell distressed loans before they are ever listed in quarter-end financial reports. Problem loans are sold to a variety of players, and these sales are not required to be reported.

The first asset-quality ratio we look at is the percentage of loans considered nonperforming. A loan is considered nonperforming if payments are 90 days or more past due. All but two of the 20 largest A+ rated institutions reported better loan quality than the national aggregate. The two exceptions were Farmers & Merchants Bank of Long Beach, Calif., and First National Bank of Newton, Pa. Despite lagging the national aggregate, both of these institutions improved their asset quality from the previous quarter.

A key indicator of asset quality as it relates to an institution's capital strength is the ratio of nonperforming assets to core capital and loan loss reserves. This ratio shows what the effect on an institution would be in the unlikely event that it charged-off (wrote off the debt) all of its nonperforming loans. Looking at this ratio, all of the largest 20 A+ rated institutions reported a lower level of capital risk from problem assets than the national aggregate.

As we have seen, institutions with high ratings tend to have a very strong capital cushion to protect against loan losses and economic disruptions that can hurt profitability. Depositors in institutions like the ones listed above, can take comfort that their deposits are in a secure, well-managed institution. Of course, it is not easy for an institution to achieve an A+ rating. If your institution is rated B or better, we believe it offers good financial security.