Weak Housing, Subprime Weigh on Bank Earnings

The weak housing market and risky subprime mortgages weighed heavily on the nation's banks and thrifts in the second quarter, a trend that looks to carry forward, according to an updated report by TheStreet.com Ratings.

The 8,698 banks and savings and loans covered by TheStreet.com Ratings reported $37.0 billion in net income for the second quarter, a decrease of 2.4% from June 2006. And while the Federal Reserve's Sept. 18 rate cut should help ease some of the pain by lowering interest rates, it probably comes too late to offset the prolonged effect a decline in residential real estate values and asset quality of bank loan holdings should have on earnings in the third quarter.

Problem loans are pressuring even the biggest financial institutions, which are showing an impact to their bottom line as they set aside more money in reserve to offset loan losses. For smaller banks and thrifts, the recent failures of NetBank and Miami Valley Bank serve as reminders of the importance of monitoring these institutions' financial health.

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Earnings Affected by Problem Loans

Loan quality continued to dominate earnings concerns, as provisions for loan losses increased 77% to $11.3 billion in the quarter, vs. the year-ago period. While this is still lower than the peak of $12.2 billion in the fourth quarter of 2006, the $6.4 billion set aside for reserves in the second quarter of 2006 is critical, because it is a direct hit on earnings.

The narrow margin between short- and long-term interest rates also continued to challenge the industry. The aggregate net interest spread remained unchanged from last quarter, at 3.3% -- its lowest level in 10 years. With the Fed lowering the federal funds rate half a point to 4.75% on Sept. 18, the aggregate net interest spread should show improvement in the fourth quarter.

Industry efficiency improved slightly from last quarter. During the second quarter of 2007, it cost 57.3 cents to generate each dollar of revenue, down from 58.2 cents last quarter, but up slightly from 57.1 cents a year ago.

The number of full-time employees in the industry dropped modestly in the second quarter. A sharper drop, along with a resulting improvement in the efficiency ratio, is expected for the third quarter, accelerating in the fourth quarter, with recent staff reduction announcements by Countrywide Financial(CFC Quote), IndyMac Bancorp(IMB Quote) and National City(NCC Quote). Bank of America's(BAC Quote) pending acquisition of LaSalle Bank from ABN-Amro(ABN Quote) is also expected to lead to significant layoffs.

The following is a list of ratings for the largest 10 institutions:

Source: TheStreet.com Ratings

While year-over-year net income improved for eight of the 10 largest institutions, five of the same 10 experienced a decline in return on average assets in the same period. The group also reported $56.0 billion in adjusted nonperforming loans (net of government-guaranteed balances), an increase of 11% from June 2006 and the highest rate since 2002. The additional problem loans were mainly split between residential mortgages and a variety of construction loan types.

Washington Mutual Bank, a unit of Washington Mutual Inc.(WM Quote), and FIA Card Services, held by Bank of America, reported the largest year-over-year increases in problem loans, more than doubling the level from June 2006.

Warning Signs

The recent failures of NetBank and Miami Valley Bank were shocking in that bank failures have been quite rare in recent years. While individual deposit accounts are insured by the FDIC for up to $100,000 (or more for certain retirement accounts), many small businesses, municipalities and other organizations could be caught with uninsured deposits in unstable banks.

Both NetBank and Miami Valley Bank were assigned ratings in the E (Very Weak) range, months before they failed. The following is a list of banks and thrifts with significant financial strength ratings downgrades from last quarter:

Source: TheStreet.com Ratings

As expected, the main driver of the downgrades was asset quality. A year ago, all the listed institutions had ratios of nonperforming loans to total loans well below 1%. As of June 30, the only institution on the list with a ratio of nonperforming assets less than 1% was First NB of Platteville, Wis. -- which took a 4.38% charge for a portion of their loan portfolio during the first half of the year.

The institution with the most alarming numbers on the list is Fremont Investment & Loan, a unit of Fremont General(FMT Quote) of Anaheim, Calif. Like its holding company, Fremont Investment & Loan has been hammered by the subprime mortgage crisis. The institution lost $705 million during the first half of the year, and is undercapitalized per regulatory guidelines. Fremont Investment & Loan has hardly any loan-loss reserves, and its ratio of adjusted nonperforming assets to total assets was 4.73%, up from 3.77% the previous quarter.

Unless its asset quality shows a remarkable turnaround, it's hard to see how this institution can survive without an infusion of capital. On Wednesday, an investor group comprised of Harbert Management and Harbinger Capital Partners Master Fund I announced it bought 9% of Fremont General's shares, causing Fremont's share price to jump. However, while this sign of private capital interest is comforting to the holding company's shareholders, it does nothing to increase Fremont Investment & Loan's capital.

The largest institution on the list is Westernbank Puerto Rico, a unit of W Holding Co.(WHI Quote). Westernbank reported a net loss of $37 million for the first half of the year, reflecting a $127 million provision for loan loss reserves. In comparison, the institution only added $25 million to reserves and posted net income of $56.5 million in the first half of 2006. While Westernbank's ratio of adjusted nonperforming assets to total assets is better than most of the listed institutions, at 2.17%, it is almost double the previous quarter. The institution's rating also suffered from the drop in capital caused by the net loss. However, it is still considered well-capitalized per regulatory guidelines.