The Mean Season: Credit Worries Loom Over Banks

A rising tide of bad loans is washing away profits at many large banks, and some experts fear the losses will turn into a flood if banks don't shore up their balance sheets.

For years, banks have hedged lending risk by tucking away cash in special reserve funds to cover loans that borrowers fail to repay. The size of the reserve is often in proportion to how much lending the bank has done, the idea being that banks can count on a certain percentage of loans going bad. But as with so many other sectors, the landscape has changed drastically over the past year thanks to the fallout in equity markets and a slowing economy.

Indeed, the speed at which the fortunes of former blue-chip companies such as Xerox (XRX Quote - Cramer on XRX - Stock Picks) and Lucent (LU Quote - Cramer on LU - Stock Picks) turned sour was a lesson in loan risk for a number of financial companies. Now some experts argue banks need to be more aggressive about targeting and anticipating defaults, and bolstering their rainy-day reserves to match.

A first-quarter earnings analysis from Putnam Lovell banks analyst Jennifer Thompson concludes that First Union (FTU Quote - Cramer on FTU - Stock Picks), KeyCorp (KEY Quote - Cramer on KEY - Stock Picks) and Comerica (CMA Quote - Cramer on CMA - Stock Picks) are among the most poorly reserved banks on a risk-adjusted basis. And Bank of America (BAC Quote - Cramer on BAC - Stock Picks) is drawing increased scrutiny from one firm as well. The fear is that these banks will be forced to play catch-up with their reserves if a hefty portion of their shaky loans has to be charged off at once, resulting in a hit to earnings.

Rainy Days

"It pays to prod a little bit today, especially when you've got a slower economy," says Thomas Theurkauf, banks analyst at Keefe Bruyette & Woods. Theurkauf applies what the firm terms a "macro reserve analysis," a detailed analysis of risk that accounts for everything from credit card loans and mortgage finance to the size of its commercial loan portfolio. Based on that, Theurkauf sees "steady erosion of reserve strength at BAC." (Theurkauf rates Bank of America underperform. KBW has no underwriting relationship with the bank.)

Bank of America said charge-offs for loan losses were $772 million in the first quarter, up sharply from $420 million a year ago. And nonperforming assets (loans past due which have not been written off yet) totaled $5.9 billion, a dramatic increase from $3.5 billion a year earlier. Bank of America played up the fact that it added $63 million more to its loan loss reserve than it charged off, calling the move an effort to strengthen the reserve for credit losses.

But Theurkauf sees things differently. After accounting for items including annualized consumer losses, a modest portion of residential mortgages and outstanding home equity loans, roughly half of nonperforming assets and a 1% reserve for current performing loans, he says the "macro reserve dropped by a very pronounced $497 million."

In other words, despite the outward appearance of holding the reserve steady, the bank is not keeping a fair pace with deteriorating credit or a slowing economy. On a macro-reserve adjusted basis, the bank would have reported earnings of 93 cents a share in the latest quarter, not $1.15, says KBW.

Trendy

While no one is suggesting the banks are being dishonest about their accounting, experts are merely emphasizing the point that tougher times call for tougher measures than the ones in place now.

"Our point is that you can't continue that trend," says Theurkauf. We "would argue that if a macro reserve is a cushion for uncertainty, there is a lot more uncertainty now. A year ago it was the new economy, 6% growth forever and no chance of a recession," he says.

And in terms of risk, Bank of America is hardly in a class by itself. Even sturdy, broadly diversified financials such as Mellon Financial (MEL Quote - Cramer on MEL - Stock Picks) are giving analysts cause for concern lately. As Gimme Credit analyst Kathy Shanley pointed out in a recent newsletter, Mellon "dropped the stodgy word 'bank' from its name in an effort to get investors to focus on its fee-based business." In general, banks have moved into fee-based businesses such as trust accounts in hopes of hedging their exposure to often volatile interest rates.

But Mellon still had about $25 billion in loans, or almost 70% of interest-earning assets, at the end of March. "It is enough exposure to cause credit headaches," said Shanley, noting loans to so-called fallen angels including a borrower in the "manufacturing industry" forced into Chapter 11 by asbestos-related issues and a "California-based electric and natural gas utility," that filed for bankrutptcy protection in early April, referring to a unit of PG&E (PCG Quote - Cramer on PCG - Stock Picks).

Bracing

"Investors should brace themselves for a catch-up loss provision," said Shanley, noting that charge-offs were greater than what the bank set aside for losses in the most recent quarter. In the latest quarter, Mellon said past-due loans were $310 million, or 1.22% of loans and other assets. That is an almost 50% leap over year-ago levels and "doesn't include the $40 million outstanding to PG&E (plus $1 million in commercial paper) which will go on NPA status this quarter." When the PG&E exposure is included, the ratio of reserve to nonperformers is a considerably lower 1.12%.

Indeed, even though banks such as Chicago-based Bank One (ONE Quote - Cramer on ONE - Stock Picks) have tried investor patience in recent quarters by taking a hit to profits to shore up reserves, the restructuring efforts are at least paying off in that the bank has built a decent reserve.

UBS Warburg's bank team recently summed up the quarter by saying nonperformers rose an aggregate 10.5% in the latest quarter at the 39 banks it covers. "We argue that this rate is understated, as several banks opportunistically sold significant amounts of problem loans during the quarter," according to the report. Yet another reason why credit quality warrants a closer look than some banks would suggest.