Wachovia Warning Whacks Banks, but Not Everyone's Worried

Wachovia's (WB) warning Thursday that profitability is under pressure and bad loans are rising has dented the giddy optimism supporting bank stocks, leaving investors to work out which institutions might soon report similar problems.

The Winston-Salem, N.C.-based bank said in a press release that its 2000 profits would probably fall short of estimates. Analysts surveyed by First Call/Thomson Financial had expected the nation's 18th-largest bank to make $5.46 per share in operating earnings this year. The bank didn't provide a new 2000 estimate. Robert McCoy, finance chief, said second-quarter operating earnings would come in close to the First Call estimate of $1.34 per share, and added that third- and fourth-quarter results would be below target.

Investors punished Wachovia's stock, driving it down 12 1/2, or 18%, to 57 11/16. Wachovia's revelations sparked a selling wave in the banking sector, driving the KBW Banks Index 5.1% lower. But a look at Wachovia's problems suggests that not all banks are equally exposed to its ills.

Market Turbulence

The bank is blaming a number of factors for the slowdown. Market turbulence has hit Wachovia's capital markets operations and investment business, which together contributed 30% of nonlending revenue in the first quarter. In addition, higher interest rates are hitting the lending arms.

The bank also says that it will be adding $200 million to its bad-loan provision in the second quarter. Due largely to repayment difficulties at a corporate borrower he declined to name, McCoy said bad loan losses, or charge-offs, will be around $70 million in the second quarter. McCoy said the problem borrower isn't Safety-Kleen (SK), the troubled industrial waste processor that missed some debt payments earlier this month. He said the bank reserved against this credit last quarter. Bank One (ONE) and Bank of America (BAC) are also thought to have significant exposure to this credit.

By making a bad-loan provision that is far bigger than losses this quarter, Wachovia effectively boosts the size of its overall reserve and increases it as a percentage of overall loans. Some analysts had recently criticized Wachovia for its provisioning policy. Chris Marinac, banks analyst at Robinson-Humphrey in Atlanta, says the bank has been unwisely letting its bad-loan reserve slip as a percentage of loans. By skimping on the reserve, a bank can boost earnings.

Reservations About Reserves

In the first quarter, the reserve was equivalent to 1.17% of total loans. Marinac points out that figure used to be much higher at Wachovia. What's more, the average for large Southeastern banks is 1.35%. "Wachovia has admitted that reserves needed to rise," says Marinac, who rates Wachovia an outperform; his firm hasn't done recent underwriting for the bank.

If other banks have been more cautious with their bad-loan reserve, then it may be wrong for them to be selling off so steeply Wednesday. For example, SouthTrust (SOTR) was down 5%, but its reserve was a solid 1.42% of loans in the first quarter. "SouthTrust has been doing the right thing," says Marinac, who rates the bank a buy; his firm hasn't done underwriting for it.

Another way of measuring the size of a reserve is to compare it with the level of nonperforming loans, which are loans that are more than 90 days past-due but haven't been charged off yet. At Wachovia, that number was 263% in the first quarter, but it was a mere 150% at First Union (FTU) in the last quarter, down significantly from 217% in the year-earlier period. And some analysts expect First Union to get hit by the same capital markets sluggishness that is hurting Wachovia. First Union didn't immediately comment.

While Wachovia isn't disclosing which credit has gone bad, it is assumed that it is a syndicated loan. (A syndicated loan is a large corporate loan in which many banks participate.) Regulators are conducting an annual examination of these loans at the moment. Observers think the regulators will be tough, and the Financial Times earlier this week quoted an official from the Office of the Comptroller of the Currency saying that he expected an increase in questionable loans. The regulators could force the banks to classify more of their loans as nonperforming, says Carl Dorf, manager of the (PBTAX)Pilgrim Bank & Thrift fund.

He's wondering whether Chase (CMB) and Bank of America, the top two syndicated lenders, will be vulnerable to this sort of regulatory pressure. His fund has no position in either bank. They didn't immediately comment.

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