Credit Worries Rock Bank Stocks for a Second Straight Day

Banks are getting squeezed in a nasty pincer movement that likely will cause more of them to report unnerving increases in bad loans.

Wachovia (WB) and UnionBanCal (UB) Thursday said they were increasing the amount of money they put aside to cover bad loans, which have spiked at both institutions recently. Investors furiously dumped both banks' shares Thursday and Friday. And bad-loan nerves have prompted a rout of bank stocks that left them 15% off their yearly high, posted only two weeks ago.

Wachovia and UnionBanCal increased their bad-loan provisions after feeling pressure from two sides. On one flank, a slowing economy and higher interest rates have made it harder for lower-grade bank customers to pay back loans. On the other, bank regulators seem to be leaning on banks to be more stringent when they classify which loans are doubtful or past due.

The Red Balloon

In the past five years, lending to companies with low creditworthiness and often high debt levels has ballooned. This has been done with syndicated loans, which are large credits that several banks participate in at once. Now, as competition continues to bite and the economy slows (albeit slightly), many of these borrowers are finding it hard to pay back loans. At the same time, Washington-based regulators, unnerved by the high level of lending to these debtors, have been toughening up their annual examination of syndicated loans' creditworthiness. That examination takes place in May and June.

On a conference call Friday, a senior UnionBanCal executive said the regulators hadn't mandated any of the $52 million of bad-loan charge-offs it expects to make this quarter. But he did imply that the decision to recognize the bad loans and add a hefty $70 million to its bad-loan provision was prompted by the regulators. "We have raised the bar, with help from our friendly regulators," the executive said.

"The regulators have been signaling their intention to get more stringent for the last two years," says Charles Peabody, a banks analyst at New York-based Mitchell Securities. They became worried, according to Peabody, after a splurge in syndicated lending during 1997 and 1998. Indeed, as far back as June 1998, the Federal Reserve warned that banks had been "easing their lending terms and standards, largely because of intense competition to attract customers."

The History Channel

But why go back two years? Two reasons. First, because it usually takes a couple of years for the true quality of loans to become apparent. Wachovia, for example, may be having problems with syndicated loans it made to the troubled real estate investment trust JDN Realty (JDN). Wachovia, which didn't comment on JDN, led two loans to the company worth $275 million. The Fed in 1998 said it feared that banks were gaining too much exposure to REITs.

Second, a glance back shows that the regulators have been concerned about credit quality for a while now. But, strangely, many in the market are only waking up to this risk. (TheStreet.com reported regulators' growing credit-quality worries last November.)

"Credit quality is an industry problem," remarks Mike Mayo, a banks analyst at Credit Suisse First Boston. On Friday, nervousness about bad loans led Keefe Bruyette & Woods to downgrade its rating and cut its earnings estimate for Bank of America (BAC), the nation's second-largest syndicated lender.

According to Keefe analyst Tom Therkauf, the bank said nonperforming loans would rise at a slightly faster rate in the second than in the first quarter, when they jumped to $3.3 billion, which was 16.3% above the year-earlier period and 7.6% higher than in the fourth quarter.

The analyst added that the bank told him that the regulators' examination was "tough." Bank of America didn't immediately comment. (Therkauf downgraded Bank of America to market perform from outperform; Keefe hasn't done recent underwriting for the bank.)

Therkauf added, however, that Chase (CMB), the country's largest syndicated lender, was "more sanguine" about its bad-loan levels, and said the firm characterized the exam as "business as usual." (Chase didn't immediately comment; Keefe rates the bank a buy and hasn't done underwriting for it recently.)

Chase and Bank of America slipped 8.7% and 6.5%, respectively, Friday, vs. a 5.6% decline in the KBW Banks Index, which tracks the performance of large banks.

The Noncrusading Spirit

Mayo says regulatory filings by Bank One (ONE), down 7.4% Friday, signal that bad loans will rise during the rest of the year. Bank One, along with Bank of America, is thought to have exposure to Safety-Kleen (SK), the beleaguered industrial waste processor. Bank One didn't immediately comment. (Mayo rates the bank a sell, and his firm hasn't done recent underwriting for it.)

The regulators themselves deny that they are on some sort of credit-quality jihad. Instead, David Robbins, deputy comptroller for credit risk at the Office of the Comptroller of the Currency, says: "We're seeing a rise in nonperforming commercial and industrial loans in banks, but not drastic increases."

But Robbins does say that, about two years ago, the OCC and others decided to stress to the banks how seriously the regulators took the annual syndicated-loan exam. He says the regulators made a point of "recommunicating" what they expected from the exam as well as what their loan-rating definitions meant and how they applied the ratings.

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