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Loan Worries Weigh on National City

The bank could offer an update at Friday's analyst conference.

The bank-sector swoon over the past two weeks shows investors are scurrying away from anything associated with mortgage lending.

Those worries will loom large Friday morning, when

National City


is due to present at the BancAnalysts Association of Boston annual fall conference.

Concerns about the banking sector's health have so far focused more on big banks like


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. Its shares dropped 10% over two days late last week after a CIBC analyst said the bank may need to cut its dividend to raise capital. Citi has repeatedly denied that its dividend is in any trouble, but the departure of CEO Charles Prince over the weekend made it clear the institution faces a painful writedown in the fourth quarter.

In any case, Citi isn't the only bank facing the prospect of pressure on its dividend. With the Midwest suffering a severe real estate pullback and hefty losses in its manufacturing job base, National City has seen a sharp rise in nonperforming assets in recent quarters.

And an analysis of the bank's filings by Ratings shows that if anything, widely discussed measures understate the Cleveland bank's exposure to bad loans -- a red flag at a time when the economy is slowing, reducing prospects for strong earnings growth.

Adding to the worries, National City's management hasn't been taking live questions from analysts on its conference calls in recent quarters. The bank has adopted a system in which analysts submit questions that are then read out on the call by National City's chief flack. While there's no law that companies must take questions from analysts in public, most companies do so. Moreover, the better bank CEOs -- such as Jamie Dimon of


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-- often impress investors and analysts with their skillful handling of tough questions.

Back to National City's question marks. One major industry concern is the ticking time bomb of rate resets for subprime adjustable-rate mortgages. Many of these loans were made with initial "teaser rates" that were quite low. When the rates are reset for the first time for loans made in 2005 and 2006, borrowers can easily face a new loan payment that is unaffordable, since their initial rate was so low.

When asked about the company's $1.6 billion in mortgages of this type, Chief Credit Officer Rob Rowe stated last month that $1 billion of the loans were insured, "so we really only have a $600 book of business that will be subjected to rate resets where we could be on the hook for loss."

Hogwash. Private mortgage insurance policies cover only a percentage of the lender's loss, if, in the event of foreclosure, the market value of the home is lower than the outstanding loan balance. Another concern is that the private mortgage insurance industry is so stressed that one or more players could become insolvent by the time a claim is made. Note the recent plunge of





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National City's insurance status aside, the biggest problem for investors is sizing up the quality of its loan book.

When bank holding companies report "nonperforming assets," they tend to only include loans in "nonaccrual" status -- meaning they don't expect to ultimately collect principal and interest.

However, there is another category of nonperforming loans, those that are 90 or more days past due, but still considered accruing. Both categories are traditionally included when calculating nonperforming asset ratios. When these are included for National City, the figures are more alarming: Nonperforming assets increased 36% during the third quarter and 74% year over year.

To complicate matters further, there is yet another problem loan category reported by banks, loans 30-89 days past due . While these loans are still considered "performing," they often point to further problems ahead. National City reported $2.8 billion in loans of this category, up from $2.2 billion last quarter.

The continued deterioration of loan quality, declining reserve coverage and increasing exposure of capital to problem assets are a major concern for investors.

One bright spot is that the company's capital ratios have increased since it curtailed stock buybacks and issued more shares to complete the acquisition of MAF Bancorp, a $10 billion bank with 82 branches in and around Chicago and Milwaukee. The company's tier-one and total risk-based capital ratios were 6.88% and 10.48%, respectively, increasing from 6.56% and 10.28% last quarter. To be considered well-capitalized by regulators, these ratios need to be at least 5% and 10%.

National City's commercial loan quality may suffer further as it moves forward with its plan to cut 1,200 additional jobs. Some of these are credit-analysis and administration positions in affected areas like Florida.

Since many commercial real estate loans have short terms and are repeatedly renewed, a smaller analysis staff makes it more challenging to complete the loan renewal documentation on time. This is often a very personal process, with the loan officer or credit analyst having several conversations with the borrower and requesting tax returns and financial statements. If the requested information is not received by maturity and the loan does not renew on time, the relationship with the borrower can be poisoned, and the loan can easily slip to nonperforming.

So where does all of this leave us? National City's stock is down 38% year-to-date, and is selling at just 1.03 times book value. Some will consider it a buy right here, as the bank is well capitalized, and while its asset quality decline has accelerated, it is not yet in dire straits.

But the most important thing for investors to consider is the potential for strong earnings growth -- which the current environment makes unlikely for the next several quarters.

With the consensus being that the worst of the real estate crisis is not yet behind us, further loan quality surprises may lie ahead. The resulting transfers to loan loss reserves will continue to hit earnings hard, which could lower capital and ultimately threaten the company's 7% common stock dividend.

Philip W. van Doorn joined Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.