Bank Loan Problems Far From Buried

A buoyant economy's no guarantee of credit quality. A guide for investors in the sector.
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It's a speech that the bank bulls must have dreaded hearing.

A raft of bank analysts have recently spilled much ink trying to convince the market that bad loans aren't a problem for the banking system. But their work was more or less undone Monday, when

Federal Reserve


Laurence Meyer

said the opposite.

In a speech to the

Institute of International Bankers

, the Fed governor said that the Fed's supervisory department had detected "a possible relaxation in credit discipline" at some banks. And the rising level of problem loans at certain banks was "troubling because the increase has surfaced despite the continuation of favorable economic and financial conditions," Meyer added.

Contrast this view with that of

Warburg Dillon Read's

Tom Hanley, the doyen of bank analysts.

He believes that bad loans are not going to become a significant problem for the banking industry anytime soon and predicts that charge-offs and nonperforming assets will not rise much as a percentage of loans from now until the end of 2000. Any problems that do occur will be "fraying at the edges; nothing more, nothing less," says Hanley.

Let's be clear: Banks aren't on the verge of reaching the hair-raising level of bad loans that existed in the early '90s, something Meyer acknowledged.

Asset-quality indicators are currently well nigh pristine. By the end of this year, Hanley predicts that charge-offs will amount to just 0.64% of average loans, well below 1998's 0.74% level. Meanwhile, nonperforming assets will constitute a mere 0.43% of total loans -- the same as last year.

Even so, credit problems do seem to be spreading. And, critically for bank-stock investors, this could mean higher loan-loss provisions -- something that can quickly eat away at the bottom line.

"Earnings will slip as banks start to up provisions," says David Ellison, manager of the


FBR Financial Services fund.

And, contrary to what many are saying, the buoyant economy is no guarantee of credit quality. Listen to this senior banker.

"Compared with two years ago, there are more challenging credits," says Robert McCoy Jr., chief financial officer at


(WB) - Get Report

. He says Wachovia is being extra vigilant in monitoring its borrowers because the Winston-Salem, N.C., bank holding company is seeing no letup in the harsh competition that has grown out of the low-inflation economy of the 1990s.

More Commercial Loans Going Sour
Net charge-offs as percentage of commercial loans

Source: Federal Deposit Insurance Corporation

"We have to look at all the companies and credit lines and ask whether they can survive in this environment," he says. Wachovia, which has a reputation for tight credit-quality management, knows this all too well. It had lent $82.9 million to the

Loewen Group


, the Canadian funeral company that recently filed for bankruptcy.

So, what institutions should investors more closely monitor for credit problems? Here's a rough and ready guide.

Stallin' Stallions

Banks that have loan growth above the industry average are often singled out for suspicion. Attention should be paid to fast growers like

SouthTrust Bank



National Commerce Bancorp



Regions Financial



All three have for a long time shown excellent credit-quality indicators. But, uncannily, each has recently reported some problem loans.

SouthTrust said that it put a "significant loan" on nonaccrual status in the first quarter of 1999, but then sold a portion of it in the second quarter. "That's the worst thing that has happened to us in a long time," says a SouthTrust spokesman. "We watch everything like a hawk."

National Commerce increased provisions by a whopping 77% in the first six months of this year, compared with the same period in 1998. Lewis Holland, the bank's finance chief, says the large jump results from low first-half 1998 provisions, which came about because the bank was overprovisioned at the end of 1997. The jump isn't a sign that the bank expects credit problems in the near future, he says: "There'll be no surprises in the third quarter."

In the year's second half, loan losses at Regions Financial leaped 63% to $38.8 million from $23.8 million in the year-earlier period. This increased the second-quarter charge-off to 0.42% from 0.19% in the first quarter. The bank did not reply to a call requesting comment.

Commercial Loans Curdling

At the moment, it also makes sense to keep an eye on banks with above-average exposure to commercial and industrial loans. Commercial loans expanded at an 11.3% clip in the 12 months that ended in June -- much faster than most other loan types. It's perhaps no surprise, then, that this loan class also has inferior asset-quality numbers.

In the second quarter, net charge-offs on loans to commercial and industrial borrowers amounted to $1.28 billion, which is $554 million, or a hefty 76%, higher than a year ago, according to the

Federal Deposit Insurance Corporation



Bank of America

(BAC) - Get Report

is the nation's largest commerical lender, it may be more vulnerable to an economic slowdown, Hal Schroeder, banks analyst with


, wrote in a recent research note. (Schroders has no underwriting relationship with Bank of America.)

A Bank of America spokesman says, "We have no problems" in the commercial loan book. "We have strong reserves and we are well diversified in our commercial loan portfolio."

Catch-Up Candidates Get Caught Out

Watch the stragglers. Certain institutions could be relaxing underwriting standards as part of efforts to boost earnings.

Summit Bank

(SUB) - Get Report




both have had trouble posting industry-level profits, and now both have reported large loans going sour. "They were trying to catch up and may have stretched things a little too far," says Jason Goldberg, banks analyst at

Salomon Smith Barney

, which has no underwriting relationship with either bank.

Officials at each bank denied that any change in standards affected those loans.

SIN-dicated Loans

Sometimes banks get carried away with certain hot, fashionable types of lending. In the late '80s, certain institutions got hurt in the leveraged-buyout market. Some observers fear the next minefield could be the syndicated-loan market. Some syndicated loans have interest rates that are too low to cover the borrowers' risk, says Tanya Azarchs, banks analyst at

Standard & Poor's

. "Banks could start getting stuck with large parts of credits that they can't sell," she says.

Azarchs' case is bolstered by satellite phone company



recent default on an $800 million loan syndicated led last year by




Chase, which generally has a sharp eye for credit quality, could stand to lose up to $50 million on this loan, estimates Raphael Soifer, banks analyst at

Brown Brothers Harriman

, which has done no underwriting for Chase. That sum is equivalent to around 13% of second-quarter charge-offs. Chase did not comment.

Honey Traps

History also shows that credit problems can evolve among banks that get carried away lending to sexy-looking emerging industries. No surprise, then, that two California banks that focus on tech-related start-ups have experienced some difficulties.

Silicon Valley Bancshares

(SIVB) - Get Report

, which focuses on technology and life sciences, reported that, in the second quarter, nonperforming loans totaled $47.4 million, or 3% of total loans. That's more than double the $19.9 million, or 1.2% of total loans, at year-end 1998. The problems were with four commercial credits, one of which was repaid in full in July. The bank declined to comment.

Imperial Bancorp


, also with significant exposure to emerging industries, said that nonaccrual loans in the second quarter amounted to $49.6 million, or 1.38% of total loans, up 62% from the year-end 1998 total of $30.6 million, or 0.89% of total loans. One of those loans -- a commercial real estate credit totaling $10 million -- was repaid in July, according to the bank, which declined to comment further.

Lost in Uncharted Territory

Finally, one strategy that is almost certainly to land in bank in trouble is a sudden move into an area in which it has little experience. It's hard to identify large banks guilty of adventurism, but Charlotte Chamberlain, banks analyst at


, says a move of that nature may be behind difficulties at a small Los Angeles-based institution,

General Bank



At General Bank, nonaccrual loans at the end of the second quarter jumped to $53.3 million from $27.7 million at the end of 1998. In the first quarter, the company put on nonaccrual status a $31 million loan on a commercial building in downtown Las Vegas.

According to Chamberlain, that sort of loan was outside of the bank's traditional area of expertise -- loans to small-to-midsize businesses with links to Pacific Rim countries. Jefferies has no underwriting relationship with General Bank, which didn't respond to a request for comment.