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Banks Continue to Stuff Loan Cushions

While subprime woes are subsiding, mounting problems in consumer credit will continue to force banks to boost loan-loss reserves.

The hits that banks have taken from the subprime mortgage crisis may be relenting, but the tab from the credit crunch is far from tallied, banking executives say.

Banks across the country from

Wells Fargo

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SunTrust Banks

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have already seen earnings sapped as they bulked up reserves to cover loan losses.

With many experiencing increasing delinquencies in consumer debt, including home-equity loans -- particularly ones made by third-party brokers -- credit cards and auto loans, executives say they're likely to step up the money they set aside to cover defaults.

The situation is becoming more dire as market observers and analysts acknowledge that the credit cycle and housing downturn are likely to last at least through next year. The state of the U.S. consumer "grows worse by the month," according to Oppenheimer analyst Meredith Whitney.

"Our view is that the credit crisis will extend well into 2009 and perhaps beyond, and although the complexion will change, the net effect will be the same: three years of multibillion dollar revenue reversals," Whitney writes in an

industry note

Tuesday. "We estimate that by the end of 2009, over $170 billion of reserve builds will flow through bank earnings on top of 'business as usual' loan loss provisions."

She remains cautious on financial stocks "as credit turns this early in the credit cycle signal to us that ultimate loss experience will be far worse than current expectations," Whitney wrote in a separate note last week.

Analysts also are pointing to commercial real estate loans -- particularly those made to residential real estate builders -- as another area of increasing concern. Banks, particularly in the Midwest and Southeast, have been hit by rising losses from loans to homebuilders as home prices slide.

One problem that banks have with the amount of reserves they allot on the balance sheet is that reserve amounts are based on historical loss experiences on a particular type of loan.

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"These historical loss experiences are far less than what we are beginning to see actually emerge in this credit cycle," says analyst David Honold, who covers financial services companies at Turner Investment Partners in Berwyn, Pa. "In some cases, loan-loss reserves are based on historical lookback of only several years. Management has some discretion in setting reserves, but to a certain degree it's formula-driven," by accountants and regulators.

Honold is most concerned about the banks that have high exposure to home-equity loans.

"It feels like the mortgage situation is one that banks have their arms around for the most part at this point," Honold says. "These other loan categories, it seems, are less clear. Consumers who have multiple types of credit extended to them are faced with choices of which loans to continue paying when they're ability to repay is diminished."

Liam McGee,

Bank of America's

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head of consumer and small business, said losses in the bank's $118 billion home-equity portfolio have risen "rapidly," during last week's UBS Financial Services conference. Losses in the near term will go higher, exceeding the Charlotte, N.C.-based bank's previous loss estimates of 2% to 2.5%, McGee said. He also expects losses in BofA's $184 billion credit card portfolio to rise, particularly in hard-hit housing areas like California and Florida.

"Whether or not we are technically in a recession, our customers are feeling significant economic pressure," McGee said.

JPMorgan Chase

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, which has avoided large losses from the credit crisis relative to other large banks, is likely to reserve more for its jumbo prime mortgage and credit card portfolios, CEO Jamie Dimon said at the UBS conference. JPMorgan had said earlier this year that it would have to step up reserves for losses in its $95 billion home-equity portfolio. The company expects losses could reach up to $900 million this year.

Nearly two-thirds of bank treasurers surveyed recently by UBS said that the ratio of reserves to loans could jump to historical highs of 2% vs. 1.5% through this year. During the 2001-02 recession, the reserve-to-loan ratio peaked at 1.78% for large banks and 1.47% for small banks, according to a separate report by BMO Capital Markets.

The UBS analysts estimate an average earnings haircut of 10% to 15% if loss reserves rise to 2% of loans.

A majority of the executives see charge-offs peaking next year, the survey said.

Even when the rate of growth on bad loans does slow, banks are unlikely to go back to extending the practically free credit seen in the earlier part of the decade. Besides mortgages, banks have been reining in the credit leashes on a wide variety of consumer loans this year to stem the tide of further losses.

Since January, approximately 70% of banks have tightened their loan standards for approving home-equity lines of credit, while 48% tightened the terms on existing lines of credit, according to the

Federal Reserve's

April 2008 Senior Loan Officer Opinion Survey on Bank Lending Practices.

Roughly 44% of banks surveyed tightened their underwriting standards for consumer loans. Slightly more than one-third of the banks surveyed implemented stricter terms for consumer credit card applications, such as requiring higher credit scores and offering lower credit limits. The report is based on responses from 56 domestic banks and 21 U.S. branches and agencies of foreign banks.

Still other bank executives say that while additional reserve builds will be necessary in the coming quarters, they won't be as large as the rapid provisioning seen since last year.

Fifth Third Bancorp

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CEO Kevin Kabat said during the UBS conference that he's "reasonably confident" bad loans will "not require significant additional reserves to cover losses."

SunTrust Banks CEO James Wells was optimistic about consumer credit quality at last week's UBS conference. According to Wells, the company was beginning to see stabilization in its home-equity portfolio.

But Nancy Bush, an independent analyst covering the banking sector, was wary of Wells' comments.

She estimates that SunTrust needs an additional $300 million to $500 million to its allowance for loan losses, which in a worst-case scenario would cost the company 56 cents to 93 cents in earnings.

"This addition would build the loan-loss allowance to roughly 1.5% to 1.65% of loans, and given that

nonperforming assets are likely to exceed the 2% level at

SunTrust before all is said and done, the optics of a reserve in excess of 1.5% would be a lot more palatable to investors, where concerns about the impacts of a worsening economy are rapidly growing."

Staff reporter Lauren LaCapra contributed to this article.