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Banks Face Quality Questions

Loan quality will start to become an issue this earnings season.

Bank earnings are at a turning point.

Investors obsessed the past two years with the

Federal Reserve's

interest rate moves and its impact on bank profits have started to shift their focus to the quality of all those loans banks have been making to consumers and businesses.

To be sure, the flattening yield curve -- or the narrowing of the spread between short- and long-term rates -- continues to plague banks that thrive by borrowing money on the cheap and investing in high-yielding bonds. But with the Fed done raising rates, investors are beginning to wonder whether borrowers will start having trouble paying their debts as the economy cools.

As the nation's banks begin reporting third-quarter earnings this week, investors and traders are looking for signs of a turn in credit-quality -- an indication that lenders are starting to gear up for some of the loans in their portfolios going sour. Up until this point, loan defaults have been a nonissue for most banks, with many lenders reducing the amount of money set aside each quarter for loan losses.

But look for investors and traders to pay stepped-up attention during conference calls to the words bank managers use to discuss their loan portfolios. A particular concern is all those homeowners who took out variable interest rate mortgages when interest rates were near all-time lows.

Credit quality has become "much more of a hot button to investors," says Chris Marinac, managing director and research director at FIG Partners, a broker-dealer that specializes in the financial services sector. He expects banks to start boosting loan-reserve accounts rather than continue to draw them down.

"You should be seeing the banks changing their behavior on reserving and becoming much more conservative," says Marinac. If that doesn't happen, he says bankers will have a lot of explaining to do.

With just a couple of regional banks --

M&T Bank

(MTB) - Get M&T Bank Corporation (MTB) Report

and

Regions Financial

(RF) - Get Regions Financial Corporation Report

-- out of the gate with their earnings reports, it's hard to tell if credit problems have really begun to hamper earnings.

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Regions says credit quality improved in the third quarter. Nonperforming assets fell by 29% from a year earlier to $312 million. Net charge-offs at the big southeastern lender fell by $7 million from the second quarter and by $13 million from the year earlier quarter to $24 million, the company says.

Credit quality showed small signs of disturbance at Buffalo, N.Y.-based M&T. The company says nonperforming loans in the third quarter rose 8% from a year ago and 15% from the second quarter, to $179 million, primarily from the addition of $26 million worth of loans related to a single automobile-dealer relationship. However, net charge-offs fell by $5 million, to $17 million.

Recent warnings from several regional banks, including

SunTrust Banks

(STI) - Get SunTrust Banks, Inc. Report

and

Fifth Third

(FITB) - Get Fifth Third Bancorp Report

, suggest that credit quality could be more problematic as 2007 nears.

SunTrust of Atlanta warned in August that it was reclassifying a $200 million commercial loan to a nonperforming loan.

PNC

(PNC) - Get PNC Financial Services Group, Inc. Report

plans to sell or securitize $2 billion in residential-mortgage loans that will result in a $50 million charge taken in the quarter.

Fifth Third says earnings will be "modestly lower" from the second quarter. Memphis-based

First Horizon

(FHN) - Get First Horizon National Corporation Report

cautioned that operating earnings could fall by up to $35 million from further deterioration in the mortgage-banking environment.

The health of the mortgage industry also could be a big issue for banks in California, where the housing slowdown has been the most pronounced. For Midwestern lenders, a prime area of concern is loans to the troubled auto industry.

Nancy Bush, an independent research analyst in Aiken, S.C., says, "We've talked for a long time about the secondary impacts about the auto impacts in the Midwest, but now we're going to start hearing the secondary impacts of the residential-construction industry in the East."

Credit quality is not the only looming issue threatening to pressure earnings. Banks are likely to be even more cautious in their tone and outlook going into 2007, as commercial-loan growth starts to stall as many anticipate.

Large-cap banks including

Bank of America

(BAC) - Get Bank of America Corp Report

,

Citigroup

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and

JPMorgan Chase

(JPM) - Get JPMorgan Chase & Co. (JPM) Report

are not immune to the worsening credit environment, yet their diversified revenue sources, such as capital markets, investment banking and other fee sources, should offset slowing loan growth and troubles in asset quality. Pure-play regional banks will have a much tougher time offsetting credit problems and slowing loan growth as they are more spread dependent.

CreditSights analyst David Hendler writes in a recent note that the full effects of the cooling mortgage market "have not yet been experienced by the banking sector."