Banks Slide as U.S. Bancorp Blowup Sends Loan-Ratio Distress Signal

Banks that have made more loans than they have deposits are at risk, analysts say.
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The Bad Apple theory of bank investing looks decidedly shaky after U.S. Bancorp (USB) - Get Report Monday slashed its earnings outlook for the fourth quarter and 2000.

The Bad Apple theorists argue that banks warning about weakening business are, for the most part, exceptions. In other words, their problems should have little bearing on the majority of banks. This was their line after

First Union



Bank One

(ONE) - Get Report



(KEY) - Get Report


National City


all surprised investors with negative news.

But U.S. Bancorp, the nation's 12th-largest bank with $77 billion in assets, Monday laid a large part of the blame for its reduced forecasts on a factor that analysts expect to hurt other institutions: higher borrowing costs.

More expensive borrowing "is going to affect the entire industry," says a bank-stock hedge fund manager who requested anonymity. "It's inconceivable that other banks won't be hit."

The market is saying something similar. Large banks' stocks were down 4.3% Monday, according to the

KBW Bank Index

. U.S. Bancorp plunged 9 3/4, or 28%, to close at 25 5/8, a new 52-week low.

Lending an Ear

Banks get hold of money for lending from two main sources: from deposits or from borrowing in the market.

U.S. Bancorp's deposits have actually fallen slightly over the past year or so, forcing it to borrow more in the market to fund its loan growth. But as the


has hiked rates three times this year, the bank's borrowed funds have become pricier, pressuring the margin it makes on its lending business.

At the end of the third quarter, U.S. Bancorp had a loan-deposit ratio of 125% -- i.e., 25% more loans than deposits. That's well above the large bank average ratio of 105%, according to

SNL Securities

. (

explored the loan-deposit ratio in a recent


"Higher funding costs are a systematic risk," says Tony Plath, associate professor in finance at the

University of North Carolina

, Charlotte. "If interest rates stay the same or go higher, then they will stay a problem and other banks will miss their earnings."

The hedge fund manager says the following institutions are vulnerable because of their reliance on borrowed funds:


(CMA) - Get Report

, First Union,


(WB) - Get Report


Fleet Boston


. (He's short Fleet Boston and First Union, and has no position in Comerica or Wachovia.)

According to the table below, all these banks have loan-deposit ratios above 100%. Anything above 80% is too high, in the opinion of Mark Davis, head of research for the


Banc Stock Group fund. His fund doesn't own U.S. Bancorp.

Wachovia's finance chief, Bob McCoy, responds: "We had been anticipating three interest-rate hikes this year and have prepared ourselves for these increases." Fleet Boston, Comerica and First Union didn't return calls seeking comment. Shares in Fleet Boston and Comerica were especially hard hit Monday, falling 7.4% and 6.7%, respectively.

Banks can make up for lower returns on lending by focusing more on fee businesses. As a result, banks with high levels of fee income are likely to fare better as interest rates rise, according to many observers. Therefore, those institutions where fees make up a relatively low share of revenue could be exposed, says Andrew Collins, banks analyst at

ING Barings Furman Selz

. Because its fees are "a low percentage of revenue,"

Bank of America

(BAC) - Get Report

is vulnerable, adds Collins, who rates the bank a hold. (His firm has done no recent underwriting with the bank.)

A Bank of America spokesman says this isn't the case, adding that "fees make up 43% of revenue and that share has been climbing." According to

Keefe Bruyette & Woods

, fees make up an average of 45% of revenue at the nation's 24 largest banks.

People Power

U.S. Bancorp also announced that its lending profits have suffered due to lower consumer lending and because in 2000 it's going to spend an extra $50 million "in people, technology and processes to improve customer satisfaction."

But these moves suggest customer service problems that may appear at other institutions, says Charles Peabody, analyst at

Mitchell Securities

. Peabody doesn't rate U.S. Bancorp, and his firm has done no investment banking work for it.

The bank's management, under chief executive and chairman John Grundhofer, appears to have sacrificed customer relations for cost-cutting after the merger of U.S. Bancorp and

First Bank System

in 1997, says Peabody.

"They seem to have recognized that cost-cutting is not the sole route to profitability," says Peabody. U.S. Bancorp's chief operating officer, Philip Heasley, denied that in a conference call Monday: "I wouldn't say that we have underinvested systematically" in the combined firm's branch network.

Banc Stock Group's Davis doubts this: "If you cut corners when cutting costs, it can come back to bite you, and, boy, has it bitten U.S. Bancorp."

He adds: "Banking is still a personal business. When you're talking about money, the only thing more important to people is sex."