Fitch Offers Grim Outlook for Banks

The ratings agency sees banks having to resort to more capital-raising.
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The steady drumbeat of bad news for banks continued Thursday, as Fitch Ratings' industry analyst said she believes financial institutions will need to continue to boost loan-loss reserves and figure out how to maintain capital levels.

Sharon Haas, managing director of Fitch's financial institutions group, said banks with exposure to asset classes under considerable stress, including mortgages, home equity and even credit cards face a tough road ahead.

"There have been many downgrades on U.S. banks and there will likely be more downgrades," Haas said at Fitch's Global Banking Conference hosted in New York on Thursday morning.

Still, Haas is not expecting "massive" debt rating changes across the banking industry. Banks are still able to service their debt obligations resulting in debt ratings that are largely "still in good shape," she said.

Banks largely had gone into this latest credit cycle -- led by a decline in consumer loan portfolios -- with weaker loan reserve ratios as compared to previous cycles, because credit had been relatively benign over the past few years, and banks base their reserve ratios on historical looks back. The credit crisis, beginning last year, became an issue "very rapidly" and "significantly" more than expected, she said.

Therefore, Hass anticipates banks playing "catch-up" as they

continue ramping up their loan reserves

.

On average, residential first mortgages make up 20% of banks' loan portfolios, while charge-offs have spiked to roughly 0.55% to 0.60% of total loans as of the first quarter, up from roughly 0.15% a year earlier, according to Fitch presentation materials.

Haas said it is too soon to tell whether the elevated charge-offs seen in banks' loan portfolios have hit a plateau or will spike again this year, as they did in the third quarter of last year. "We do think it will get worse before it gets better, she said.

Fitch is particularly concerned about the deterioration in home equity loans and the resulting mess that it causing banks.

Charged-off home equity loans also jumped from the third quarter to the fourth quarter. They are still rising, as a result of declining home prices and the fact that banks that hold the home equity lines of credit are likely last on the list to recover a loan that is delinquent.

Home equity loans that go into delinquency "are almost always write-offs," Haas said. "The loss severity is extremely significant."

On the commercial loan side, troubled areas are mostly contained to the "sliver related to housing that is lumped into commercial real estate," she said. This is particularly troubling to regional and small community banks that have a large portion of their equity tied to residential construction loans. On average, regional banks have half of the equity in residential construction, but in some cases can run as much as 800% of total equity, compared to around one-quarter of the equity for the largest banks, Haas said.

Analysts at Fox-Pitt, Kelton Cochran Caronia Waller echoed Fitch's cautious sentiment in an industry note on Thursday. The note wrapped up a conference in which Fox-Pitt, Kelton hosted about 20 small- and mid-cap banking companies in New York earlier this week.

"Just about all of the presenters indicated that there is more credit quality issues to come and pressure is intensifying in existing problem areas, in general," the note said.

The Fox-Pitt, Kelton analysts maintain an underweight rating for the sector as credit costs are expected to rise "significantly" and regulators are placing more pressure on the banks to raise capital and boost loan loss reserves.

"We continue to believe further capital raising is necessary and this capital raising will be more expensive as time passes," the report said, noting that all of the banks were interested in raising capital as opposed to share repurchases, increasing dividends or seeking acquisitions. "The M&A market is essentially dead and the limited activity may occur will be government assisted deals or buying branches of failed banks."

Earlier this week,

Fifth Third

(FITB) - Get Report

said it would

raise $2 billion and slash its dividend

to shore up its balance sheet. It is hardly the first bank to resort to raising capital, joining the likes of

Citigroup

(C) - Get Report

,

Washington Mutual

(WM) - Get Report

and

KeyCorp

(KEY) - Get Report

.

Haas believes that more banks are likely to cut their dividends.

Going forward the combination of increased regulation, stricter and more scrutinized capital requirements and increased disclosure regarding a variety of different risk factors, is likely, Fitch says.

Challenges will "persist into 2009," Haas concluded. "We would just say to you 'Be careful out there.'"