Sizzling Loan Growth Has Some Bank-Stock Investors Smelling Smoke

Bank stocks could find a month-long rally snuffed out should earnings growth cool.
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Just as some drivers accelerate to get out of troublesome situations, some banks may be speeding up loan growth in a bid to avoid lower profits in their lending businesses.

Putting the pedal to the metal is always a questionable move on the pike. And it could end up hurting banks, if, in their eagerness to boost loans, they become less picky about their borrowers and lend too much to firms and people more likely to default.

Initial first-quarter results suggest that some banks, like

SunTrust

(STI) - Get Report

,

BB&T

(BBT) - Get Report

and

Summit

(SUB) - Get Report

, may be adopting this apparently go-go strategy. What's more, the banks don't appear to be increasing the cash reserve they keep to protect themselves against a possible spike in bad loans.

Summit and SunTrust say strong loan growth in the first quarter isn't something to worry about, while BB&T didn't comment.

Plenty of investors hope that's true, especially now. Bank stocks have rallied since early March. Even with Friday's market plunge, major regional banks are up nearly 22% since then, according to data-tracker

Baseline

. This fierce move up was fired largely by investors who thought banks were undervalued and that they represented a safe place to put their money with tech stocks falling apart.

But for the spurt to have a greater chance of continuing, first-quarter numbers will have to show signs that banks can produce good profits for some time. And this is getting harder after the

Fed's

five hikes in interest rates, starting in June last year. The Fed funds rate is now 6%, vs. 4.75% in Nov. 1998, and any hope that the Fed was done raising was effectively blown away Friday when a

key inflation number came in way above expectations.

Fighting Compression

These higher interest rates can hurt profitability at banks' lending businesses, since they increase the cost of the money that banks borrow and then lend on. But one way to offset higher interest expense is to get more interest income from borrowers, and one way to do that is to lend more. The percentage difference between a bank's interest expense and its interest income is called its net interest margin.

As first-quarter results have come in, some commentators have been surprised at the pace of loan growth at some banks, especially at a time when the Fed has been slowly applying the brakes to the economy. Also, some feel that after nearly a decade of economic growth, fewer attractive lending opportunities exist for banks now.

But banks are making loans hand over fist. For example, SunTrust's loans grew by 9.6% in the first quarter vs. the year-ago period. In the fourth quarter of last year, the growth rate was 8.2%. Similarly, Summit's loan growth rates were a torrid 13.8% in the first quarter and 9.9% in the fourth quarter. BB&T's overall loan book expanded 10.9% in the first quarter and 10.6% in the fourth, but its commercial loans, which some analysts think is the area most likely to show a jump in bad loans, zipped ahead 19.4% in the first quarter, against 18.4% in the fourth.

"I think banks are chasing higher-margin loans to offset margin compression," says James Record, head of banks research at Charlottesville, Va.-based

SNL Securities

, which doesn't do underwriting.

First-quarter net interest margins at all three banks are slimmer than in the year-ago periods (see table).

Charles Peabody, banks analyst at New York-based

Mitchell Securities

, says SunTrust's higher loan growth "could mean credit problems later." (Peabody rates SunTrust a sell and Mitchell hasn't done any underwriting for the bank.)

Falling Reserves

But the higher growth wouldn't unnerve some observers so much if banks were building up the reserves that are designed to protect them from a higher level of bad loans. Yet, this so-called loan loss reserve as a percentage of total loans is falling at all three banks. SunTrust's reserve was 1.3% of total loans in the first quarter, compared with 1.6% in the year-ago period. At Summit, it dropped to 1.4% from 1.6%, and at BB&T it slipped to 1.3% from 1.4%.

So how long might it take for bad loans to spike, if indeed they do? The Fed hiked rates seven times in the 12 months from February 1994 to February 1995, and loans for the entire federally insured banking system jumped 10.9% over that period. Bad loans, or charge-offs, for the whole system started climbing in early 1995 and peaked in late 1998. Based on this historical precedent, bad loans could start going up around the middle of this year -- or a year after the Fed tightening started in June 1999.

SunTrust and Summit say they have been careful who they lend to and say their reserves are sufficient. A SunTrust spokesman rejects the argument that net interest margin compression can be offset with growth. "If we wanted to offset margin pressure, we'd slow loan growth," and thus reduce the amount of higher-cost money needed to fund loans. And he adds that the bad-loan reserve has dropped as a percentage of total loans, because the bank sold higher-risk credit-card loans in the fourth quarter.

Summit investor-relations executive Kerry Calaiaro says that the bank's high-loan growth is the result of its specialization in buoyant industries and popular loan products. And she adds that loss rates for these areas are low.

Calaiaro says that Summit's bad-loan reserve is appropriate. She says were it otherwise, the bank would risk action from the

Securities and Exchange Commission

, which has recently been targeting banks it feels have purposely kept an overly high reserve with the intention of running it down later to

pad future earnings artificially.

But SNL's James Record says that some banks are perhaps disingenuous to point to SEC pressure on reserves, since a recent incident suggests the bank regulators -- like the Fed and the

Comptroller of the Currency

-- are heading off SEC pressure on this front. He's talking about

City Holding's

(CHCO) - Get Report

announcement last week that it had retroactively

increased

its loan loss reserve after an inspection by bank regulators.