Using Bank Regulators as a Contrarian Indicator - TheStreet

Using Bank Regulators as a Contrarian Indicator

The Fed and OCC have been hammering banks on credit-quality issues, but is there cause for concern? Some would say no.
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Cavalier as it may sound, playing chicken with bank regulators could make you rich.

The nation's most powerful bank watchdogs, the

Federal Reserve

and the

Office of the Comptroller of the Currency

, have repeatedly warned of a decline in lending standards in recent months. Those statements helped deepen a long decline in bank stocks that has only recently showed signs of ending. (Click

here to read some of the regulators' remarks.)

One problem: Banks' just-released third-quarter numbers contained no evidence that credit quality is worsening. An absence of bad loan news doesn't disprove the regulators' claims outright -- time could always prove them right -- but it does start to undermine their credibility, since asset-quality indicators should be showing some material signs of deterioration if banks are getting sloppy.

Perhaps understandably, some investors are now beginning to suspect that the regulators are crying wolf.

Everyone Has to Be Somewhere

While the economy stays buoyant, asset quality will remain strong, says Mark Davis, head of research for the


Bank Stock Group fund. "You simply won't see a problem across the board unless there's a major economic problem," he says.

Another investor thinks the bank regulators are merely bureaucrats trying to justify their paychecks. "They have got nothing better to do," says Jeff Miller, a manager of the

Acadia Fund

, a Villanova, Pa.-based bank stock hedge fund. "They'd rather see banks make only the safest types of loans."

Both the Fed and the OCC declined to comment on the issue.

As it is, cleaner-than-expected third-quarter results and receding inflation fears have assisted the roughly 20% rise in the

KBW Banks Index

since the beginning of last week.

For 134 large and midsize banks, the average level of net charge-offs (loans that banks assume won't get paid) actually fell to 0.32% of loans in the third quarter from 0.37% a year earlier, according to

Keefe Bruyette & Woods

, a New York-based investment bank.

That compares well with the 0.56% charge-off rate in the year's second quarter for the many hundreds of banks monitored by the

Federal Deposit Insurance Corp.

And don't forget that the charge-off rate for the FDIC-tracked banks has been at less than 1% since the beginning of 1993.

True, nonperforming assets at the institutions in the Keefe sample jumped 10% in the third quarter, to $22.8 billion from $20.7 billion in the year-earlier quarter. But that's more or less in line with the 9% loan growth over the same period. And, adds Sean Ryan, banks analyst at

Bear Stearns

: "The fact that we're moving out of Nirvana does not mean we're heading straight to hell."

Ryan suspects there's an element of grandstanding in the regulators' stance. The Fed, after being overly lax in the '80s, could be going out of its way to show how vigilant it is, he says. The regulators and bearish analysts could be trying to "fight the last war" to become "heroes of the banking industry," he adds.

In fact, says Ryan, the Fed was guilty of being too tough in the early '90s because it forced banks to charge off too many loans that were then found to be collectible. In other words, who's to say that this overly strict way of thinking isn't still prevalent among Washington's financial-industry bureaucracy?

Fed Up With Naysayers

To be sure, many banking experts say it makes no sense to doubt the regulators.

"These warnings should be taken seriously," says Peter Wallison, a fellow at the

American Enterprise Institute

, which, being politically right of center, can usually be relied on to question regulators.

Wallison's main reason for trusting the bureaucrats in this case is that they get a much closer look at credit quality when their supervisors conduct regular examinations of banks' loan books. "They do get to see data that investors don't," he says.

But Bank Stock Group's Davis says: "I don't believe that for a moment," arguing that, under current disclosure rules, investors do get a pretty good picture of the state of banks' loan books.

Dave Ellison, who runs the


FBR Financial Services fund, says investors shouldn't put too much trust in numbers that currently look very healthy. Problem-loan numbers usually start as a trickle. "A river doesn't start with a raging torrent," he says.

Supporters of the regulators also wonder if the economic underpinnings of the strong loan quality data are looking shaky. The rise in bad loans in the late '80s coincided with higher interest rates and a sharp slowdown in economic growth -- in other words, with the end of what's called the credit cycle. "The Fed is not on our side right now," Ellison says.

But some economists think it highly debatable that the Fed's interest-rate-setting arm is about to bring the credit cycle to an end. "With inflation at bay, it becomes hard to see the Fed raising rates and causing a pullback in borrowing," says Joseph Abate, an economist at

Lehman Brothers

. The Fed may raise rates again this year, but domestic growth is unlikely to fall below 3% for some time, he adds.