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Bank on It! Credit Quality Issues Rear Their Ugly Heads Again

A mounting pile of bad loans looks to weigh on banks' earnings. But things could be worse.

Credit quality questions have come back to haunt bank stocks.

    Bank Stocks to Avoid as Credit Worries Mount

    Junk-Bond Funds Face Growing Risk of Telecom and Tech Defaults


    bad loans at

    First Union



    Bank of America

    (BAC) - Get Bank of America Corporation Report

    spooked the market this week.

    Federal Deposit Insurance Corp.

    head Donna Tanoue warned that U.S. banks face a greater risk of real estate loan defaults. Many bank stocks, both money center and regional, swooned. Perhaps most worrisome to banks, bond spreads -- i.e. the interest rate they must pay to bond holders compared to the Treasury rate -- have surged to levels not seen since the 1990-91 junk bond debacle; that move reflects fear about their financial future.

    These are the worrisome events that caused

    Merrill Lynch

    bank analyst Judah Kraushaar today to write in a report, "Credit trends are clearly deteriorating in the banking/financial services industry in general. Non-performing assets on the commercial side bottomed about a year ago. We have now had a full year of accelerating non-performing asset growth and our sense from the banks is that this growth is continuing to accelerate. We are also seeing very wide credit spreads on non-investment grade bond issues, which we view as worrisome. Credit spreads today are as wide as they were in the fall of 1998, and we think that is very deflationary."

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    Meanwhile the economic mood music is getting less and less upbeat.

    GDP growth continues to slow. The "soft landing" theory remains the conventional wisdom on Wall Street, but between the lines you can sense increased fear of a "hard landing" (i.e., recession). Are we returning to the bad old days of the early 1990s when real estate and junk bond loans effectively bankrupted dozens of large banks and thrifts? If so, this would be horrible news for all investors -- not just those who own bank and brokerage stocks -- because it would call into question the viability of the financial system and raise the specter of "systemic risk."

    Hold on. Calm down. Let's break this down a bit.

    Bad loans


    rising, and U.S. banks' reserves against such "non-performing assets" have not kept pace. That is not a good sign for future bank earnings. Why not? Because when banks grow their loan portfolios faster than their loan loss reserves, they become more exposed to loan losses. If those losses come to fruition, then the banks must divert profits to bolster the reserve to keep in the good graces of bank regulators.

    Today, when the economy is slowing, you should assume that many banks will build reserves, especially in light of the growing regulatory concerns. That is why

    Lehman Brothers'

    bank analyst

    Chip Dickson wrote recently that "earnings growth driven by reducing the reserve to loan ratio is not sustainable." In short, the pressure on banks to add to their loan loss reserves is growing and that will hit earnings growth at many banks.

    Dickson warns about institutions with a reserve-to-loan ratio trending toward 1.3 or less. His list includes


    (STI) - Get SunTrust Banks, Inc. Report



    (FSR) - Get Fisker Inc. Class A Report


    Associated Banc-Corp




    (BBT) - Get BB&T Corporation Report


    Compass Bancshares



    Regions Financial


    , which are all coming close to the 1.3 threshold, as well as those that are already replenishing low reserves such as

    Bank One

    (ONE) - Get OneSmart International Education Group Ltd Report


    First Union


    PNC Financial

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


    TCF Financial



    Telecom Comes Calling

    Another flat tire for some banks will undoubtedly come from the

    unfolding disaster in new era telecom companies. Until recently, banks have been literally throwing money at all these money-losing, highly leveraged New Economy outfits. Since 1996, telecom lending was the pot at the end of the rainbow for loan officers and investment bankers at more than a few commercial banks. It might seem that telecom lending was to the late 1990s what real estate lending was to the late 1980s -- the area of greatest excess. The fact is that there is a problem that's serious but not comparable in size to the real estate loan catastrophe that crushed the banking sector in the early 90s.

    Oddly enough, U.S. banks may face relatively fewer problems than Canadian banks.

    Morgan Stanley Dean Witter

    analyst Sheryl Strother recently wrote on the growing telecom loan problem in a review of Canadian bank stocks, "Credit Quality: Monitoring Telecom Exposure." Her work puts hard facts on anecdotes that the Canadian banks have recently been among the most aggressive lenders to the new era telcos. It was a way for our northern neighbors to get those fat commercial and investment banking fees in the 1996-1999 period.

    Strother writes, "Several Canadian banks have been active financiers of this sector, which has raised concerns about their potential exposure. With concerns about the market and the economy, we believe credit quality will be an important issue over the coming year. Generally, we expect some deterioration and, although telecom exposure currently appears manageable, we will continue to monitor this area closely." (Note the use of the phrase "currently appears." She may be leaving herself an out in case things turn out worse than she expects.)

    Strother takes some comfort -- not a lot -- from the fact that on average the Canadians' loan exposure to telecom and related sectors is only 3% of total loans and 47% of bank equity. In 1992, the comparable exposure to real estate lending was greater -- 11% of total loans and 128% of bank equity.

    If her assumption of a soft landing proves too optimistic, however, there is real risk here for investors in the banks she highlights. They include

    Toronto Dominion

    (TD) - Get Toronto Dominion Bank (The) Report

    , which she says has the greatest exposure to telecom among the Canadians. She just cut her earnings-growth outlook for Toronto Dominion and wrote in a report released Tuesday, "Given our concerns for a more challenging revenue growth environment in addition to possible rising credit losses, we believe it will be difficult for Canadian bank stocks to outperform."

    U.S. Picks and Pans

    What about U.S. banks? Here is what Merrill's Kraushaar wrote: "Some investors may look at Bank of America with the


    credit issue and think that maybe they're trying to get ahead of the credit issue by taking special charges in Q4. However, when you look at the rate of growth of non-performing assets and the degree of incremental chargeoffs our question becomes whether these companies can quickly get ahead of the credit problem till the

    Fed begins to ease. We are maintaining our defensive stance towards financials focusing on companies that have unusual diversification away from credit-related earnings and the U.S. investment credit cycle. We are also looking at companies that are at the trough of the credit cycle."

    He grudgingly offers a few picks. "Our top recommendations remain


    (C) - Get Citigroup Inc. Report


    Bank of New York

    (BK) - Get The Bank of New York Mellon Corporation Report





    Wells Fargo

    (WFC) - Get Wells Fargo & Company Report

    . Our deep value recommendation is

    Chase Manhattan


    . To see a convincing bottom in financials we feel we need to see an overt Fed easing. However, with relatively low unemployment and a strong consumer sector we do not believe a Fed easing is around the corner. As a result, we think that there may be further earnings risk in our universe."

    Those are honest words from an experienced analyst.

    Credit quality issues are bad news for bank earnings. But bad loans are unlikely to threaten the fundamental financial health of U.S. banks as they did 10 years ago. So don't look for any sustained rally in bank stocks until after it becomes clear that the Fed has changed course and has started cutting interest rates for real. When that happens, the newspapers and magazines will be filled with the drip, drip, drip of banks announcing loan losses, and it will take discipline to step up and buy. That time has not yet come.

    If now is not the time to go long the banks, which are great economic barometers, then is it time to aggressively get long the stock market in general? If you are an investor looking to take a position to hold for a year or more, the banks are a red flag. Watch the

    Philadelphia Stock Exchange/KBW Bank Index

    , the BKX. It has been sagging of late. The overall stock market is unlikely to soar from current levels if the BKX stalls out.