With all the gloom and doom in the banking industry, it's no surprise that consumers are scared about the fate of their deposits. But before stashing your cash under the mattress, there are some ways to investigate the health of your bank.
Though few consumers enjoy poring through financial data, taking matters into one's own hands might be the best way to protect your cash, says Andrew Karolyi, an investment-management scholar and finance professor at Ohio State University.
Banks' troubles today stem from bad loans and a lack of capital to cover those risky assets. Essentially, borrowers are unable to afford the big mortgages and other debts they took on and are becoming delinquent or defaulting. Banks are left holding the bag of sour debt and devalued assets -- hence the billions in writedowns and charge-offs over the past few quarters, followed by a scramble to raise capital.
There's no clear-cut way to determine which banks will survive the current economic downturn and which will go under. It depends on a slew of factors -- including regulatory moves, risk mitigation, investor confidence and the health of the consumer -- that are impossible to predict with any certainty. But a quick check of a bank's financial statements, stock performance and preparations it has taken for further losses can provide clues about how well or poorly a bank is faring.
"You can't call it conventional or common wisdom in terms of how to really judge the financial health of the bank," says Karolyi. He adds that "as much as it's interesting to look at the bottom line number," consumers need to "look beyond that to see what kinds of actions or consequences the bank will be taking."
A non-performing asset ratio shows bad loans as a portion of total loans: the higher the percentage, the more troubled the loan portfolio.
There is no standard percentage to use as a benchmark for a "healthy" portfolio. It helps to look at how the ratio has changed over time and how the bank stacks up against its peers. Make sure to compare apples to apples -- a regional bank and a national bank don't operate the same way, nor do two small banks operating in different geographical regions, nor do an investment bank and a retail bank.
IndyMac became the second-largest bank failure in the history of the FDIC earlier this month. The Pasadena, Calif-based bank's NPA ratio was 6.51% at the end of the first quarter -- a rapid acceleration of six times as high as the year-ago period.
By comparison, the nation's largest retail bank, Bank of America (BAC), had a 1.13% ratio at the end of the second quarter, which is four times as high as the year-ago quarter, but still a small portion of its loans. Washington Mutual's (WM) NPAs took up a bigger chunk of the pie, at 3.62%, which is three times as high as the year-ago period. Wachovia's (WB) 2.41% was lower, but still five times as high as the second quarter of 2007.
The NPA ratio provides the scope of the bank's problem -- just how much of its portfolio has gone sour. Write-downs show how the underlying assets' value has declined, while charge-offs tell how much of the problem has already been taken off the books.
While the billions worth of writedowns and charge-offs can seem like staggering figures, the bigger they are, the more the bank is facing the music, getting rid of the problem and trying to move forward. A bank may take a $5 billion hit in one quarter to get rid of a large swath of loans that aren't earning any money. But if it is still standing and funding its operations, the move might be better than holding onto those assets.
"Some of these guys are posting extraordinary losses and trimming that from their balance sheet," says Karolyi. "These big baths do have immediate and long-term consequences, so it's definitely about getting ahead of things."
Losses, writedowns and charge-offs are all in the past. A related -- and arguably more telling -- metric, called a loan-loss provision, gives a sense of how much more of those assets will go bad in coming quarters.
For instance, Wachovia's $8.9 billion second-quarter loss, due to declining asset values and special charges, got much attention on Tuesday. However, it also boosted its loan-loss provision to $5.6 billion, reflecting "current and anticipated severe deterioration in the residential housing market," particularly in Florida and California.
In other words, there will be more pain ahead.
There are several ways to measure capital adequacy, but one oft-cited measure divides core -- or "Tier 1" -- capital by risk-weighted assets.
A bank is considered "well-capitalized" if its Tier 1 ratio is 6% or greater. It is "adequately capitalized" if the ratio is 4% or more and "undercapitalized" or "significantly undercapitalized" if the ratio falls below 4% or 3%, respectively. Banks with a ratio of 2% or less are "critically undercapitalized" and regulatory action is typically taken at that point.
If capital ratios are subpar, find out whether the bank has taken any steps to shore up its cash: slashing dividends, issuing new stock, cutting jobs or closing branches. While some of this retrenchment may seem like negative news -- particularly for shareholders -- it also means the bank is actively working to stay afloat.
While the bank stocks have undoubtedly declined over the past year, some have performed far worse than others, indicating a lack of confidence in the market.
"If they've suffered a cumulative 90% loss in their share price over the last year, that's going to put them in a bad place," says Karolyi.
For instance, IndyMac's shares finished last year down 87% at $4.40. They fell an additional 83% through the first half of 2008 and closed at just a nickel on July 18, their last trading day. If your bank is publicly traded, compare its stock performance over a certain period with that of its peers.
Location and Scope
Community and regional banks are not necessarily more likely to fail than national giants. However, some local economies are doing much worse than others and if a bank operates purely in a troubled market, it will not be capable of offsetting the decline with other business.
Housing markets in Florida, California and other regions in the South and Southwest have declined more sharply than the national average. Michigan is also not faring so well either, due to the troubled U.S. auto market, on which its economy once stood.
Banks that operate strictly in those states will have a harder time dealing with cash-strapped consumers and declining asset values.
A Critical Eye
Karolyi notes that while a bank's senior managers know its financial health better than anyone else, they also have "lots of incentives to not be fully transparent."
The finance expert doesn't suggest making a run on the bank unless you still have serious doubts after delving into its financial data, stacking it up against competitors, taking its size and scope into consideration and listening to what management has to say about its outlook -- with a "critical perspective."
If a consumer decides to take his money and run, should he forego the interest and sock it away under the mattress to make sure it remains safe?
"Not only do I not recommend it," says Karolyi, "but I'm not doing it myself."