Bank Stocks Are Bad, but Big Failures Unlikely

Regional banks will begin reporting earnings on Tuesday, and the market is primed for more bad news following a rash of recent dilutive moves by cash-hungry lenders.

Equity infusions of $7 billion apiece for Wachovia ( WB) on Monday and Washington Mutual ( WM) last week exemplify the challenges banks face with rising risk during the credit crunch.

But while dilutive actions like new stock issues and dividend cuts make banks an unattractive investment at the moment, an analysis by TheStreet.com Ratings suggests the industry's woes are not likely to lead to the worst fears of some industry observers -- the prospect of a major bank failure.

To identify institutions of concern among the largest 100, TheStreet.com Ratings focused on the 10 with the worst asset quality ratios and the 10 with the lowest risk-based capital ratios at the end of last year.

Capital Punishment

There is no question banks are going through a difficult time right now.

Wachovia and WaMu's efforts to raise capital includes stock sales, dividend cuts and private equity investments. Talks of deals also were in the air. JPMorgan Chase ( JPM) was rumored to be among the suitors for WaMu before the bank announced its $7 billion capital infusion last week, and National City ( NCC) is shopping around to find a buyer as quickly as possible.

But while these events are great news in terms of banks' survival prospects, they can be brutal for investors. WaMu's sale of $1.5 billion in common and $5.5 billion in convertible preferred shares to institutional investors diluted other investors' ownership in the company by roughly 50%.

Wachovia's announcement Monday that it would sell $7 billion in equity dilutes its common shareholders for the second time this year, along with cutting the dividend 41%. With a much larger shareholder base, how long might it take for that quarterly dividend to climb back to 64 cents?

Fifth Third Bancorp ( FITB) is one of many holding companies reported to have made bids for the troubled National City, whose main subsidiary, National City Bank, has the distinction of being among the 10 worst banks for asset-quality and risk-based capital ratios, according to TheStreet.com Ratings' analysis.

We discussed National City in detail last week, noting why another rumored combination with KeyCorp ( KEY) would be a bad deal for KeyCorp's shareholders.

The latest reports on potential suitors for National City center on Bank of Nova Scotia ( BNS), Canada's third-largest bank holding company.

The Sky Isn't Falling

But while it may be a terrible time to hold stock in a holding company that may need to raise capital, there have been many predictions of much worse -- namely bank failures -- over the past year. And while several tiny institutions and the larger NetBank, have failed, there's little chance in the short term of the same fate awaiting the largest 100 banks and S&Ls.

The following are the 10 banks with the worst asset quality ratios as of Dec. 31:

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As we recently discussed in detail, Downey S&LA, held by Downey Financial ( DSL), was required to include modified mortgages that were still performing, as part of its Dec. 31 nonperforming assets.

If we exclude the modified performing mortgages from Downey's year-end numbers, the institution's nonperforming assets ratio was 4.39%, its loan loss reserves covered 62.54% of nonperforming loans, and its ratio of nonperformers to core capital and reserves was 28.65%.

IndyMac Bank, the main subsidiary of IndyMac Bancorp ( IMB), and Lehman Brothers Bank, held by Lehman Brothers Holdings ( LEH), also had a high percentage of nonperforming loans as TheStreet.com Ratings recently noted.

Many of IndyMac's nonperforming loans were written down when transferred from held-for-sale to the institution's portfolio. Some of the writedowns were to cover anticipated credit losses, creating an "embedded reserve" providing more of a cushion on top of the loan loss reserves.

Lehman Brothers Bank marks loans to market each quarter. The company stated that the markdowns on problem loans are aggressive enough that it does not need to set aside additional loan loss reserves.

Privately held AmTrust Bank reported nonperforming assets comprising 5.34% of total assets as of Dec. 31, shooting up from 3.49% the previous quarter and 1.70% at the end of 2006. Loan-loss reserves covered just 24.41% of nonperforming loans as of Dec. 31. While this is low reserve coverage, the institution's risk based capital ratio climbed during the year, as it reduced the size of its balance sheet and avoided paying dividends.

Like all 10 institutions listed above, AmTrust's provisions for loan-loss reserves in 2007 greatly outweighed its net loan charge-offs. The ratio of net charge-offs to average loans was 0.58% for 2007, and loan-loss reserves covered 1.33% of total loans at the end of the year. This means that even if it were to add nothing to reserves during 2008, AmTrust could easily double its loan charge-offs from last year without exhausting its loan loss reserves. Of course, continuing declines in housing prices could lead to a much more serious scenario over the next few quarters.

BankUnited FSB, held by BankUnited Financial ( BKUNA), made it clear in its earnings conference call that it resented being tossed with the bathwater. The holding company's stock closed at $4.29 on April 10, just 0.20 times book value and down over 79% year-over-year.

During the real estate boom, BankUnited's loan growth centered on option-payment mortgages with negative amortization features. These loans, in which borrowers choose a payment which could result in adding principal to the loan, represented 61% of its loan portfolio at year-end.

One of curious lending innovations during the real estate boom was qualifying option-mortgage borrowers at the low, initial "teaser" rate, rather than at the "fully indexed" rate at which interest would otherwise accrue. During the conference call, CEO Alfred Camner strenuously objected to "some of the nonsense that has been printed about us" and hammered home the point that BankUnited always qualifies borrowers at the fully indexed rate, and has conservative underwriting.

BankUnited reported nonperforming assets comprising 2.99% of total assets as of Dec. 31, with reserves covering 30.39% of nonperforming loans. Loans past due 30 to 89 days, but still considered performing, comprised another 2.23% of total assets. Both of these categories climbed steadily during 2007 and will probably continue to do so all through 2008. BankUnited's capital ratios were pretty high at year-end, all things considered.

Risk-Based Capital

High levels of capital are a great thing in the current environment, especially for institutions with loan quality concerns. However, for banks or S&Ls with strong asset quality, shareholders might prefer lower capital ratios resulting in higher returns on equity.

A bank or S&L needs to maintain a leverage ratio of at least 5% and a risk-based capital of at least 10% to be considered well-capitalized under regulatory guidelines. Because the risk-based capital ratio takes asset-quality and loan-loss reserves into account, this is the ratio that most often slips below the threshold.

Looking at the list of 10 institutions with the lowest risk-based capital ratios, it is clear that most of the group has good asset quality:

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Associated Bank NA, held by Associated Banc-Corp ( ASBC), had the lowest risk-based capital ratio on the list, at 10.04%. Its capital ratios declined during the year because the bank kicked dividends up to its holding company amounting to nearly all of its earnings.

Associated's nonperforming assets ratio was 0.82% as of Dec. 31 -- pretty nifty in this market -- and only a slight increase from 0.70% a year earlier. Loan loss reserves covered 128.66% of nonperformers, making it quite unlikely for the company's capital position to be threatened by problem loans in the near-term. The institution could always slow its expansion or tweak its dividend policy a bit, if it wants to build up capital.

Fifth Third Bank of Grand Rapids, Mich., held by Fifth Third Bancorp, reported a risk-based capital ratio of just 10.14%. But its leverage ratio was 10.57%, rather high for a $53 billion institution.

Fifth Third Bancorp has several bank charters, with the largest being Fifth Third Bank of Cincinnati, with $61.5 billion in total assets.

Getting back to Fifth Third of Grand Rapids, the institution's capital ratios dropped over the past year because it paid out dividends to the holding company amounting to 81% of its net income, while growing its balance sheet by 10%. The increase in nonperforming loans also contributed to a decline in the risk-based capital ratio.

Fifth Third of Grand Rapids reported nonperforming assets of 1.57% of total assets as of Dec. 31, compared to 0.62% a year earlier. Loan loss reserves covered 67.15% of nonperformers at year end, a reasonable level. Depending on how much nonperformers climb over the next quarter or two, we may see some shifting of assets among Fifth Third's charters to make sure all the institutions remain well capitalized, or maybe a reduction in dividends paid to the holding company.

Philip W. van Doorn joined TheStreet.com Ratings., Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.

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