'Too Big to Fail' Money Center Banks Still Face Stress

NEW YORK (TheStreet) -- The Federal Deposit Insurance Corporation's Quarterly Banking Profile, or QBP, has a wealth of data and information covering the banking system and the types of assets where stress still exists.

On Tuesday, I wrote The Banking System's Slow, Stressful Recovery.

Now I'll discuss how the "too big to fail" money center banks still have risk exposures as the "Great Credit Crunch" continues.

Our nation's biggest financial institutions also face financial issues that are not presented in the FDIC QBP such as new Basel III capital requirements, regulatory stress tests, the living wills and the Volcker Rule to limit proprietary trading. In Tuesday's article I discussed the funding of the Deposit Insurance Fund. The banks covered here will be required to pony up larger DIF assessments than the smaller community banks.

The FDIC report shows the status of four categories of risks for the banking system since the end of 2007, when the "Great Credit Crunch" began. I will focus on the four "too big to fail" banks, which are bigger today then when the crunch began.

Residential Mortgages (homes housing one to four families) have declined by $370 billion, or 16.5%, since 2007. These mortgages are on the books of the banks, not in the securitization pipeline.

The potential problem here is that mortgage delinquencies remain elevated and additional foreclosures will occur. The slow progress in this category was a sequential rise of 0.9% in the second quarter to $1.88 trillion versus the first quarter.

Home Equity Loans declined $27.2 billion since the end of 2007. Problems with these second lien loans occur when the primary mortgage is being serviced by a different bank.

In this case, if a homeowner was current on his primary mortgage but is missing payments on the home equity loan it becomes difficult to foreclose, as such would not be in the best interest to the primary mortgage holder.

Other Real Estate Owned, or OREO, is up $29.6 billion since the end of 2007, and totals $41.8 billion -- up 244.2% since "The Great Credit Crunch" began at the end of 2007.

This asset class grows as foreclosed properties become hard assets on the books of our banks. It is an asset with costs attached such as; property taxes, HOA fees, and maintenance. The net total of OREO peaked at $53.2 billion in the third quarter of 2010, as properties are sold to new investors.

Notional Amount of Derivatives have increased by $58.9 trillion since the end of 2007 to $225.0 trillion. This rise of 35.4% during a period when risk was supposed to be deleveraging remains a red flag and will be a source of additional time bombs for the global economy.

De-leveraging and financial reform is supposed to provide more transparency, but I have not seen any sense that derivatives are under increased scrutiny. This category of risk peaked at $251.3 trillion in the second quarterly of 2011.

The seven largest participants in the Derivatives markets initiated $204.4 trillion (98%), and this includes three of four "too big to fail" banks: J.P. Morgan Chase ( JPM), Bank of America ( BAC) and Citigroup ( C).

According to the report:

Reserve for Losses increased by $74.1 billion, or 72.4%, to $176.5 billion since the Great Credit Crunch began at the end of 2007 -- showing that banks expect additional bad loans to surface over the next several quarters at least. Reserves for losses peaked at $263.1 billion in the first quarter or 2010 and the decline to $176.5 accounted for a significant contribution to earnings. Despite the decline, reserves remain elevated.

Noncurrent Loans increased by $182.2 billion since the end of 2007, up a staggering 165.6%, which means that the banking system is still saddled by $292.2 billion of bad loans. Noncurrent loans peaked at an even higher $405.4 billion, also in the first quarter 2010.

Noncurrent loans are thus 27.9% off the peak, but still up 165.6% since the beginning of the "Great Credit Crunch." The FDIC Reserve Coverage Ratio is shown below.

Profiling the "Too Big to Fail" Banks:

Bank of America: On Jan. 11, 2008, Bank of America announced it would buy Countrywide Financial for $4.1 billion in stock, in a rescue of the largest mortgage lender. This deal was a take-under at a 7.5% discount to where Countywide was trading the prior day. Delinquencies and loans pending foreclosure were rising.

On July 24, 2012 a Boston Globe article showed this acquisition could cost the bank significantly more due to what seems to be an endless flow of legal claims associated with Countrywide's subprime mortgage business.

JPMorgan Chase: On Sept. 26, 2008, JPM paid $1.9 billion for Washington Mutual in a deal brokered by U.S. regulators, which was the largest bank failure in history at that time. It appears reasonable to assume that the $176 billion in home loans picked up by JPM still includes additional potential problem loans.

JPM built up the largest portion of the notional amount of derivatives, and we know back in mid-May that the bank made a bad bet on derivatives in the "London Whale" situation. We still do not know the bottom-line loss in that bad trade.

Citigroup: faced a shareholder law suit back in November 2007, which was an early warning for the "Great Credit Crunch." The suit contended that the bank misled shareholders about the bank's exposures to subprime mortgage debt. Later that year the bank wrote down Collateralized Mortgage Obligations tied to subprime mortgages and in their fourth-quarter 2007 earnings report took at $9.83 billion loss. This law suit was settled in late August this year for $590 million. Sounds like peanuts, but can there be more problems ahead?

Wells Fargo ( WFC): In early October 2008, federal anti-trust regulators approved Wells Fargo's acquisition of Wachovia. You remember this one? Wachovia spurned a $2.2 billion government-sponsored sale to Citigroup, by accepting a superior offer from Wells Fargo.

What I have always wondered about is what happened to the bad loan exposures after this merger was completed. Wells Fargo had the largest industry exposure to home equity loans where the primary mortgage is not with Wells Fargo. Wachovia had the largest exposure to the riskiest type of residential mortgage loans called Option-ARMs. I am not sure whether or not these exposures are still problematic.

In summary, the bailout of Washington Mutual, Countrywide and Wachovia made the "too big to fail" money center banks even bigger. Exposures have been whittled down beginning in 2010, but still remain quite high by historical standards as shown in the FDIC Quarterly Banking Profile for the second quarter of 2012.

This means that balance-sheet time bombs continue to tick in the U.S. banking system.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

Richard Suttmeier has an engineering degree from Georgia Tech and a master of science from Brooklyn Poly. He began his career in the financial services industry in 1972 trading U.S. Treasury securities in the primary dealer community. In 1981 he formed the Government Bond Department at LF Rothschild and helped establish that firm as a primary dealer in 1986. Richard began writing market research in 1984 and held positions as market strategist at firms such as Smith Barney, William R Hough, Joseph Stevens, and Rightside Advisors. He joined www.ValuEngine.com in 2008 producing newsletters covering the U.S. capital markets, and a universe of more than 7,000 stocks. Richard employs a "buy and trade" investment strategy and can be reached at RSuttmeier@Gmail.com.

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