The “A” is a growing source of discomfort as the recession drags on. With growth slowing and unemployment rising, a broad swath of consumer and business loans is beginning to sour. “Most of the banks that have failed to date have had significant early credit-cycle exposure — subprime, option-ARM, residential construction loans,” says Cannon. “We’re starting to see significant deterioration in midcycle credit: prime mortgages, home-equity loans, some nonresidential construction. And there’s increasing concern about late-cycle credit instruments such as commercial real-estate mortgages and commercial loans.”
It’s prudent, therefore, to keep an eye on a bank’s loan-loss reserves and nonperforming assets. “If you put a couple of quarters together and you see a trend increase in the loan-loss reserve and an increase in the amount of delinquencies, you start to get a picture of what is likely to happen to these assets in the near future,” says the University of Florida’s Flannery. “There are two categories [of delinquent loans] reported. One is 30 to 89 days late, and that’s kind of noisy; it includes all the people who mailed their checks late. Ninety days–plus is a problem; you know you’re going to have some sort of loss on that.”
Banks are taking a beating on write-offs of delinquent loans. In February, credit-card defaults rose to their highest level in 20 years. IRA predicts that net charge-offs will peak in 2009. Total net charge-offs for the industry reached 2% of assets in 1990–91, the tail-end of the savings-and-loan crisis; this time around they will reach 3% or 4%, IRA predicts. “These charge-offs are already baked in,” says Whalen. “They are the result of portfolio decisions made during the last three or four years.”
How many banks will be done in by the deterioration of their loan books? Whalen agrees that most banks, particularly smaller ones, are sound. Still, while most community banks (typically banks with assets under $1 billion) weren’t affected by subprime or Alt-A loans, they don’t have a diversified geographic footprint and are “very exposed” to the local economy, points out Valentin. “Banks that have large construction portfolios are probably at risk,” he says, particularly in states like California and Florida. Layoffs and unemployment will mean higher vacancy rates in commercial buildings, which will result in more defaults.
When All Else Fails
Despite all of the attention on banks’ earnings the past year and a half, a flawless diagnostic tool for bank soundness has yet to be invented. “There’s no single perfect measure of solvency,” says Cannon. “Accounting statements are not a perfect measure of value. They are all shorthand for solvency. We spend a lot of time looking at balance sheets and we still haven’t got it right on some banks, given how quickly things have deteriorated.”
Scott Bugie, a managing director at Standard & Poor’s, thinks capital ratios are unreliable. “Unfortunately, and much to the consternation of the global regulatory authorities, the correlation between creditworthiness and capital ratios is weak,” he says. Regulatory capital ratios and the capital measures used by S&P “have by themselves been mediocre indicators of relative strength of credit,” says Bugie. “If one institution has a 12% capital ratio and another has a 6% ratio, that doesn’t necessarily mean that the latter is more likely to encounter problems or to default.” Bugie says S&P is working on a new measure of bank capital, called the risk-adjusted capital framework, that it believes will correlate with a bank’s creditworthiness better than its current ratios do.
Of course, there’s another, forward-looking indicator of a bank’s strength: what the market is willing to pay for a share of stock. As of April 1, the KBW Bank Index had fallen more than 60% in the past year, while the KBW Regional Banking Index had dropped more than 40%. Shares in Citigroup traded at just $2.68. While that is a big improvement over the stock’s all-time low of 97 cents in March, it’s a long way from a price that would indicate the hard times are over. For many banks, unfortunately, the worst may lie ahead.
Edward Teach is articles editor of CFO.