Banking Dip Won't Turn Around Soon

January 14, 2008
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GRAND RAPIDS — Last year was a rough one for bank stock prices and bank operating fundamentals. Credit quality problems dragged down earnings for nearly half of all U.S. banks. Rising levels of troubled loans in all major loan categories in the third quarter — most notably residential mortgages — led to a steep increase in expenses to cover bad loans, according to the Federal Deposit Insurance Corp.’s recent Quarterly Banking Profile.

FDIC data indicate that industry earnings fell 24.7 percent from the third quarter of 2006 to the third quarter of 2007 to $28.7 billion, the lowest level for industry earnings since the fourth quarter of 2002. Loan losses in last year’s third quarter were nearly 50 percent higher than a year earlier, with loan-loss provisions totaling $16.6 billion, compared with $7.5 billion that insured banks had set aside for credit losses in the third quarter of 2006. The number of institutions on the FDIC’s “Problem List” increased for the fourth consecutive quarter, from 61 to 65.

Although 10 large financial institutions actually accounted for half the decline in industry earnings in 2007’s third quarter, banks in the $1 billion to $10 billion asset range saw their charge-off/loan ratios jump from 19 basis points to 35 basis points, and their return on assets drop from 1.30 percent to 1.08 percent, according to Stifel Nicolaus bank analysts Ben Crabtree, CFA, and Stephen Geyen, CFA. They suggest that in terms of operating fundamentals, it’s very likely the decline isn’t over yet.

Crabtree told the Business Journal that the worst of it will likely be sometime in the first half of the year, but he has no way of knowing how long it will linger.

“… Credit losses seem headed higher, and it is quite possible that the weakness in the residential real estate sector may spread to consumer spending and the broader economy,” he and Geyen noted in Stifel Nicolaus’s Midwest Bank Monthly report published Monday.

They said, given the large number of negative “pre–announcements” banks have made regarding large loan loss provisions, fourth quarter results could be worse. There’s already some indication of that: Mercantile Bank of Michigan reported a 55 percent decline in net income for year-end 2007. Mercantile’s net income for the fourth quarter was $0.1 million, a 98.1 percent decline in income from the $4.6 million reported for the fourth quarter of 2006. Total revenue for 2007 was $61.4 million, down 8.1 percent from the $66.8 million reported for 2006. Macatawa Bank will release its financial results tomorrow and Independent Bank is to deliver its results next week. 

Crabtree and Geyen said they expect that nearly half of the Midwest banks they cover will report an earnings decline, with a median decline of 2 percent.

“While we do not expect many extraordinarily large charges, we do expect most of our covered banks to report significantly higher charge-off and loan loss provisions, and to voice caution about the outlook for the next few quarters.”

In terms of the declining real estate market, Crabtree said, there’s a good chance that for Michigan, which has been wrestling with that issue for a while, the bad news is close to peaking.

“If we were convinced that the weakness in housing prices — and therefore the weakness in home equity and perceived wealth — was not going to lead in a real significant cutback in consumer spending, we’d probably be saying that the worst is over. The problem is we don’t have an idea whether or not consumers will react to what they see happening to their balance sheets and the continued decrease in housing prices and decide to really pull back, which would lead us into a consumer-driven recession. That’s the big question out there.”

What are the implications of higher loan losses for the average consumer? Half the growth in consumer spending in this country over the last two or three years was in mortgage equity withdrawal, with people refinancing or running up their home equity loan balances, Crabtree said. “You can’t do that anymore. Home values are going down, and there is just that much less equity to tap into.”

Mitch Stapley, chief fixed income officer for Fifth Third Asset Management, said when banks take hits on their loan portfolio, they have to write off the bad loans and dip into their capital to offset the cost. Then they have to rebuild their capital base. So the availability of capital to new borrowers then becomes more restrictive.

“You’re going to pay more for a loan because they’re not going to be as willing to extend credit because their financial reserves have been stressed by higher charge-offs. Consumers will see fewer good deals from borrowers and some may even be denied credit because there’s a smaller available pool.”

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