Oh them banks!
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September 14, 1999
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Heard on the Street
Bank Stocks Face Pressure
From Loan, Portfolio Worries
By RICK BROOKS
Staff Reporter of THE WALL STREET JOURNAL
It's bad enough for bank stocks that the U.S. Federal Reserve boosted interest rates last month, setting off a tailspin that hasn't ended yet. But there could be even more trouble ahead.
Bank stocks have plummeted 11% since the rate increase as investors fret that banks are about to get bruised by rising rates even while they already are coping with slower loan growth and other revenue challenges. On top of all that, though, some analysts and investors are growing more concerned about two gathering storm clouds that could darken in a hurry, especially if interest rates inch any higher.
One danger sign is the continuing erosion in commercial-loan quality despite the economy's overall vigor. With loan-loss reserves as a percentage of total loans at their lowest point in more than a decade, the flexibility of banks to absorb additional bad loans without damaging bank profits is shrinking.
At the same time, rising interest rates are starting to hammer bank securities portfolios, causing unrealized trading losses to balloon at some of the nation's largest banks. Some experts fear a portion of those as-yet-unrealized losses soon might turn into real losses if rates keep climbing.
"These are yet two more risks, which, by themselves, are not threatening, but, when combined with other risks, threaten to significantly derail earnings," says Michael Mayo, a banking analyst at Credit Suisse First Boston and one of Wall Street's loudest bank-stock bears during the past several months. He predicts that a few banks could be forced to start realizing their paper trading losses in the fourth quarter.
Of course, with bank stocks already down about 15% since early July, just the threat of additional trouble could rattle some already skittish investors. "I'm not so worried about what it's going to do to the bottom-line numbers, but it will have a much more negative impact on the psychology of investors who own those companies," says Scott Edgar, director of research at Sife Trust Fund, a mutual fund in Walnut Creek, Calif., specializing in financial-services stocks.
Of the two approaching clouds, Wall Street is more nervous about mounting damage in the commercial-loan portfolios of some banks. It's easy to see why: At the 25 largest U.S. banks with at least a third of their assets in the form of loans, nonperforming commercial loans reached a combined $6.58 billion in the second quarter, according to securities filings and bank officials. (Nonperforming loans are loans for which a bank isn't receiving principal and interest payments, as well as restructured loans and foreclosed real estate.) The total, excluding data from five banks that declined to disclose the information, is up 19% since the end of 1998 and has surged 30% from $5.05 billion in June 1998.
The disclosure last month by Summit Bancorp, a regional bank based in Princeton, N.J., that a $60 million loan to a company is going bad suggests there are more problems in the pipeline. Bankers admit privately that they expect to see the level of troubled commercial loans keep rising, even if interest rates hold steady.
Also growing is the number of loans to companies that are in such bad shape that they can't repay their debt, forcing a bank to charge off the loan. The 25 largest U.S. banks wrote off a total of about $780 million in commercial loans in the second quarter, down 2% from the end of 1998 but up 67% from $468 million in June 1998, figures from the banks show.
Looking ahead, R. Harold Schroeder, a banking analyst at Schroder & Co., also sees troubling parallels in a recent surge of newly issued corporate debt that is rated speculative. With that percentage now at its highest point since the mid-1980s, Mr. Schroeder fears a possible replay of what happened next back then: By the late 1980s, a surging number of companies had started to default on their debts, and banks soon found themselves stuck with serious loan problems.
"My point is that you need to be aware of the risks out there," Mr. Schroeder says. "The credit cycle has not been repealed ... and there is pressure building in the pipe."
To be sure, no one on Wall Street is suggesting right now that a loan-quality disaster akin to the late 1980s and early 1990s is looming. And plenty of experts are unconvinced that a problem is emerging at all, since troubled-loan levels still are very low compared with historic averages.
"I sit here and scratch my head," says Carl Dorf, portfolio manager of Pilgrim Bank and Thrift Fund, a mutual fund in Phoenix that invests in financial stocks. "I do not see enough of a deterioration in credit quality to cause me ... to worry."
But one thing almost everyone agrees on is that climbing interest rates are taking a beating on banks' portfolios of securities, at least on paper. Just look at Bank of America, the nation's second-largest bank: As of June 30, the Charlotte, N.C., company's $77 billion available-for-sale portfolio had piled up $2.4 billion in unrealized losses, compared with an unrealized gain of $400 million at the end of 1998, according to a securities filing. A swaps portfolio used to hedge against interest-rate fluctuations had a paper loss of $811 million, instead of its unrealized gain of $942 million as of Dec. 31.
In addition, PNC Bank has unrealized losses of $368 million, or 4% of its $9.2 billion available-for-sale portfolio, while Chase Manhattan's paper losses total $1.3 billion, or 2.6% of its $49 billion portfolio, according to Charles Peabody, banking analyst at Mitchell Securities. He calculates that 18 big banks he follows have total unrealized losses of more than $7 billion, equal to about 1.5% of their combined available-for-sale portfolios.
"I don't know if they will become realized or not," he says, but the pressure would build if interest rates climb a few notches or other businesses stumble.
The worst-case scenario is that some banks with climbing unrealized losses might take at least a portion of those losses just to put a stop to the bleeding. Credit Suisse First Boston's Mr. Mayo compares the current situation to 1994, when interest rates also jumped, pounding bank securities portfolios and causing some banks, including Bank One (then called Banc One) to take large write-offs.
"It's possible it's deja vu for 1994," the analyst says.
"It's a concern," adds Lisa Welch, a senior research analyst at John Hancock Advisers in Boston. But she notes that banks can offset the losses with gains elsewhere in their operations, which could soften the blow of additional interest-rate increases.
A Bank of America spokesman says any unrealized losses in the company's securities portfolio are offset by gains in the value of the bank's deposits, as part of the bank's routine interest-rate hedging strategy. "You're only seeing one-half of the story," he says. "I can promise you the realized losses will be zero."
With so much up in the air, what should bank investors do? Many analysts recommend sticking only with banks that have proved they can perform well in good times and bad. Robert Patten, a banking analyst at Lehman Brothers, recommends Firstar, based in Milwaukee, which has one of the highest revenue-growth rates in banking. One of Mr. Schroeder's picks is SunTrust Banks, Atlanta, famous for its squeaky clean credit culture. "You need to be cautious and selective," he says.
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