WASHINGTON — Though the snapshot of second-quarter earnings came well before the current credit crunch, ample signs of trouble to come were visible in a Federal Deposit Insurance Corp. report released Wednesday, including sharp increases in noncurrent loans, loan-loss provisions, and chargeoffs.
At a press conference announcing the results, FDIC Chairman Sheila Bair said problems were likely to get worse as many hybrid subprime loans reset this year and next, putting more pressure on struggling borrowers. Current problems in the markets also cast doubt on the internal models banks will rely on when calculating Basel II capital requirements, she added.
Still, Ms. Bair and other FDIC officials said they expect the banking industry to weather any coming storm because of its high capital levels and diversification. Ultimately, banks may benefit, she said.
"While a lot of mortgage companies have become insolvent — they've gone out of business — there may be, longer term, an opportunity for banks to capture market share in the mortgage lending area," Ms. Bair said. "The market is going through a period of readjustment. We knew it was coming. It was inevitable. I think we're getting through it."
In response to a question, Ms. Bair — who has raised repeated concerns about whether the Basel II capital accord will result in significantly less capital held by banks — said she is worried that current conditions show flaws in the internal risk models used by the largest institutions.
She also noted that Basel II relies on ratings from the credit agencies, which have been under fire for giving subprime-backed securities triple-A ratings when the loans that underpin the bonds were so poorly underwritten that they should not have gotten such ratings.
"We are seeing that models don't always work the way you think they should," she said. "Historical data will only get you so far in terms of modeling this, and rating agencies are themselves getting blame."
But she said the FDIC remains committed to the Basel II process agreed on by the federal regulatory agencies last month. "The agreement has real teeth, and it will set up the process that will prevent unbridled reductions in capital for the large banks that will follow the advanced approaches under the accord," she said. "These economic times remind us why strong capital cushions are very, very important for banks that are insured by the FDIC."
But she also raised concerns about adjustable-rate mortgages, particularly in the subprime sector, that are scheduled to reset in coming months. The resets could cause problems for more borrowers, she said.
"The payment reset problem is there, and it's looming large," Ms. Bair said. "The bulk of the problem is ahead of us, but I think we can work through it."
She said she hopes most lenders will work with struggling borrowers when the loans reset to ensure the loans can be repaid, and she noted that 85% of the hybrid ARMs originated in 2005 are performing. "We think those are good candidates for either refinancing or restructuring as the loans reset," she said.
Rising problem loans were already a problem in the second quarter, according to the FDIC's Quarterly Banking Profile. Noncurrent loans grew 10.6%, to $66.9 billion, the largest quarterly increase since the fourth quarter of 1990.
Such loans grew about $17.8 billion, or 36.2%, from a year earlier — the largest dollar-amount increase year-over-year since 1991. More than one-third of the increase in noncurrent loans came from construction and development credits, which jumped 39.5%, to a total of $7.7 billion. Noncurrent residential mortgage loans rose $3.1 billion, or 12.6%, to $27.5 billion.
Chargeoffs also leaped, by 51.2% from a year earlier, to $9.2 billion. Nearly all loan categories saw an increase in net chargeoffs, including commercial and industrial loans, whose chargeoffs rose 71.4%, to $1.4 billion; residential mortgage loans, up 144%, to $715 million; and consumer loans other than credit cards, up 61%, to $2 billion.
Despite the rise in troubled assets, the industry's earnings grew 2.1% in the quarter, to $36.7 billion, the fourth-highest quarterly total ever. However, the earnings number was down 3.4% from a year earlier, the second straight year-over-year decline.
The agency attributed much of the earnings difficulty to higher loan-loss provisions, which were up 75%, or $4.9 billion, from a year earlier, to $11.4 billion. Overall, 824 institutions reported quarterly losses — 224 more than a year earlier — and this was the biggest such increase since the third quarter of 1996.
Unprofitable institutions were 9.6% of the total, the highest proportion since the second quarter of 1991. "Depending on the asset mix, some institutions obviously are going to be challenged more than others," Ms. Bair said.
The average return on assets dropped 13 basis points, to 1.21%, from a year earlier, and 59% of all institutions reported lower ROAs than in the second quarter of 2006.
Still, the agency said that earnings were strong by traditional measures and that it saw other positive signs. Net interest income grew 3.3%, to $88.6 billion, and noninterest income gave a large boost to earnings, up 9%, to $68 billion, from a year earlier. The FDIC attributed much of the latter increase to trading revenue that rose 28.5%, to $6.1 billion.
Loan volume was led by commercial and industrial credits, which grew in the quarter by a record $51.3 billion — or 4.1% — to $1.3 trillion. Credit card loans rose 5.3%, to $372.8 billion; home equity lines grew 3.6%, to $577 billion; and construction and development loans increased 3.1%, to $600 billion. Residential mortgage lending, meanwhile, grew less than 1%, to $2.19 trillion.
However, the agency said higher noninterest expenses — which totaled $90.6 billion — were partly to blame for the earnings trends.
Ms. Bair said lower credit quality can be expected after the industry enjoyed consecutive quarters of record earnings.
Now "the credit pendulum" is swinging "back into balance," she said. "We've had tremendous growth for banks. We're not going to see that kind of performance. Overall, I think banks are very strong historically."
The agency's ratio of reserves to insured deposits grew by 1 basis point, to 1.21% in the second quarter. The agency has said it wants to return the ratio to its target level of 1.25% by sometime in 2009.
Overall, the agency estimates it raised about $330 million in premiums in the first half of the year. However, the reserve ratio also appeared to get a boost from a flattening of deposit growth. The $4.2 trillion in insured deposits was up less than 5% from a year earlier. Total domestic deposits, meanwhile, declined for the first time since the third quarter of 2003, off 0.05% to $6.7 trillion. The decline was largely due to a drop in time deposits, according to industry data.
Foreign deposits, on the other hand, rose a record $143.3 billion in the quarter, an increase of 11.9%. That change was likely due to lower rates being paid on foreign deposits relative to domestic ones, according to call report data.
Much of the increase in foreign bank deposits was due to large institutions. Citigroup Inc.'s main subsidiary raised foreign deposits 7.5%, to $522 billion, from a quarter earlier, according to call report data. JP Morgan Chase & Co.'s primary bank saw its foreign office deposits jump 11% from the first quarter, to $224 billion, according to call report data. Foreign office deposits at Bank of America Corp.'s primary bank rose 13% to $179.6 billion, according to call report data.
The FDIC's "Problem List" of troubled institutions grew by eight, to 61 institutions, and assets in those institutions grew by 7.4%, to $23.1 billion.
