The once-fearless stock market is now unnerved - as are many investors and bankers. Most predicted a market correction, but few expected it this fast and with such ferocity.

Bank stocks have been hit particularly hard. While the Dow Jones has fallen over 15%, bank stocks suffered a more dramatic drop-some by more than 50% - with an average of about 30%.

Research has found that the market is a leading indicator of economic performance. Now is the time for us all to ask some tough questions: What is the market telling banks about their loan portfolios? And what should we be doing about it?

Investors are often a much harsher-and more timely-judge of changes in risk than managements are. In 1989, bank stocks began to slide early in the year and had dropped significantly before its end, well before a number of institutions announced heavy losses and set aside considerable loan-loss reserves.

A joint project of Robert Morris Associates and First Manhattan Consulting Group published last year showed that the market rewarded the banks with the best credit performances with a more moderate stock price decline of 33% from their cyclical highs in 1989 to their cyclical lows in late 1990.

The banks with low loan losses were also able to achieve full stock price recovery in early 1991, just six months after hitting their cyclical lows. In contrast, the banks with high loan losses suffered stock declines on average of 75% and took two and a half years to achieve full stock price recovery.

Today the market is clearly concerned about credit quality and is punishing bank stock prices as a result. While some banks have been hit particularly hard, some institutions such as Wachovia have fallen far less. (Wachovia's market high for the year was $90, and Monday afternoon it was at $87.50.)

Though I am concerned about falling bank stock prices and overall economic trends, I don't believe that we're looking at 1989 conditions again. First, the banking industry has never been more strongly capitalized. This was not the case in 1989. Moreover, there are a number of technological advances that enable better risk management techniques, highlighted in the published study, "Winning the Credit Cycle Game." This industry is also far more efficient than it was in 1989.

Nonetheless, bank performance is a barometer for overall economic performance and bank stocks are clearly down. In addition, banking is a cyclical business and we must always be prepared for the economic pendulum to move against banks and their customers. This is particularly the case now that global economic strains are beginning to have an impact on the U.S. economy. Several stress or pressure points have emerged within the U.S. economy that require attention and which could, in combination, cause stress on portfolios in the next 24 months:

Commodity prices have fallen significantly. Compared with a year ago, West Texas crude is down 23%, corn 33%, wheat 39%, and soybeans 24%. If prices bounce back next year, economic dislocation would be contained. But consider the impact on credit quality if commodity prices continue to decline or stay at these levels for one, two, or three more years like they did in the early '80s.

Exporters are feeling the pinch. I talked with one banker whose U.S. manufacturing customer historically derived 40% of sales from exports. Because of the strength of the dollar and weakness in emerging-market economies, that 40% has dried up. Obviously the credit quality of the customer has changed.

Significantly, some of American's largest companies, such as Gillette and Coke, are starting to report declining revenues and earnings. How many middle-market companies have not yet felt or recognized the impact of the strong dollar and a diminished export market because of weakness in a number of global economies? We are now seeing second- and third-level impacts of the international markets beginning to affect the North American domestic markets.

Increased imports could create deflationary pressures. Global economies under pressure will export their goods to the United States at cheaper prices. Rather than providing a check against inflation, what if this dynamic dramatically drives down prices and has a negative effect on companies that compete with imports?

Overall loan structure has been weakened. As the business cycle has expanded through its eighth year, loan structure, particularly covenants, has weakened considerably. During the downside of an economic cycle, this trend could prove particularly troubling for banks. A number of loans booked over the past few years pass muster only because of the strength of the U.S. economy. In a less favorable environment these loans will cause problems.

Many industry veterans who weathered the last downturn have left the industry. Intense industry consolidation has caused many seasoned credit risk professionals to retire or pursue new careers. Many of today's managers have never experienced the downside of an economic cycle. Moreover, workout groups may be understaffed.

Real estate expansion has intensified over the past year. It is clear from the number of cranes in the sky that the real estate market is expanding rapidly. Recently a number of big players have taken some hard hits and a number have stopped lending, waiting for market conditions to improve.

Consumer confidence could fall. Millions of Americans are beginning to see, perhaps for the first time, a material decline in their 401(k) savings plans. With more than 40 million participants in such plans, and most vested in stock plans, the market decline will undoubtedly have an emotional impact.

With consumer spending driving 75% of the overall U.S. economy, what happens if consumers pull back on spending because of paper losses in the stock market? It is a question of perception, and I would argue consumers could become alarmed by outside events - as happened during the Gulf War- and could pull back on spending. Most employees will have received their quarterly 401(k) statements this month.

I don't want to sound like an alarmist, but the industry has clearly entered a different environment. Industry leaders had their August vacations interrupted, and September proved to be more traumatic. Markets are skittish and volatile. Regulators are also working overtime.

Robert Morris Associates believes the guardians of credit quality are about to be tested. Banks are in a cyclical business and will take losses during the downside of the business cycle. However, as risk managers we can control the level and degree of loss.

Clearly, it is time to make sure that risk management processes of all types are working well and management is prepared for the downside of a credit cycle. The good news at this point is that, unlike 1989, the industry is well capitalized and has a strong loss reserves position. Nonetheless, investors will probably reward those institutions with superior risk management skills.

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