Profits grew faster than credit problems among the first batch of community banks to post second-quarter results — another tentative sign the sector is recovering.

These small banks continued to get hit with nonperforming loans and chargeoffs, but they did not take as bad of a beating as they did the previous quarter and a year earlier. Median net income rose by 4%-9.6% from the previous quarter depending on the region, according to a report from Sandler O'Neill & Partners LP and SNL Financial LC. At the same time, regional declines in nonperforming loans ranged from 2.3% to 9.5%.

Lower expenses, higher net interest income, and the strides in credit quality fueled earnings growth.

"It feels to me like the industry is healing, albeit slowly," said Mark Fitzgibbon, director of research at Sandler O'Neill.

But bankers and analysts sought to temper the enthusiasm.

In the first quarter, people "got a little too optimistic" in predicting the economic recovery, said R. Scott Smith Jr., chairman and chief executive of Fulton Financial Corp. in Lancaster, Pa. "But six weeks ago, it seemed the economy just kind of stalled."

The $16.6 billion-asset company's net income rose 230% year over year, to $26.6 million, and nearly 19% improvement from the first quarter.

An $11 million increase in net interest income year over year, and declines in provision for loans losses and FDIC insurance expenses led the turnaround.

However, Fulton's nonperforming assets rose by 9.7% from the first quarter, to $342.6 million. That led to a larger provision.

Lingering asset-quality issues and a sluggish economic recovery have kept bankers like Smith from talking about a rebound in the near term.

"My prediction is that it will be lumpy," he said. "This is why we continue to build our loan-loss reserves. … The slower [the economy] is, the more credit issues we continue to have."

Among the 140 banks and thrifts that reported second-quarter earnings as of July 22, growth in net income ranged from 4% in the Northeast to 9.6% in the West. Median nonperforming loans declined across all regions, from 2.29% in the Southeast to 9.49% in the Northeast.

"Credit is getting better faster than both investors as well as bank management had expected," said Jeff Davis, a managing director at Guggenheim Securities LLC.

Some banks, such as Cardinal Financial Corp. in McLean, Va., exceeded analysts' expectations in earnings and levels of nonperforming loans.

The $2 billion-asset company more than doubled its bottom line since last year, to $4.7 million, and beat the consensus earnings-per-share estimate by 2 cents.

Also, the $6.9 billion-asset CVB Financial Corp. in Ontario, Calif., reported its second-highest quarterly earnings in its history. The parent company of Citizens Business Bank said profit rose nearly 20% from a year earlier, to $19 million. CVB gained $9 million from selling securities.

Higher net interest income bolstered profits at a number of banks. In some cases, it also helped generate higher net interest margins.

CVB said its net interest margin rose to 3.99% from 3.76%. Cardinal also increased its margin to 3.74%, from 2.84% in the second quarter last year.

The spread has been improving during the past year as rates on term deposits fell and tracked closer to loan rates. But some banks are still getting squeezed, possibly even more so in the future, as indicated by a 2-basis-point decline in the Middle Atlantic and a 6-basis-point quarter-to-quarter drop in the Southwest.

In general, second-quarter performance "didn't improve as much as I thought," said Doug Rainwater, managing director and senior bank analyst at Rodman & Renshaw LLC. Though there is still a lot of liquidity, there is not much loan demand, so banks continue to contract balance sheets overall, he said.

Many community and regional banks have aggressively charged off loans, mostly in commercial and construction financing. Despite signs of stability in delinquencies, banks still have to reappraise properties that serve as collateral. And when appraisals come in lower, the bank has to write it down, whether or not the loan is delinquent which in turn, hurts capital.

"The battle today is valuations," said Michael Ross, president and CEO of Dearborn Bancorp Inc. and its Fidelity Bank subsidiary in Michigan.

The $933 million-asset Dearborn charged off $10.5 million in the second quarter despite a decline in nonperforming assets because reappraisals came in lower on properties tied to loans.

As a result of the chargeoffs, Dearborn now has $9.5 million in residential land development loans, down from $29.2 million at midyear.

Elsewhere, chargeoffs grew by 3.87% in the Southeast and by 12.39% in the Southwest from the first quarter.

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