The most nutritious food for suspicious minds is the repeated assertion that nothing is amiss, which is one reason why credit quality is bank investors' top concern in 2007.
Not a single large U.S. bank has said it believes weakening credit quality will present serious problems this year. Bankers' urgency to prove that all is well has spawned the latest performance buzzword: normalization. An informal survey of recent conference calls and presentations by large banking companies turned up 10 executives claiming that they expect credit costs to be "normal" or to "normalize" in 2007.
In fact, in a Jan. 23 conference call, executives at Bank of America Corp. used the terms 13 times to describe credit conditions. Three analysts repeated them during the question and answer session.
Executives can call it whatever they want, but after several years of low provisions and chargeoffs, "normal" can mean only one thing.
"It means banks expect provisions to rise," said Sean Jones, a senior vice president in the financial institutions group at Moody's Investors Service Inc.
Executives, regulators, and investors knew that rising credit costs were inevitable, given their muted levels in recent years. As credit quality statistics improved throughout 2004 and 2005 and held up throughout most of 2006, bankers occasionally seemed surprised, as if they couldn't quite believe their good fortune.
But the sustained outperformance has led to a fair amount of apprehension. Influenced by the cold logic of credit cycles, the industry has collectively held its breath during this prolonged period of strong credit. The longer costs betrayed their historical averages, the greater the fear that a credit conflagration was in the offing.
Banks, for a variety of very good reasons, generally do not like to make a lot of noise about rising credit costs. The suggestion scares regulators, not to mention investors. But managing expectations is essential to keeping both constituencies happy. With a soft housing market, heavy consumer-debt burdens, and eased underwriting standards, ignoring the changing credit landscape is not a winning strategy. Banks can withstand pressured lending margins, but credit still kills, and the only thing worse than admitting serious credit problems is pretending they don't exist.
The beauty of "credit normalization" is it allows banking executives to acknowledge rising credit costs while explicitly conveying a second, more important message: that the increases are completely expected and manageable.
"Normalization is the return to the historical average run rate for chargeoffs," said John McCune, the director of financial institutions at SNL Financial LC. "The intent is to say that asset quality is going to get worse, but it's not that it's going to get really bad. It's that it has been good for so long it is just going to return to what it is normally like."
It's a semantic balancing act.
Executives prefer to refer to "normalizing" credit costs "because they don't want to scare their stock too much," said David Hendler, an analyst at CreditSights Ltd. "Banks are trying to calm down the markets by saying it's normalization."
Of course, the problem with applying "normal" to credit is identical to the one in applying it to a person: There is no such thing. The most objective measures of cost vary widely depending on the period studied.
The best stab at normal is probably 69 basis points — the weighted average of quarterly net chargeoffs to total loans since 1984 — which is as far back as data from the Federal Deposit Insurance Corp. goes.
But in the five years from 1989 to 1993, the rate was 1.20%. And since 2001, quarterly net chargeoffs have averaged less than half that amount — 59 basis points — according to the FDIC. So what should investors say to banks that claim normalizing credit costs?
"The response should be, 'Okay, tell me what normal is for your model, and then we can have a useful debate about it,' " said Christopher Whalen, managing director of Lord, Whalen LLC's Institutional Risk Analytics. "If their definition of normal is the last five to seven years, then I can guarantee that they are wrong."
He argues that for most of the past five years, the cost of lending has been negative.
"They didn't have to put any money in provisions, the current default rate was negligible, and even the administrative costs were low, because if you don't have defaults, you don't worry about spending time and money on external vendors and modeling exercises," he said.
Mr. Whalen says he is convinced the historic run of good credit has bred a complacency that now represents one of the industry's chief threats.
"Banks' business models have adjusted to assume such a below-normal cost of lending that when it does revert to the mean, they are going to get the proverbial two-by-four between the eyes," he said.
There is only so much banks can do about preparing their balance sheets for changes in credit quality. Concerns a decade ago about earnings management put loan-loss reserves under the scrutiny of the Securities and Exchange Commission, and that concern hasn't gone away.Mr. McCune said banks frequently use the past five years' historical data to benchmark future losses. Given the experience of the past five years, that benchmarking "is resulting in lower levels of reserves to loans than what we've seen before — but the levels are completely justified by the data."
Five years ago the aggregate loan and loss reserves of all insured depository institutions equaled 1.75% of the loans and leases held on their balance sheets. For the third quarter — the most recent for which FDIC data is available — that ratio dropped to 1.09%.
In the meantime, there were very clear signs in fourth-quarter results that the long-anticipated weakening in credit had occurred.
Last week HSBC Holdings Plc said soured loans are forcing a 20% boost in its reserves, to $10 billion.
The nation's largest 16 retail banks provided an aggregate $7.3 billion for loan losses in the fourth quarter, up 29% from the third quarter and even modestly above the fourth quarter of 2005, when several large banks took charges related to a bankruptcy law change. The provision for the median bank in the group jumped 41% from the third quarter and 17% from the fourth quarter of 2005.
The problem with normalizing credit is that credit is, after all, cyclical. Once the cycle inflects, it frequently doesn't take long to move from reverting to the mean to exceeding the mean.
That's why Richard Bove, an analyst at Punk, Ziegel & Co., finds credit trends "very upsetting."
"There is no such concept as a 'normal' level of loan losses," he wrote in an e-mail. "Loan losses are either moving up or down: When they are moving down, bank earnings benefit and profit reports are higher; when they are moving up, as they are now, bank earnings suffer."
Whenever good times persist, it's only a matter of time before some observers speculate that the credit cycle has been repealed. And there's plenty of evidence to suggest that banks have finally figured out how to diversify credits and shed risk.
When commercial borrowers started blowing up early this millennium, banks took some hits but shrugged them off — mostly because, as Mr. Jones put it, capital markets took "a lot of risk away from the banks."
Even as corporate defaults as a percentage of outstanding issuance reached near-record highs, "in bank land, the nonperformers to total loans increased moderately only," he said. "There was a disproportionate amount of risk taken by the bond market over the banking market."
He said that though he believes banks may have figured out how to smooth the credit cycle, he is not convinced they will be as immune to credit troubles as they were in the last corporate downturn.
Mr. Hendler said that many of the risk-dispersing qualities of the capital markets are likely to disappear if there's a serious downturn. Liquidity will dry up, and losses in structured-finance vehicles sponsored by banks will leave their mark. And credit derivatives can only help so much.
"Even if you are buying insurance or credit-default swaps on mortgage-backed and asset-backed securities, you can only lock down the protection for six months to a year," he said. "If the trends are negative, it is going to start costing you more."
So he's a bit skeptical about banks' claim of normalizing credit. The idea that costs will merely return to historical averages but not go substantially above them is "true for some banks, but wishful thinking for others," he said.
