Loan repayments surged at a handful of midsize banks last quarter, improving credit quality but exacerbating the banking industry's biggest headache — sluggish lending.

Sound and unsound borrowers have started making loan payments again, but they aren't renewing commitments after mailing out a last mortgage check or revolving credit payment.

Higher paydowns cut credit costs at KeyCorp, Huntington Bancshares Inc. and M&T Bank Corp. while weighing on loan growth, particularly commercial and industrial borrowing.

"It's a good and bad thing," said Henry Meyer 3rd, the chairman and chief executive of KeyCorp of Cleveland, which reported its first quarterly profit in two years Thursday. "It's a good thing when the nonperformers are paying down."

Less good: When healthy and stable borrowers pay down without borrowing up again.

A spike in paydowns prompted Key to set aside substantially less money to cover loan losses and release some loan reserves. But the $94 billion-asset company's loan renewals were down from a year earlier. Paydowns also hurt Key's net interest margin, or the spread between the interest it collects from loans and securities and pays to depositors. The margin dipped slightly as it took funds from paydowns and bought lower-yielding securities, which generally tend to be less profitable than loans and have become even more so thanks to turmoil in the debt and equities markets.

Despite that, Meyer characterized rising paydowns as a net positive for Key and the economy. An 83% quarter-to-quarter rise in payments on nonperforming loans helped drive that book down for the third straight quarter to the lowest point in at least a year. Key reported a profit of $29 million after losing money for eight consecutive quarters primarily because of problems with commercial borrowers. Meyer said rising paydowns were also a "very good thing for banks" by indicating a "stabilization in the economy."

Stabilization in unemployment is helping consumers and businesses return to financial health, so they have more money to make loan payments. Banks have also been taking pains to avoid foreclosing on overdue business loans in the past year, modifying terms and taking other actions to keep stressed businesses afloat.

"They have had enough time now to generally get to a healthier state than they were at the point of the shock," said Steven Steinour, the chairman and CEO of Huntington. "We would expect to see more payments this year."

Troubled loans that have been modified are easier to pay off; business loan workouts may involve a balance or interest rate reduction. Steinour said payments on nonaccruing loans are good for a bank because nonperformers are deadweight. Payments ease the "loss of revenue plus the cost to carry" nonperforming loans, he said.

Huntington's nonaccruing loans fell sharply last quarter as paydowns rose across its nonperforming commercial loan book. Easing credit costs helped the Columbus, Ohio, company earn $19.3 million in its second straight profitable quarter after a spell of losses on subprime home loans. But nontroubled loan paydowns offset modest growth in its commercial and industrial lending. Huntington has been trying to ramp up lending to business borrowers across the Midwest.

Rene Jones, the chief financial officer of M&T Bank in Buffalo, takes an optimistic view of paydowns. He said in an interview Wednesday that the volume of overdue-loan paydowns rose last quarter as more residential builders, transportation and health care businesses resumed payments. "It is not in one space, which leads us to believe the economy is on better footing," he said.

Unlike Huntington, the $68.2 billion-asset M&T's net interest margin was actually buoyed by loan paydowns. Prepayment penalties on paid-off loans and interest gathered from nonaccruals pushed the margin up slightly. M&T's loan portfolio is shrinking, too.

But Jones said the contraction is from chargeoffs more than paydowns. "The drop that we're seeing in our loan balances is on loans that are not paying us," he said.

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