Troubled debt restructurings are about to emerge from the shadows of banks' earnings statements, given worries they're masking the depth of credit problems.

TDRs got some — but not a lot of — attention in the second quarter, but that was before many observers started to make a connection between them and a much-touted fall in loans late at least three months.

"The headlines are: 'We lost money but our early-payment defaults are falling.' Then you see TDRs went up," said Paul Miller, managing director in the financial institutions group at Friedman, Billings, Ramsey & Co. Inc. "How many early-stage delinquencies have they modified? The market thinks they are getting this overall picture of improvement. However, these guys are actively modifying these loans and not really giving you those numbers. You don't know what, exactly, the 30-day defaults would be if they didn't modify them."

TDRs are an accounting classification for loans granted concessions that reduce their net present value. They are worrisome because they tend to live up to their name: they're troubled. Easing a loan's interest rate or principal makes it easier for borrowers to stay on top of their payments in the short run. But history shows that more than half of all restructured loans tend to go bust. Analysts said they will strive over the next two weeks — JPMorgan Chase & Co. kicks off the reporting of third-quarter results today — to discern what kinds of loans banks are restructuring and how much capital they are setting aside to cover them, among other things.

The correlation between TDRs and early-stage delinquencies in the second quarter became evident later, as many banking companies touted a decline in loans at least 30 days late and downplayed their mounting levels of restructured loans. Banks have broad leeway in how they report TDRs in quarterly earnings reports to the Securities and Exchange Commission. Most offer scant details on these credits and bury them deep in their filings. Also, some banks consider TDRs nonperforming loans. Others don't.

Analysts said they got a more accurate and troubling picture of the industry's surging TDRs after scouring the second-quarter call reports banks filed with the Federal Deposit Insurance Corp. in July. Call reports include more details than SEC filings about the types of credits banks have modified and the number of restructured loans that have gone delinquent.

"Yeah, 30-to-90-days [past-due loans] were splattered down but TDRs went to the moon," said Frederick Cannon, co-director of research at KBW Inc.'s Keefe, Bruyette & Woods Inc. "Are you … fixing a problem or just kicking it down the road?"

TDRs aren't the first low-profile balance sheet item to fall under the spotlight as the recession drags on. Analysts and investors similarly latched onto previously obscure tangible common equity ratios last year to get a sense of whether banks had enough capital to absorb losses.

Last week KBW highlighted some troublesome trends in a report on TDRs at 192 170 banks.

Banks tracked by KBW had about $60.7 billion in TDRs at June 30, compared with about $45.4 billion in the prior quarter. The vast majority of TDRs are tied to home loans.

KBW found that TDRs as a percentage of total loans increased to 1.15% on June 30 from 0.84% three months earlier and 0.58% a year earlier. Tracking data from the last four quarters, it found that 27% of all restructured loans go 30 to 89 days past due within a quarter. And 65% of restructured loans less than three months late were reclassified as 90 days past due or more within a quarter.

"TDRs tend to go past due relatively quickly," said Jefferson Harralson, another KBW analyst. "Restructured loans have a pretty high chance of going delinquent pretty quickly."

Executives with companies that have been most active in restructuring loans say TDRs are a sound tool for stemming losses. They contend that restructurings help homeowners stay in their houses while ensuring that lenders do not have to seize a property that will cost them time and money to unload. They also give businesses time to improve their financial health, the argument goes.

Critics of TDRs say granting a workout simply delays an inevitable loss.

"It's part of the 'extend and pretend' mind-set that banks are operating in," said Matthew Kelley, a senior research analyst with Sterne, Agee & Leach Inc. "Look, just because you have reduced the borrower to interest-only … there still isn't going to be enough cash flow there to get the full principal back on the property."

TDRs present other complications by potentially obscuring the banking industry's true financial health, Kelley and other analysts said. Cannon said it does not look like banks have set aside nearly enough reserves to cover potential losses tied to TDRs, even as some of the largest banking companies have said in recent months that they are nearing a peak when it comes to adding to reserves.

KBW's research found that as of June 30 banks had only set aside enough reserves to cover 17% of the total nonperforming assets including TDRs that they have accumulated in the last four quarters.

"The bottom line is that banks are still playing catch-up," Cannon said. "Reserve building has still not kept up with the growth of problem loans."

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.