The industry continued to break records in the second quarter, but not the kind bankers brag about.
Loan-loss provisions reached a high-water mark for the third consecutive quarter, and the results suggest the figure is likely to rise the rest of this year and possibly well into next year.
A review of earnings releases by the country's 18 largest banking companies with retail operations showed their provisions rose 20% from the first quarter — when the previous record was set — and a stunning 296% from a year earlier, to $33.3 billion. These companies, which hold the majority of the country's banking assets, served as a reliable bellwether of overall industry performance in the past.
Mounting nonperforming assets at these companies virtually assure that the industry is far from the trough of a devastating credit cycle.
"The story was asset quality. The story is asset quality. The story will remain asset quality," said Anthony Davis, an analyst at Stifel, Nicolaus & Co. "We have not seen a cresting of new problems, despite the fact that chargeoffs continue to jump. Even though banks are writing off more, there is an acceleration of new problem loans in the quarter."
The rising tide of bad debts swamped the easing pace of market-related writedowns at investment banking units. Those losses — on structured mortgage products, leveraged loans, and exposure to monoline insurers, among other things — continued to hamper industrywide results, but the degradation of financial performance from an earnings event to a capital event comes squarely from traditional lending portfolios.
Credit losses related to falling house prices produced high-profile hits for residential construction portfolios, prime mortgages, and home equity loans, but deterioration is increasingly evident in all lending types.
"Delinquencies are rising across the board. That's what happens when you go into a downward swing of a business cycle," said Kevin Blakely, the chief executive of the Risk Management Association. "We can expect continued asset quality deterioration for a period of time. We are in the early stages."
Despite provisions that exceeded net chargeoffs by an aggregate $14.4 billion, these 18 companies could not keep up with rising levels of nonperformers, and reserve coverage fell relative to bad assets. Their nonperformers nearly tripled from a year earlier, to $65.5 billion. And aggregate loss allowances of $90 billion put their coverage at 137%, versus 216% in the second quarter of last year.
At five of these companies — Wachovia Corp., SunTrust Banks Inc., Fifth Third Bancorp, Comerica Inc., and Marshall & Ilsley Corp. — nonperforming loans have exceeded loan-loss allowances.
Credit experts quickly point out that the increases are distorted by extremely low levels of nonperforming assets leading into the downward cycle. And they caution that the absolute level of bad assets is not a reliable indicator of loss exposure, because many assets have substantial collateral.
But the rapid slide argues persuasively that the depth of the industry's problem is just now coming into focus.
Rising nonperformers explained a curious dynamic: The median banking company's net interest income increased 11% from a year earlier, but the net interest margin contracted. That is because net interest income does not reflect provisioning, while the margin reflects an increasing number of loans that are no longer accruing interest.
As a result, the shape of the yield curve is no longer the primary culprit in margin deterioration, as had been the case in recent years.
The question dogging the industry is the loss content of the bad assets, and there is little in public disclosures to provide clarity on that score. That has led executives into a rhetorical battle to convince investors and regulators that the bank has lent more prudently than its competitors, and that relatively stronger underwriting standards and stronger collateralization will mitigate exposure in the case of default.
Outsiders are largely at the mercy of executives, so trust ultimately plays a strong role in market valuation. About the only consolation — and a slim one for investors — is that the truth will ultimately come out. In the meantime, determining loss content without access to credit files is a sucker's game.
"We don't sit on the loan committee," Mr. Davis said. "That's the hard part for those of us trying to analyze the companies: trying to understand the mix of loans, where they were made, the underwriting."
Historical benchmarks for loss content may hold little predictive value in the current cycle, because plunging house prices have defied historical trends.
"I've seen just about every kind of institution in my 32 years in the business, and I can say that loss content varies greatly. It depends on the product, the geography, and the underwriting," said David Gibbons, a former deputy comptroller for credit risk at the Office of the Comptroller of the Currency, who is now an adviser at Promontory Financial Group Inc. "A bank that made first-lien mortgages at reasonable loan-to-values is still going to have an earnings drag from a loss of interest income, but its NPAs may not have nearly the severity of a bank more heavily concentrated in second mortgages or in land development and construction. It's hard to look at NPAs and calculate for X."
Analysts poring over earnings releases and other financial reports can come to some rough conclusions, but that provides little definitive comfort.
"If you have to foreclose in Charlotte, you might have a more typical writedown of 20 cents on the dollar. In Phoenix, you're looking at something much heavier than that," Mr. Blakely said. "When you're in a market with shifting values such as a deteriorating housing market, you can put your best analysis into it this quarter, and it could very well change by the time the next quarter comes along."
A credit cycle that began in subprime and nontraditional mortgages has bled into prime mortgages, home equity, credit cards, auto loans, commercial real estate, and commercial and industrial lending, though analysts have said C&I generally has held up better than other types.
In aggregate, these loan types have pushed up nonperformers as a percentage of total assets to heights not seen since 1990 and 1991, and chargeoffs as a percentage of loans are getting close, too, according to Mr. Davis.
"And the eerie thing is that we've gotten back to those loss levels largely because of loans related to housing — and without a recession," he said.
A more pronounced economic slowdown is, of course, the proverbial other shoe that could make for widespread losses in commercial lending. The weakness has already left its mark in residential development loans, but observers note the contamination of industries intimately associated with new homes, including appliance makers, equipment makers, and providers of housing materials. New residential developments also bring projects like retail strip malls that are suffering as projects collapse and foreclosures mount.
And rising energy and food costs pose obvious threats.
The warnings are dire enough that even pessimists are touting whatever good news they can find, including nascent signs of stabilization in some California markets. And there is some evidence that early-stage delinquency growth is starting to ease.
But that stabilization, if it exists, is too late to solve bankers' immediate problems.
Credit problems are "likely to continue well into 2009," Mr. Gibbons said. "Even if the early delinquencies completely flatten out and start to tip backwards, there is still going to be the big lag effect, with an earnings drag caused by a loss of interest income and by continual loan losses for 18 months at the minimum."
All signs point to a credit cycle that is still closer to its beginning than its end, despite the huge costs already inflicted by failing mortgages.
"Only 14% of NPAs is in other real estate owned, and during the last real estate cycle that number peaked in the mid-30s in 1993," said Mr. Davis. "We are still in the early stages of these banks foreclosing, taking title, and getting ready for resale. That process is still really getting under way."
All of which means the second quarter's unhappy record is unlikely to remain a record for long.
"Most of the folks we talk to are looking to '09 or '10 for the equilibrium to come back into the housing market," Mr. Blakely said. "We have been dealing with the consumer credit cycle for a year already. Maybe it takes another year for things to begin settling down to the point where we see definite improvement."