Asset Quality And The Mortgage Mess
The bank industry’s bad loans and foreclosed properties have come down over the past two years, with banks like BB&T (BBT) making significant reductions in homebuilder and other very risky portfolios since 2008. Moreover, indicators of future loan quality, like 30-to-89 day delinquencies and new problem loans, have also declined, suggesting that problem assets will continue to move in a positive direction in the year ahead, with the pace of improvement dependent on how quickly the economy and the housing market recover.

Further asset-quality improvement ought to lower the costs of maintaining foreclosed real estate and allow banks to make smaller provisions to their loan loss reserves in 2011, or even permit some to reduce reserves. However, problem loans are still relatively high by historical standards. For banks situated in areas with severe housing problems, like Zions Bancorporation (ZION), problem loans may take longer to resolve. That bank has operations in southern Nevada, where housing activity is deeply depressed. Meanwhile, some banks let their loan loss reserves decline much faster than their problem assets fell in 2010, and may not be able to lower provisions to their reserves as drastically in 2011 as they did last year. In all, it may take another year or two for banks’ asset quality ratios and credit costs to return to lower pre-2008 levels, but the industry is making progress toward that goal. 

In addition to addressing their problem assets, banks that sold mortgages that later defaulted to government-sponsored entities, like Freddie Mac, and other mortgage investors are being presented with claims that they buy back the troubled loans. Bank of America (BAC – Free Bank of America Stock Report) has already resolved some of the claims by government agencies. The bank industry is also resisting a proposal by the Obama Administration that mortgage servicers reduce loan balances in situations where the borrower owes more than the home’s current market value. The concern is that doing so may encourage more borrowers to default. Cleaning up the mortgage mess will take time, and the way forward still isn’t clear.

Building A Buffer
Equity capital, like the loan loss reserve, is a kind of a shock absorber in the bank industry, serving as a cushion against future losses. In the aftermath of the economic and housing crises that rocked the bank sector in 2008 and 2009 and prompted the federal government to bail out a number of such leading institutions, there have been calls by legislators and regulatory agencies for banks to take steps to mitigate the impact of future downturns. The industry intends to adopt stricter capital requirements by the start of 2019 that reflect policies still being formulated by the Basel Committee on Banking Supervision, a group of central banks and bank regulators from major industrial nations. Banks are gradually phasing in the expected changes, which will require them to maintain higher capital levels. Many banks believe that they are close to meeting the guideline changes that have already been discussed. In addition to the Basel Committee’s guidelines, financial reform law passed in the U.S. last year could allow regulators to require banks considered “systemically important’’ (mostly banks with at least $50 billion in assets, but also some nonbank financial service providers) to maintain even more stringent capital levels than the Basel guidelines.

The impact of the new capital rules on banks is unclear. Having a bigger buffer against unforeseen losses is desirable, and having to maintain additional capital is likely to discourage banks from engaging in very risky activities, but might also result in slower earnings growth than in the past. But the rules are still being formulated and will be phased in over a number of years, during which much could change.

Revenues Under Siege
The bank industry’s revenues (net interest income and noninterest revenue) are facing pressure from three directions.

There has been some increase in lending activity recently, but with memories of the 2008-2009 recession still fresh, many consumers and businesses remain reluctant to borrow. Loan paydowns are still offsetting new loan growth, resulting in continued declines in most banks’ loan balances. Loans are among the most profitable of a bank’s assets, and their continued erosion is depressing net interest income. This situation may not turn around until late 2011 or in 2012, provided the economic recovery remains on track.

Meanwhile, the Federal Reserve Board continues to keep short-term interest rates extremely low. Most banks have already reduced the interest rates that they pay for deposits to near-zero levels, and may not have much more room to pare their deposit costs.  The continued pressure on bank margins is also depressing net interest income. When short-term interest rates eventually rise, we expect most banks to raise the interest rates charged on loans faster than the rates they pay for deposits, alleviating this margin squeeze. However, with loan demand weak in the past two years, some banks instead built large portfolios of fixed-rate investment securities and may not benefit when interest rates eventually increase.

In addition, pressure from regulators and consumer advocates regarding bank fees they consider excessive and practices considered abusive have spawned numerous new restrictions on bank fees and changes in the ways banks operate that are taking a big bite out of the industry’s noninterest revenue. Among the new regulations are rules governing credit card practices and debit card overdraft and card swipe fees, and rules prohibiting banks from engaging in proprietary trading. Mostly due to the new restrictions on overdraft income, quarterly service charge revenue at Bank of America declined by over $500 million between the June and December periods of 2010.  The banks have been taking measures to make up for the revenue lost due to the financial reform measures, including eliminating free checking. But it probably will take several years for the industry to find ways to offset most of the negative impact of the new rules, which are still being implemented and may be more painful in 2011 than in 2010.

The number of players in the banking industry has been declining, and probably will be reduced further over time. The pressures on revenues outlined above and still above-average credit costs are making it more difficult for some banks to operate independently, and probably will prompt a number of them to join forces in the future. A few banks have already been driven to combine. In December, Louisiana-based Whitney Holding Corporation (WTNY) agreed to be acquired by Mississippi-based Hancock Holding Company (HBHC) and Bank of Montreal (BMO.TO) announced plans to tie the knot with Wisconsin-based Marshall & Ilsley (MI). Both companies being acquired have been struggling, largely due to high credit costs, in Marshall & Ilsley’s case the result of lending outside its region, and the acquiring banks sought to expand their geographic reach. Note also that a report published recently by the Federal Deposit Insurance Corporation indicated that, of the 7,657 banks in the U.S. at the end of 2010, 884 were on its problem bank list. In addition to being acquired, some (but not all) of the problem banks probably will fall by the wayside over the next few years, possibly reducing competition.  

Summing It All Up
The bank industry still has a lot of work ahead of it, and some banks are still in intensive care, but the sector on the whole appears to be slowly heading in a positive direction. The new regulations limiting noninterest revenue and measures to clean up the mortgage mess may be especially painful this year. But we expect the sector to make more progress in resolving problem assets and look for the industry’s earnings to move further along the recovery path over the next few years. 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.