Credit problems only beginning for regional banks

The credit crisis has taken a toll on national and investment banks, but is only now starting to rock smaller, regional banks.

It is a problem that is likely to stick around for the foreseeable future, leading banks to raise loss reserves and look for new capital.

Keefe, Bruyette & Woods Inc. analyst Fred Cannon said regional banks' problems have been apparent recently as they have increased loss provisions to cover faltering loans. But, those reserves are still short of the amount needed, he said.

Bank reserves are below historical levels seen entering previous economic downturns, Cannon said. Going into the 2001 recession, reserves were about 1.85 percent of total loans. Reserves are at about 1.35 percent of total loans today.

Almost universally, regional banks have been disclosing increases in loss provisions and charge-offs _ loans written off as not being repaid _ as they announce first-quarter financial results.

Sovereign Bancorp Inc. said Wednesday it set aside $135 million to cover bad loans during the first quarter, nearly triple the reserve taken during the year-ago period.

Last week, U.S. Bancorp increased its loan-loss provision to $485 million, a $260 million increase over the fourth quarter of 2007, as its earnings fell 4 percent. Net charge-offs reached $293 million during the quarter, 30 percent more than the previous quarter and 66 percent more than the year-ago period.

The mounting worries have sent shares of regional banks falling throughout the year as well. The KBW Regional Banking Index has fallen 10 percent since the beginning of 2008.

Credit market turmoil first hit investment banks in 2007, which have to account for potential losses by taking write-downs and marking investments to their current trading value. Those problems led to a crisis of liquidity, said James Abbott, an analyst with Friedman, Billings, Ramsey & Co.

The liquidity crisis has stabilized somewhat, Abbott said, making way for the second phase of the credit turmoil _ actual losses in lending portfolios.

Since regional banks typically hold loans they originate in a portfolio, they only account for losses by building up reserves to cover charge-offs.

Residential mortgages were the first to falter, but those problems have spread to other types of loans, including construction and home equity loans.

Abbott expects an uptick in commercial loan defaults as well because as consumers cut down on spending, it will make it tougher for businesses to repay loans.

Because of the need for more reserves, banks will also need to find new sources of cash.

More than 20 regional banks could be in need of new capital, according to a report recently released by Keefe, Bruyette & Woods.

"A lot of companies should be out there raising capital," FBR's Abbott said. If banks do not adequately raise new funds they will likely emerge from the credit tumult in a "significantly weakened" position, he said.

In its report, KBW estimated 23 regional banks might have to raise as much as $10 billion to maintain operations.