FOOL ON THE HILL
Bad Loans Surge

A Weiss Associates report shows that the loan loss reserve ratio, the amount of money that banks set aside to handle bad debts divided by the actual value of losses, has dropped to its lowest level in eight years. In 2001 loan defaults skyrocketed, and the banks did not keep up with their reserving. This bodes poorly for the economy, but could provide some opportunity for investors looking to buy high-quality bank stocks.

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By Bill Mann (TMF Otter)
January 18, 2002

We can file this one under the "Wow, but duh file."

According to a report released Wednesday by bank rating agency Weiss Associates, as of September 30, 2001, U.S. banks' loan loss reserve ratio decreased to its lowest level since the economy was emerging from a mini-recession back in 1993. In two years, this reserve has decreased from 170% in 1999 to 129% in 2001. Weiss Associates' survey sample was all 9701 banks in the United States.

What the heck does this mean? Well, there is a statutory requirement that all banks set aside money in a reserve in order to protect the bank's depositors (and shareholders) against having a series of losses, or one big loss, that might take down the bank. Banks do this, generally, by estimating the default risk for their loan portfolios each year, given the financial health of their debtors, the economic environment, and a myriad of other influences. Even though the company does not have to disburse these moneys, it cannot carry them as assets on its balance sheet, either -- it holds them in "reserve." Occasionally a bank will overestimate its loan loss reserves and move some of it back to its regular unencumbered asset account.

Not this year, though. In 2001 the average bank set aside 42% more than it had in 2000, meaning that the banks were prepared for some rough times among their loan customers. But they underestimated just how bad it would be: The loan charge-offs through the first three quarters increased by 50%. So even though the raw number was substantially higher, the ratio was lower.

Defaults much higher than anticipated
We're talking about some big bucks, too. The total amount set aside was $30.2 billion; the amount charged was $25.4 billion. This, mind you, is only the dollar amount of loans that were completely written off -- maybe the debtor declared bankruptcy, or the bank seized collateral but could not recover the full amount of the loan. Then add to this the number of nonperforming loans -- those loans out of compliance by being more than 90 days past due but have yet to be written down as losses -- which increased from $48.8 billion to $59 billion in 2001.

There are a number of ways to look at this, and none of them point to an economy that is poised for a rebound. Dr. Martin Weiss, chairman of Weiss Associates, pointed out in a press release that U.S. banks were too slow in recognizing the rapid degradation of the economy in raising their loan loss reserves. "The industry has started to acknowledge the need for higher reserves to cover the losses, but it is too little too late as the growth in problem loans continues to outpace the growth in reserves." It was just such a problem, for example, that knocked shares of sub-prime lender Providian (NYSE: PVN) down more than 90% last year after its default rate suddenly skyrocketed.

I'd have to say that there are a few points that come clear with this data. First and foremost, while an increase in loan losses is a bad thing, it shows that some of the excess investment capital that businesses made in the go-go late 1990s is starting to burn off. This is a painful process, since these bank defaults often come at the tail end of company bankruptcies. With this continued charge-off activity comes new job losses, personal loan defaults, and a general lack of liquidity. After all, the multiple Federal Reserve interest rate cuts in the last year were meant to stimulate additional lending by the banks and additional spending by companies. If the banks are seeing their existing loan portfolio's net charge-offs increase by 50% at the same time, are they really going to increase their loan activity or take more debtor risk? Not likely.

These charge-offs are a fairly significant drag on the equity value and earnings of the banks themselves. Interestingly enough, though, another Weiss Associates study released in the past week shows the level of effectiveness that regulatory controls on bank lending have: Of the 9700 banks in the country, only four failed in 2001, a year when financial conditions were ripe for bank defaults given the spiraling number of bankruptcies. Of the four banks that did fail, each of them has Weiss' lowest rating for loan quality.

The other thing to consider is that the financial standing and performance of banks may suffer, as the money that is set aside is subtracted both from earnings and from the company's asset base. This may provide some additional future investment opportunities in strong community banks and regional banks, as poor earnings comparisons over the next 12 months could cause them some stock price pain. Of the banks that were highlighted as having the worst loan quality in the country, only one, Prestige Bank (Nasdaq: PRBC), is publicly traded. Several of the companies with the highest loan quality are also publicly traded, including Bank of Granite (Nasdaq: GRAN), Farmers and Merchants Bank (Nasdaq: FMBL), and  Burke & Herbert (OTC: BHRB), and may provide opportunities for getting excellent companies at reasonable prices.

The end result here, though is that the banks are seeing more loan pressure and greater degradation than they had anticipated, meaning that the recession we have entered is deeper than many of those who provide access to liquidity had earlier assumed. This has great historical precedence, as we generally do not realize that we are in a recession until well after it is already underway, just as we won't know we are emerging for the recession until we've actually emerged. But those who are saying that they are seeing improvements probably haven't consulted the banks, who are wondering when the bad loan surge will begin to recede.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann was in no way part of this particular problem. Other problems, definitely. He does not own shares in any of the companies mentioned.