(Fortune) -- The banks have taken some
lumps since the economy went bad. But
some believe their biggest headaches are
yet to come.
at which U.S. commercial banks are
adding to their loan loss reserves has
slowed this year, while loans continue
to go bad at a brisk pace.
of lenders like Wells Fargo (WFC,
some observers warn that banks aren't
socking away enough for a rainier day.
disconnect is particularly acute in
commercial real estate, where lenders
are facing a surge of defaults on
commercial mortgages and construction
loans made when prices were much higher
and demand for space much stronger.
have been recognizing commercial real
estate losses slowly, even though the
high season for defaults isn't expected
to arrive until next year.
That's not the only problem. Ill-defined
or inconsistently applied rules for
valuing securities and handling loan
modifications can make it hard to say
how healthy banks really are, from
and Bank of America (BAC,
is that this year's recovery could turn
out to be a false dawn, delivering
another blow to investor trust -- not to
mention people's 401(k)s.
credibility of the banking system could
take another step back," said Paul
Miller, an analyst at FBR Capital
Markets. "Everyone is expecting we've
seen the peak in losses, but it's
impossible to know for sure because you
can't get an apples-to-apples
have been swimming in losses since the
collapse of the credit markets in
mid-2007 sapped demand for all sorts of
goods and services.
written off as uncollectible hit their
highest level on record in the second
quarter, according to government data.
Loan loss reserves are also at a peak
since the government started keeping
track in 1984, according to data from
the Federal Reserve Bank of St. Louis.
losses on souring loans and troubled
assets eats into profits, which tends to
drive down share prices and executives'
pay. The losses also erode capital,
reducing lendable funds and forcing
banks to raise new money by selling
stock or businesses.
Accordingly, banks have been eager to
stretch their losses across as long a
period as possible. Facing a
and trying to manage hundreds of
troubled lenders, regulators are willing
to go along, up to a point.
accounting rule makers gave banks more
leeway in valuing hard-to-trade
securities. That's led to current
discussions over when banks will have to
bring some off balance-sheet assets and
liabilities back in house.
"Politically, this sort of forbearance
is the lowest-cost way of stopping the
train wreck," said Wayne Landsman, an
accounting professor at the University
of North Carolina. "The banks wanted
that April change very badly, and you
have to assume they wanted it for a
Behind the curve
of course, is that deferring the
reckoning can create a bigger problem
later. And there are those who believe
the banks are doing just that.
Nonperforming and restructured assets
grew six times as fast as loan reserves
over the past year, analysts at Keefe
Bruyette & Woods estimate, while reserve
building as a proportion of new troubled
loans tapered off after peaking in the
fourth quarter of 2008.
pattern suggests "the banks are not
ahead of the curve in providing for
troubled loans," the KBW analysts wrote
in a report earlier this month.
trouble is ahead. Prices on apartment,
industrial, office and warehouse
properties dropped 33% over the past
year, according to the Moody's/REAL
commercial property price index.
estate research firm Foresight Analytics
estimates banks should have booked
losses on around $110 billion of
defaulted commercial real estate and
construction loans. But so far they have
taken their medicine in only about a
third of those cases.
means the banks could face a backlog of
$70 billion or so defaulted but
unreserved loans as we head into the
teeth of down cycle in commercial real
estate -- where the bulk of bubble-era
loans are due to be repaid or refinanced
between 2010 and 2012.
and community banks, rather than the
giant TARP-taking entities, will bear
the brunt of this onslaught. Banks with
between $100 million and $10 billion in
assets have almost $900 billion of
commercial real estate exposure,
Foresight estimates. That's three times
now, we're closer to the beginning of
this problem than the end," said Matthew
Anderson, a partner at Foresight in
Apples and oranges
seemingly well established positive
trends look muddled with a closer look
at the numbers.
instance, publicly disclosed financial
reports have been showing a slowdown in
the growth of early-stage delinquencies,
those in which borrowers are a month or
two behind on their bills. Investors
have been cheered by this trend because
it suggests the worst losses are behind
regulatory filings by the same banks
often paint a less upbeat picture, said
nonperforming asset levels were 17%
higher in regulatory filings than in
public statements, according to FBR
estimates based on second-quarter data
for the top 25 banks and thrifts by
assets -- suggesting that some big banks
are understating problem loans as they
go through the restructuring process.
into this puzzle is the banks' handling
of loan modifications and other changes,
under the category of troubled debt
debt restructurings have doubled over
the past year, according to KBW, as
banks extend loan maturities and cut
interest rates or loan balances,
particularly on troubled residential
all institutions account for
restructured loans in the same fashion
-- which could mean some bank investors
are in for a surprise down the road as
many restructured loans go sour.
issue is that accounting for loan mods
is not transparent and makes delinquency
data appear better on the surface,"
FBR's Miller wrote in a note to clients
Troubled debt restructurings have become
such a hot button that Private Bancorp (PVTB),
a Chicago-based commercial lender, felt
compelled to address the issue in its
third-quarter conference call with
important to recall the company does not
hold any troubled debt restructured
loans on its balance sheet and does not
restructure problem loans to defer or
delay problem loan status," chief risk
officer Kevin Van Solkema said.
cleared of those questionable practices,
Private Bancorp has enough problems.
shares lost half their value over two
days this week after the bank nearly
doubled its estimate of loans it won't
be able to collect, mostly in the
commercial real estate and construction
sectors. Many of the bad loans were
written since new management took over
two years ago in a self-proclaimed
"strategic growth plan era."
Nicolaus analysts responded the next day
with a comment that could apply to more
banks as the loss-recognition process
now apparent that loans made during the
strategic growth plan era are not immune
to the credit cycle," they wrote. "A
consequence of this revelation should be
a higher degree of investor skepticism
and a lower stock valuation for an