Do banks have something to hide?

Even experts have a hard time getting a handle on how bad losses might get as the commercial real estate market implodes.

EMAIL  |   PRINT  |   SHARE  |   RSS
google my aol my msn my yahoo! netvibes
Paste this link into your favorite RSS desktop reader
See all RSS FEEDS (close)
By Colin Barr, senior writer

How strong is any economic recovery in your area?
  • Very strong
  • Small signs of a rebound
  • No recovery here

NEW YORK (Fortune) -- The banks have taken some lumps since the economy went bad. But some believe their biggest headaches are yet to come.

The pace 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.

Despite the optimism of lenders like Wells Fargo (WFC, Fortune 500), some observers warn that banks aren't socking away enough for a rainier day.

The 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.

Banks 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 Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) on down.

The risk 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.

"The 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 comparison."

Extend, pretend?

Banks have been swimming in losses since the collapse of the credit markets in mid-2007 sapped demand for all sorts of goods and services.

Loans 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.

Taking 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 triple-digit bank-failure count and trying to manage hundreds of troubled lenders, regulators are willing to go along, up to a point.

In April, 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 reason."

Behind the curve

The risk, 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.

This 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.

Plenty of 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.

Real 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.

That 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.

Regional 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 their capital.

"Right now, we're closer to the beginning of this problem than the end," said Matthew Anderson, a partner at Foresight in Oakland, Calif.

Apples and oranges

Even some seemingly well established positive trends look muddled with a closer look at the numbers.

For 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 the banks.

But regulatory filings by the same banks often paint a less upbeat picture, said FBR's Miller.

He 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.

One view into this puzzle is the banks' handling of loan modifications and other changes, under the category of troubled debt restructurings.

Troubled 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 loans.

But not 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.

"The 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 this month.

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 investors Monday.

"It is 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.

But even cleared of those questionable practices, Private Bancorp has enough problems.

Its 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."

Stifel Nicolaus analysts responded the next day with a comment that could apply to more banks as the loss-recognition process creeps forward.

"It is 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 indefinite period." To top of page

Company Price Change % Change
Ford Motor Co 8.29 0.05 0.61%
Advanced Micro Devic... 54.59 0.70 1.30%
Cisco Systems Inc 47.49 -2.44 -4.89%
General Electric Co 13.00 -0.16 -1.22%
Kraft Heinz Co 27.84 -2.20 -7.32%
Data as of 2:44pm ET
Index Last Change % Change
Dow 32,627.97 -234.33 -0.71%
Nasdaq 13,215.24 99.07 0.76%
S&P 500 3,913.10 -2.36 -0.06%
Treasuries 1.73 0.00 0.12%
Data as of 6:29am ET
More Galleries
10 of the most luxurious airline amenity kits When it comes to in-flight pampering, the amenity kits offered by these 10 airlines are the ultimate in luxury More
7 startups that want to improve your mental health From a text therapy platform to apps that push you reminders to breathe, these self-care startups offer help on a daily basis or in times of need. More
5 radical technologies that will change how you get to work From Uber's flying cars to the Hyperloop, these are some of the neatest transportation concepts in the works today. More
Worry about the hackers you don't know 
Crime syndicates and government organizations pose a much greater cyber threat than renegade hacker groups like Anonymous. Play
GE CEO: Bringing jobs back to the U.S. 
Jeff Immelt says the U.S. is a cost competitive market for advanced manufacturing and that GE is bringing jobs back from Mexico. Play
Hamster wheel and wedgie-powered transit 
Red Bull Creation challenges hackers and engineers to invent new modes of transportation. Play

Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.