Saturday, October 31, 2009

Do Banks Have Something to Hide?

Yes, of course!

Can you see the elephant in the room? Or is it more like Godzilla?

Not only are they hiding losses, as this Fortune article states, “nonperforming and restructured assets grew six times as fast as loan reserves over the past year,” but they didn’t even talk about overal debt levels (the elephant), derivatives and how levered the banks are to these markets (Godzilla). Still, a good article that actually made the mainstream…

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.

By Colin Barr, senior writer
October 29, 2009

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.

"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."

Oh yeah, nine more banks were closed by the FDIC yesterday. Remember the good old days when it was one or two per Bank Failure Friday? I’m thinking those days are well behind us…

As far as commercial real estate goes, the stock market has indeed discounted the industry. IYR, the Dow Jones Real Estate Index (commercial), is still down 51% from its February, 2007, high.

On the approximately 4 year weekly chart of IYR (above), you can see that it performed a near perfect 38.2% retrace of its plunge, a plunge that was so deep that the bounce off the March ’09 bottom resulted in it currently sitting with a 102% gain from the low! Did you buy it there and hold? Didn’t think so… I hope those who did have studied Elliott Wave and know what wave C down means. Hey, commercial real estate, banks, and derivatives… Go, Go, Go - Godzilla!

Blue Oyster Cult – Godzilla: