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Community Trust Bancorp, Inc. (NASDAQ:CTBI) is a regional bank with 76 locations in Kentucky and 6 in southern West Virginia. On January 9, 2009, CTBI updated its earnings outlook for the fourth quarter of 2008 and year-to-date 2008. During the fourth quarter, the company "increased its provision for loan losses by $0.7 million compared to the 3Q 2008." The provision for loans losses was $2.875 million for the three months ended September 30, 2008. Therefore, CTBI increased its provision for loan losses to $3.575 million for the three months ended December 31, 2008.

The paltry increase in the provision for loan losses does not do nearly enough to raise the allowance for loan and lease losses, a reserve account for loans. Historically, the allowance for loan loss as a percentage of nonperforming loans were as follows (all numbers in thousands):

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Prior to 2007, the allowance as a percentage of nonperforming loans never dipped below 134%. As of December 31, 2007, the allowance as a percentage of nonperforming loans fell to 88%. In other words, the allowance for loan and lease losses remained essentially unchanged during 2007 while nonperforming loans doubled. Then, as of September 30, 2008, the allowance as a percentage of nonperforming loans swooned to 61%. Again, the allowance for loan and lease losses remained essentially unchanged for the first 9 months of 2008 while nonperforming loans were up 50%.

The drop in the allowance as a percentage of nonperforming loans does not seem warranted given the current economic conditions. In fact, First Financial Bancorp (NASDAQ:FFBC), a regional bank with 87 locations in Ohio, Indiana, and northern Kentucky, announced on December 30, 2008 an anticipated increase in their fourth quarter loan loss reserve to address increased economic stress. FFBC is expecting their allowance for loan and lease losses as a percent of nonperforming loans to be between 190% and 200%.

If CTBI’s allowance as a percentage of nonperforming loans should be 193.53%, then the allowance for loan and lease losses should be $61.696 million ($31.879 million X 193.53%) and $95.411 million ($49.300 million X 193.53%) as of December 31, 2007 and September 30, 2008, respectively. These allowances would result in a $33.642 million decrease to net loans and a corresponding $33.642 million increase to the provision for loan losses for the year ended December 31, 2007 and a $31.861 million decrease to net loans ($65.503 million cumulative) and a corresponding $31.861 million increase to the provision for loan losses for the nine months ended September 30, 2008.

For the year ended December 31, 2007, a $33.642 million increase to the provision for loan losses would cause after-tax net income to drop by $23.230 million ($33.642 million X [1-30.95%]) and diluted earnings per share to drop by $1.51 ($23.230 million/15.372 million shares). For the nine months ended September 30, 2008, a $31.861 million increase to the provision for loan losses would cause after-tax net income to drop by $22.676 million ($31.861 million X [1-28.83%]) and diluted earnings per share to drop by $1.50 ($22.676 million/15.153 million shares).

According to their investor presentation at the Sandler O’Neill conference on November 13, 2008, one of CTBI’s 2008 corporate goals was "working through our asset quality issues." However, it appears that CTBI is doing nothing as far as their accounting regarding the allowance for loan and lease losses to address the issues. So far, investors seem to be ignoring the issues as well. CTBI’s stock price was up 33% in 2008, even though it has retreated 15% so far in 2009, closing at 31.17 on January 12, 2009.

Disclosure: Author is short CTBI.

Source: Banking on a Low Allowance at Community Trust Bancorp