Banks' Loss Reserves Can't Keep Pace with Troubled Loans

The latest FDIC Quarterly Banking Profile reveals that banks increased loan loss reserves by 11.5% and the ratio of reserves to total loans increased to 2.5%, an all time high. Despite the large loan loss reserves, the ratio of reserves to noncurrent loans fell for the 12th consecutive quarter to 66.5%, the lowest level in 17 years. This low reserve ratio, despite large increases in loan loss provisions indicates that the banking industry’s estimates of future delinquencies has consistently been too low.

Reserve Coverage Ratio

Even if the amount of noncurrent loans level off, the implications for future banking profits is a dismal picture. In order to establish an adequate coverage ratio for noncurrent loans, loan loss provisions will have to rise dramatically.

Prime Mortgage Defaults - Another Black Swan

The banking industry’s low estimate for loan delinquencies may be due in large part to the unexpectedly large increase in default rates seen on prime mortgages. Prime mortgages were never expected to have a default rate above the historical ratio of around 1% since these were mortgage loans made to the best customers. In the past, the only defaults typically seen on prime mortgages were due to unexpected job loss, a divorce, illness or other factors beyond the control of the borrower.

The rapid increase of delinquencies on prime mortgages has caught the banks off guard. The default rates on prime mortgages is now almost 5% (5 times normal), a true Black Swan event for the banking industry. In addition, the default rate could rise even higher since 25% of prime mortgage holders now have negative equity, a situation which enhances the odds of delinquency and defaults.

Based on the rapidly deteriorating numbers for prime mortgages, loan loss reserves need to be increased significantly. The myth that most of the smaller community banks are not exposed to the risks that afflicted the bigger banks is only partially true. Banks of all sizes have significant exposure to the mortgage market and the growing number of defaults by prime mortgage borrowers will cause significantly higher than expected losses at all banks.

Prime Mortgage Delinquencies, courtesy of: moremortgagemeltdown.com

Problem Banks, Failed Banks Increasing Rapidly

The 36 failed banks we have seen this year has expanded dramatically from 25 for all of 2008, but has remained very low considering the extent of the losses in the banking sector. Many very weak banks have apparently been allowed to stay open under the misguided hope that mortgage defaults would decrease as the economy improved. The number of banks classified by the FDIC as “Problem Banks” has risen to 305 from 90 last year. The latest surge in mortgage defaults due to job losses, declines in real estate prices and negative income trends will have a devastating effect on an already weakened banking industry.

The FDIC’s line of credit with the Treasury was recently increased to $100 billion from $30 billion. The FDIC can borrow up to $500 billion with Federal Reserve and Treasury Department approval. Expect to see the FDIC draw down significantly on their expanded line of credit with the Treasury as the FDIC is forced to close increasing numbers of insolvent banking institutions.

Comments

[venividivici:]

Get with the program, Bill. This market is going to keep going up no matter what.

Jun 02 11:09 AM

[Pj568:]

One needs to exercise care with the terminology when reading articles in this industry. My read of the FDIC report is the increase in prime mortgage defaults is primarily driven by the Adjustable Rate Mortgage products as opposed to the prime fixed term mortgages.

Isn't this pretty much what we've been told was going to happen as those resets come due?

Jun 02 11:47 AM

[twotraps:]

Enjoyed the article, shocking to read the stats on the banking situation. Not sure how it plays out but stalking some shorts in the sector might not be a bad idea.

Jun 02 12:07 PM

[XRTrader:]

Interesting point. However, i think we will see a significant decrease in NPL (non performing loans) as the loans as a significant uptick in housing sales begins to clear these from the books.

Jun 02 01:40 PM

[Darius:]

An important point that is being missed is that not all delinquent loans will translate to 100% losses. For sake of example, say a bank makes a construction loan for $80M to build a house that will be worth $100M and the borrower stops making payments; then you will have a $80M NPL. However, the reserves shouldn't be $80M because the sale of the collateral should pay back at least some and probably most if not all of the loan. So, comparing the dollar amount of reserves to the dollar amount of the NPL without regard to underlying collateral or other factors, does not provide a complete story.

Jun 02 02:20 PM

[pitchingpen...:]

Darius -
Have you ever actually seen a home stopped in the construction phase by a default and foreclosure? It gets really ugly - really fast! It will usually be stripped and weatherbeaten before the Trustee's Sale date. To rehab and finish your 100M home will ususally take 130M plus costs of sale.

Jun 03 02:16 PM

[Value Inter...:]

Pitchingpennies,

Good point. But not all non-performing loans will be new construction. Most will probably be existing homes. So it is a fair assumption that banks won't realize anything close to a 100% loss on all NPL.

Jun 04 12:55 PM

[Mark54:]

100% loss never happens (that's giving the property away...literally) but consider what happens when a bank owns 3-4 homes in the same neighborhood? If it accepts a firesale price on one then it essentially sets a comp where the rest of the homes will be bid at. These banks cannot hold these homes for an indefinite period of time. Banks have shown restraint thus far but eventually they need to get what they can. Losses have historically been in the 20%-30% range... that was until 2008. Loss severities on residential properties have increased significantly since. I cant find hard numbers but suspect its in the the 40% range. Couple this with the fact that nonperforming assets at banks 50-5billion have been increasing about 20%-25% per quarter and I think you'll see banks starting to take more lowball bids and higher loss severities.

Jun 23 11:58 PM