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BirdsEye View

 Many opine that this third quarter results imply that our industry is in the eye of the storm.  Banks are lending less  for the 5th quarter in a row, as is evident in the most recent FDIC earnings report.  This is the result of both slacking loan demand as well as borrowers' inability to meet the more rigid credit criteria and financial  strength expectations.  The pipeline for potential losses remains strong as delinquent loans continued to rise , currently at  the highest level in more than a quarter of a century.   Reserve coverage build has slowed down, though, as capital continues to be depleted by  losses.  Economic recovery might be hitting the headlines, but not banks' balance sheets.  The environment offers a persistent challenging backdrop , as well as enormous opportunities.

Offsetting the negative credit factors were higher revenues and lower expenses in the third quarter.  Behind the fee income expansion were gains on asset sales as well as higher servicing fees,  driven by an increase in deposits. Top line, net interest income rose due to improvement in the industry’s margin to 3.51%, up 2 bps  (still less than the 9 bps linked quarter improvement in 2Q09).  The industry’s securities losses were $4.1B, 48% better than a year earlier. Expenses declined by almost 2% over the last 12-months driven primarily by lower costs for goodwill impairment and other intangible assets plus a decline in premises and fixed assets.  Top line revenue growth, while up linked quarter, continued to be stymied by balance sheet shrinkage.

Capital preservation remains a key driver.  Access to capital has  improved meaningfully, but is slowing down.  Capital rose by 2.9% during the quarter to $40.2B which boosted Tier I capital ratio to 11.49% from 11.05% in 2Q09 and from 9.79% in 3Q08. The  majority  of the capital growth was related to improved valuations of securities.  However, the marketplace is still very unpredictable ...

Overall, the third quarter 2009 positives are: 

ü      Profits are back

ü      The yield curve is favorable

ü      Cost control remains front and center

There are also negatives.  Balance sheets shrunk again on a linked quarter basis by  an unprecedented almost 3%, following a nearly 2% decline in 2Q09.    Deposits increased by 0.9% in 3Q09, which followed a 0.7% rise in 2Q09, with deposits in foreign offices rising the most during both quarters. 

The industry boosted its provision by 22% over the last 12 months to $62.5B, but this was a decline of 7% on a sequential quarter basis. Also, the 22% year-over-year rise was the lowest percentage increase in two years. The FDIC noted that credit quality continued to decline but at a slower pace.  So, is the linked quarter decrease in loan loss provisions is appropriate?

The net charge-offs ratio was 2.71% in 3Q09 with net charge-offs at $51B, up from 2.55% in 2Q09, and 1.32% in 2Q08.  Remember when the net charge-off ratio stood at 0.49% in 2Q07!  Commercial and industrial loans led the rise in net charge-offs, although all categories had noticeable increases.  Delinquencies continued to rise,  up 10.5% in 3Q09 to 4.94% of loans compared to 4.35% in 2Q09 and 2.31% in 3Q08.  The pipeline for potential losses remains strong as delinquent loans continued to rise and is at the highest level in more than a quarter of a century!  

 In response to climbing credit quality woes, the industry’s reserve coverage rose to 2.97%, up from 2.77% in 2Q09 and up from 2.51% in first quarter 2009. This was the smallest increase in 2 years.  I am concerned about the slowing pace of the reserve coverage build.  Will it be enough to keep pace with the increase in nonperforming assets and net charge-offs?

 Bank failures continue to deplete  funds from the Deposit Insurance Fund (DIF) at a rapid pace. The DIF has a negative balance of $8.2B, which included a reserve of $39B to cover losses over the next year.  The FDIC recently approved the 3-year prepayment of deposit insurance premiums to help rebuild the DIF. For year-end 2009, the DIF is expected to be boosted by $45B.  

The DIF ratio was north of 1.30% at the beginning of this decade.  There were two insurance funds: a bank insurance fund (BIF) and a saving insurance fund (SAIF , which was north of 1.40%).  The two funds merged on March 31, 2006. 

Will the DIF of $45B be enough to cover the growing list of problem institutions?  The list continued to grow.  In the most recent quarter,  the list of troubled banks grew 33% to 552  institutions, with assets of $346B ,  a 15% jump on a linked quarter basis.   We all expect more problems and failed institutions before this storm passes. 

Industry deleveraging and deteriorating credit quality measures were key weights on earnings during the most recent quarter.   Solid management teams throughout  the industry are fighting every single day to make it through the quarter.  Many of these teams will build fortress  balance sheets, buy distressed institutions for a song and continue building solid core assets.  This challenging environment is presenting enormous economic opportunities, especially in financial services.   Remember, there is a silver lining in every cloud.