Credit Quality Poses Biggest Threat to Banks

(MoneyWatch)  FDIC chief Sheila Bair, OCC head John Dugan and other banking regulators were on Capitol Hill yesterday to update lawmakers on the state of the industry. As their testimony makes clear, the major concern for commercial banks and thrifts today is no longer liquidity, as in the early days of the meltdown, but declining credit quality.

The percentage of overdue loans has reached the highest level since the mid-1980s, during the Savings & Loan crisis. The rate at which banks are writing off loans is also accelerating. For example, net charge-offs for credit card loans rose to a record 9.9 percent in the second quarter. Meanwhile, continuing economic uncertainty is dampening new lending.

Dugan highlighted a number of factors driving this deterioration in credit:

• Falling loan demand, as reductions in consumer spending cause businesses to cut back on inventory and other investments
• Decreasing credit demand from borrowers who may've been able to afford or repay a loan when the economy was expanding, but now face constrained income or cash flow
• Declining loan demand as households work to rebuild their net worth
• Tightening underwriting standards and loan terms
• Banks scaling back their risk exposure due to weaknesses in various market and economic sectors
• Troubled banks curtailing their lending due to funding and capital constraints
• Continuing uncertainty on the part of borrowers and lenders about the pace of economic recovery

In a positive sign, the rate at which loans are souring may be slowing. The second-quarter increase in non-current loans was about a third smaller than in the first quarter. That trend should continue as households continue shedding debt and banks remain prudent in their lending.

The greatest risk to banks is the commercial real estate sector, Bair said. Rising unemployment is squashing demand for offices, retail space and other property types. Investors are also exiting the sector amid lower market valuations for commercial buildings. The worst is yet to come, unfortunately. Huge volumes of CRE loans are set to roll over in coming quarters. But because property prices are falling, borrowers will struggle to refinance.

Said Bair, "The ultimate scale of losses in the CRE loan portfolio will very much depend on the pace of recovery in the U.S. economy and financial markets during that time."