Is Wachovia's Plight A Warning?

The bank may be just the first this year to be hurt by poor loans

So much for Wachovia Corp.'s squeaky-clean image. On June 15 the Winston-Salem bank, generally known as one of the industry's most scrupulous lenders, announced it will take a $200 million charge against earnings to cover nonperforming loans for the second quarter.

The news sent the bank's shares down 20% in just four days. Bank stocks in general dipped 6% on fears that Wachovia is the beginning of a larger trend. Lulled by a booming economy, banks have lowered their credit standards and run down loan-loss reserves to free up capital to bankroll yet more lending. "This is not an isolated event," says Michael L. Mayo, an analyst at Credit Suisse First Boston. "You will see more loan problems at banks."

Banks are not the only financial institutions that risk getting shellacked if there's a spike in bad loans. Since the last recession in the early 1990s, new players--from mutual funds such as Franklin Templeton to institutional investors--have entered the syndicated loan market. They buy pieces of bank loans and trade them like government or corporate bonds. The lure is that the loans pay more interest than comparable bonds. "The investor base has widened," says Tanya S. Azarchs, managing director at Standard & Poor's Corp., like Business Week a part of The McGraw-Hill Companies.

Indeed it has. Mutual funds, insurance companies, and the like now hold nearly 10% of all the loans that banks sell off, up from next to nothing a decade ago, according to Thomson Financial Securities Data. Furthermore, nonbanks now buy nearly 40% of so-called leveraged loans, those made to companies whose credit rating is too low to issue bonds, says broker PaineWebber Group.

A MATTER OF TIME. The new buyers of bank loans confess that they've seen evidence lately of slacker lending standards. But they still view the loans as a great investment. "There clearly are some deals in the market that were done to poor underwriting standards," says Rick Kilbride, a portfolio manager, who runs one of Merrill Lynch & Co.'s two bank-loan funds totaling $9 billion in assets. The trick, he says, is to avoid bad deals by carefully examining the underwriters' history.

While most bankers will admit to worries about the likely impact of rising rates and a slowdown, they say problems aren't widespread. "Banks in general still have sound loan portfolios," says W. Kendall Chalk, senior executive vice-president and chief credit officer at BB&T Corp.

Still, analysts say that it's just a matter of time before others follow Wachovia and take charges to build reserves against losses. Wachovia's chief financial officer Robert S. McCoy agrees. He says the bank took the charge because, with the economy slowing, some of the bank's customers are starting to see "a stress that was not there before." As for contentions that Wachovia's experience could be an isolated event? "Maybe the economic slowdown only applies to our customers," McCoy says dryly. In fact, he says, the problems he sees are arising in many industries and regions.

So which banks are most at risk? Underwriting standards are the biggest determining factor, analysts say. Banks that get most of their income from lending, not fees, and have low reserves to cover problem loans are likely to be most vulnerable if their underwriting standards are poor.

Several other southeastern banks, in fact, fall into that category (table). Hibernia Corp. of New Orleans, for example, has a 1.42% loan-loss reserve, below the industry average of 1.68%, and relies on lending for nearly 70% of its income. Hibernia already ranks eighth among banks over $10 billion in percentage of nonperforming assets. Birmingham's Compass Bancshares Inc. and Regions Financial Corp. also have unusually low loan reserves and get most of their earnings from lending.

Although banks insist that everything is hunky-dory, they could be caught with their pants down if a recession comes. Considering Wachovia's plight, even a soft landing for the economy could be painful to investors with poor loans on their books.