U.S. Banks Brace for a Tough 2008

Credit and liquidity concerns will weigh on the sector, says S&P Ratings, but weaker earnings won't necessarily translate into lower ratings

The fourth quarter of 2007 was difficult for many financial institutions, and the ensuing months will continue to test the sector, perhaps significantly so, depending on the length and depth of the economic slowdown. With the rapid speed at which events have unfolded since last summer, earnings aren't the only story anymore.

Credit and liquidity problems have quickly developed as significant factors affecting issuers and investors. The speed at which they have become apparent and their severity have taken market participants by surprise, although Standard & Poor's Ratings Services was aware for some time that certain risks were piling up waiting for the right moment to bring things crashing down. Fortunately, many financial institutions entered this down cycle from a position of strength. But as the dislocation becomes protracted, they're clearly using that strength up.

Despite the fears of recession and deteriorating asset quality, lower earnings won't necessarily translate into lower ratings. We've built a normal cyclical decline into the ratings, as well as considerations of improved risk management, and we will consider ratings changes in the context of the larger economy, as well as in comparison to institutions with similar profiles. For the most part, our rating actions and outlook changes have been related to outliers with respect to risk management lapses and outsize concentrations of risk.

Bank Credit Quality a Continuing Problem

Our current ratings distribution for bank holding companies has a slight negative bias, and recent outlook changes on the broader financial institutions have been more on the down side than up, with ratings going to stable from positive or to negative from stable. Banks with a high exposure to assets of deteriorating quality carried a higher risk of credit downgrades in the fourth quarter and will continue to do so in 2008. In the past quarter, we downgraded 13 financial-sector noninsurance companies and lowered the outlook on 17.

Financial Institution Upgrades Since Sept. 30, 2007
Issuer From To
U.S. Trust* AA AA+
PNC Financial Services Group A A+
Wheels A– A
Greater Bay Bancorp* BBB– AA+
Colonial BancGroup BBB– BBB
Government Development Bank for Puerto Rico BBB– BBB
Icahn Enterprises BB+ BBB–
Nasdaq Stock Market BB BBB–
Financial Institution Downgrades Since Sept. 30, 2007
Issuer From To
Citigroup AA AA–
Merrill Lynch AA– A+
Bear Stearns A+ A
Synovus Financial A A–
Countrywide Financial A– BBB+
First Horizon National A– BBB+
Washington Mutual A– BBB+
Nelnet BBB+ BBB
MoneyGram International BBB BB
Nuveen Investments* BBB B+
Residential Capital BBB– BB+
IndyMac Bancorp BBB– BB+
E*Trade Financial BB– B

*Event driven. Source: Standard & Poor's.

Big Players Take Huge Writedowns

The ongoing deterioration in the subprime mortgage market is clearly a leading culprit in the sector's difficulties, and forecasters don't expect the U.S. housing market to rebound before 2009. Several large banks and brokers have already taken massive writedowns of mortgage-related securities, including Citigroup (C) and Merrill Lynch (MER), both of whom were downgraded and carry a negative outlook. Citi has taken $21 billion in writedowns on collateralized debt obligations (CDOs), subprime residential mortgage-backed securities, and leveraged loans, and Merrill has taken $16.8 billion in writedowns in second-half 2007, with the possibility of more to come.

JPMorgan Chase (JPM), Bank of America (BAC), Morgan Stanley (MS), and other large financial institutions have also taken big hits on mortgage-related assets. Other banks have increased their reserves for mortgage loans in response to rapidly deteriorating loan portfolios and have posted net losses for the fourth quarter. It has been the rapid speed with which loans are deteriorating that might make the bottom of this cycle more severe than past ones. The wide range of institutions reporting large losses for the fourth quarter is not something usually seen at the beginning of a downturn.

As we've noted recently, the big problem in 2008 will be provisioning. Banks have been adding to reserves in excess of charge-offs, and big banks have been adding more reserves than smaller banks because they were less well-reserved to start with. One bright spot for the banks and brokerages: Many are less exposed to the leveraged loan market thanks to a window of opportunity in the ongoing credit squeeze last October, when they were able to reduce the amount of these loans they had on their books. Recent additional declines in loan pricing will reduce the hit they will likely have to take in the first quarter.

Bank Can Only Tap Markets So Often

These mortgage-related writedowns have reduced capital, and we've already seen an institutional rush to cash-rich institutions in Asia and the Middle East in search of funds to prop up balance sheets. Many institutions' strong franchise value, however, has allowed them to raise capital, generally in the form of mandatory convertible issues. Large companies' ability to raise capital is, so far, in equilibrium with investors' willingness to buy into this sector. But we have to assume that these institutions can only go to the well so often.

In the long term, banks will face pressure from shareholders to address the massive dilution that will ensue after these hybrid products are converted to equity. In addition, some smaller financial institutions have encountered unfavorable conditions that hinder their ability to tap the markets for more capital.

A more recent question for the largest U.S. banks and brokers has been whether the weakening credit profiles of the bond insurers will spill over to result in writedowns and hurt earnings. The area with potential for the highest losses is the hedges that bond insurers provide for the so-called super-senior CDO tranches.

To date, losses that banks have reported on their CDO exposures have predominantly been on unhedged exposures. However, $125 billion of subprime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is. However, we know that some, including Citi, have posted reserves against these hedges because of the uncertainty surrounding bond insurance. Bond insurers, however, don't hold all of the hedges against this tranche of CDOs.

Regional Banks Being Hurt, Too

Finally, the weakening economy will likely take a toll on many classes of loans in addition to mortgages and housing construction. Prime mortgage nonperforming assets and net charge-offs are now being reported not just at banks managing large mortgage banking businesses, but also at the large regional and regional banks. The home equity line of credit (HELOC) losses continue to break new ground.

Auto loans and credit cards also continued to show weakness in the fourth quarter. The record high losses in HELOCs are a fallout from the peak growth of these loans in 2005 and higher risk underwriting, including moving up the loan-to-value scale, and falling home prices in key mortgage markets. Auto and credit-card performance in 2008 will depend heavily on how the overall economy affects consumers.

Credit quality pressures in the fourth quarter weren't just restricted to the subprime mortgage and HELOC portfolios. Because they're tied to the sinking housing market, the sectors that displayed the most dramatic spike in nonperforming loans during the quarter were housing-related construction and commercial real estate loans. Banks whose credit losses and exposures are outsize compared to those of peers are those most vulnerable to negative rating actions. We will base our tolerance for weak credit performance at individual banks on the institution's rating level and weigh in the context to the individual bank's earnings, capital, and business franchise.

It won't be a great year for U.S. banks and brokerages, but it should also prove to be a very bad one only for those with poor risk management policies or higher exposures to assets of deteriorating quality. The economic slowdown will play a key role in determining the prospects of the financial sector this year. While we don't see an extremely severe economic falloff, if one occurs we will reassess our outlook for these institutions.

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