Banks' Credit Quality: 2009 Outlook Is Dim

By any measure, the U.S. banking industry has endured extraordinary shocks in 2008 that we expect to reverberate through the sector for years to come. Heading into 2009, startling systemic events have shaken the financial services industry. Among these are the bankruptcy of Lehman Brothers Holdings, the forced sales of Bear Stearns & Co. and Wachovia, Citigroup's (C) government support package, and the regulatory seizure and sale of Washington Mutual.

Heading into 2009, although the banking industry is confronting liquidity and confidence challenges, it now has in place financial support from the U.S. government, including programs offering capital injections and debt guarantees. These are highly meaningful, system-stabilizing influences, but in Standard & Poor's Ratings Services' view, even with this safety net of supportive system-wide measures in place, the credit quality trends of U.S. banks will, as they have in the past, mirror the course of the economy. As the U.S. recession drags on,, banks' overall credit quality is likely to continue to deteriorate during at least the next year, in our view. We expect a further increase in loan credit costs and continued high loan-loss provisioning to eat into earnings into 2009.

Our core credit observations for the U.S. banking sector in 2009 include the following:

Our current ratings outlook for the U.S. banking industry through 2009 is negative, mainly reflecting deteriorating economic conditions and mounting asset-quality problems. On the heels of our negative ratings actions and outlook revisions in 2008, we project that negative rating actions will continue to sharply exceed positive ones in 2009. However, we will likely see a further divergence in the fundamental performance of individual banks, and this will be reflected in our ratings.

Given the high degree of uncertainty in the global economy and markets, we expect the industry to continue to be subject to global market concerns about systemic shocks (system-wide liquidity and counterparty confidence risks) through at least early 2009. However, our industry outlook assumes that these concerns will not revert to the peak September-October 2008 crisis levels that followed the Lehman bankruptcy. This is because the U.S. government has clearly demonstrated its direct support for the industry at times of systemic financial crisis through safety net programs such as the U.S. Treasury's Troubled Asset Relief Program (TARP) and numerous other guarantee and liquidity measures.

Beyond its role in regulation, the U.S. government's involvement in the banking industry as a whole has become a central theme in the credit analysis of the industry. The government's reaction to the global financial crisis has become critical to the stability of the global financial system. The government's willingness to take extraordinary measures to support the sector is not completely unexpected, given the U.S. banking industry's vital importance to the health of the world economy. In terms of our analysis of individual institutions, we include the government's support as a significant credit factor for those institutions that were identified as being systemically important. More generally, we incorporate into our analyses the funding and capital benefits of programs such as the U.S. Treasury's direct preferred-stock investments in many U.S. banks, the FDIC guarantees on new debt issuances from participating banks, and the Federal Reserve's numerous liquidity programs.

Although we expect government programs to largely support the banking system as a whole, they will not serve as a panacea for all U.S. banks, particularly midsize and smaller institutions that the government does not recognize as systemically important. As in other credit cycle downturns, the number of bank failures will likely rise in 2009 from an already high number in 2008, in our view. History also indicates that when banks fail, a heightened risk exists for regulatory actions that may be harmful to creditors (to protect depositors), and we continue to incorporate that risk into our ratings.

We expect nonperforming loans (NPLs) and loan net charge-offs (NCOs) to continue to rise in 2009 and 2010, and we expect asset-quality weakness to spread to a wider range of loan types. In 2008 the severe asset-quality deterioration has been most evident in subprime and other poorly underwritten residential mortgage and home equity loans, as well as residential construction loans and housing-related commercial loans. We believe that in 2009, asset-quality problems will increase in other commercial real estate (CRE) and in consumer-related loans, like credit cards, as well as certain pockets of commercial lending, such as loans to the auto and retailing industries. We expect the significant disparity in asset-quality trends among banks to continue in 2009, depending on individual banks' underwriting standards and credit risk management, as well as their geographic footprints.

Core earnings will likely continue to suffer from high loan-loss provisions, as banks need to build loan-loss reserves further. We believe that banks will also take additional significant investment writedowns, realizing a portion of the mark-to-market losses on their balance sheets. However, overall, the market-related write-down amounts should decline from 2008's extraordinarily high levels. Banks' balance-sheet growth will likely remain constrained because most banks are still tightening credit standards and probably will not substantially step up lending.

Capital will be key to the industry's resilience in 2009. For the first time in recent history, many U.S. banks will have a significant new preferred-stock shareholder—the U.S. government. Regulatory capital levels will benefit from many banks' participation in the Treasury's senior preferred investment program. Although we believe that this program is clearly a positive credit development both for the industry and for individual banks, the ultimate success of such a program will be evident if the renewed market stability allows the banks the financial flexibility to raise common equity from private investors.

The industry's competitive dynamics in 2009 are a wild card. The landscape has dramatically changed in 2008 and will probably change further in 2009, given 2008's major high-profile failures (e.g., Washington Mutual), announced acquisitions (e.g., National City), and the conversion of Morgan Stanley (MS) and the Goldman Sachs Group (GS) into bank holding companies. By the latter part of 2009, we expect the pace of acquisitions to rise as healthy banks consolidate with weaker banks, in some cases partly aided by funding from the preferred-stock infusions from the U.S. Treasury.

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