Will Commercial Loan Losses Hurt Regional Banks?

Many midsize bank loan portfolios are more than 50% commercial and may suffer as the recession continues. Real estate is a particular worry

By David Bogoslaw

Bank stocks enjoyed a nice rally on Apr. 9, fueled by Wells Fargo's (WFC) surprisingly strong preannouncement of its first-quarter earnings. The KBW Bank Index, which tracks two dozen of the biggest banks in the U.S., jumped more than 20% on Apr. 9.

Wells Fargo's report that mortgage refinancings went particularly well in the first three months of 2009 prompted feelings of relief among investors, who now believe banks may be able to earn their way out of their precarious capital circumstances, says Erik Oja, an analyst at Standard & Poor's Equity Research. (S&P, like BusinessWeek, is a unit of The McGraw-Hill Companies.) "Through the refinancing business in the first quarter, banks are making enough money that there's a good chance they can build up their capital levels this quarter," Oja says.

That could bode well for both smaller community banks and megabanks such as Wells Fargo, Citigroup (C), and JPMorgan Chase (JPM), where residential mortgages account for a relatively big chunk of overall business. Less fortunate may be the regional banks caught in the middle, whose bread and butter tends to be commercial loans, which are seen as in greater danger of deteriorating as the recession continues.

For many regional banks, commercial loans constitute more than 50% of their loan portfolios. In an Apr. 9 note, Oja said he was "increasingly concerned about commercial lending exposure at regional banks" because "we think commercial lending credit declines may begin in force this year."

a "Rolling Recession" by asset classes?

In initiating Calyon Securities' coverage on 11 of the larger national and regional banks on Apr. 6, analyst Mike Mayo rated six "underperform" and the other five "sell," saying he anticipates a "rolling recession" by asset class, with loan losses in various categories peaking at different times. If as he expects, losses for all loans, commercial and other, climb from the current 2% to 3.5% by the end of 2010, Mayo predicts banks will lose $600 billion to $1 trillion over the next three years, compared with about $400 billion that they have written down on risky investments to date.

David George, an analyst who covers banks for Robert W. Baird, says he foresees loan losses rising to 1.5% to 2% of all commercial loans this year from around 1% currently. But just because a certain percentage of loans goes bad doesn't mean banks can't make money, he says, citing wide spreads between interest rate accruals on loans and the much lower interest rates banks pay on deposits.