Is the Credit Crisis Hitting a Second Phase

In keeping with my continued concerns about the adequacy of bank capital below is a recent article in Business Week. The long and short of it is if losses abate banks will have adequate capital to keep lending. If losses continue than banks will come under severe capital constraints and lending will be sharply curtailed. If you couple the latter scenario with increasing energy prices, which will result in higher food prices then US consumer is going to be in for a very rough ride in 2008 and 2009. My guess is we will know what is going to happen by election time. Text in bold is my emphasis.

Nobody was expecting an easy year for U.S. banks, but many observers thought the bulk of the industry's credit troubles would come in the first quarter. Now, it seems the rest of the year may be even worse. Case in point: A May 28 announcement from KeyCorp (KEY). Mounting loan losses at the regional bank company suggest the banking industry's troubles with bad loans are just beginning.

Cleveland-based KeyCorp, which holds $97 billion in assets, says the year's net loan charge-offs—a measure of how much bad debt the bank may have to write off—could almost double previous predictions for 2008. The bank expected charge-offs of 0.65% to 0.9% of total loans just three weeks ago, but now says they could be in the range of 1% to 1.3%.

The main culprit is the bank's portfolio of loans to residential homebuilders, KeyCorp said in a Securities & Exchange Commission filing. Losses have also increased on education loans and home-improvement loans.

Worry Shifts from Wall Street to Main Street.

Investors responded May 28 by fleeing banking stocks. KeyCorp shares tumbled 11%, to 19.59, on May 28, just above the stock's 52-week low. Other similar, regional banks suffered, too. Shares of Wachovia (WB), Fifth Third Bancorp (FITB), and Regions Financial (RF) all dropped 4% or more to 52-week lows.

Subprime securities had already decimated Wall Street banks and other financial firms. For investors, the worry now seems to be shifting from debt securities to simple, traditional loans, and from Wall Street to Main Street.

"Near-term credit trends appear to be getting worse," said R.W. Baird analyst David George. Those hoping for a recovery in the second half of the year will be disappointed, he wrote in a May 28 note, "as loss rates appear to be rising."

Higher losses on loans to developers and homeowners are disturbing enough. But what also unnerved investors was the suddenness of the change in KeyCorp's outlook.

Estimates for losses jumped just a month after the company's most recent earnings announcement. That suggests, Deutsche Bank (DB) analyst Mike Mayo wrote on May 28, "either misjudgment before, or a significant deterioration in, asset quality." The news flow from banks had been relatively quiet since they reported first-quarter financial results in April.

After months of a credit crisis and a weakening economy, most banks did see profits fall. But since the collapse of Bear Stearns (BSC) in March, there was a sense that losses on subprime-related securities had peaked. Major banks "have now probably weathered the worst marks on holdings of various asset-backed securities" and other debt instruments, Stifel Nicolaus (SF) analyst Anthony Davis noted earlier this month.

However, other troubling trends remained, and threatened to get worse. There is no sign the depressed housing market is perking up. In data released May 27, the S&P/Case-Shiller national home price index dropped 14.1% in the first quarter of 2008, the largest drop in 20 years. Loans to struggling homebuilders are a primary credit issue right now, according to Davis' note, but concerns are also rising about consumer loans.

Despite housing and credit troubles galore, banks such as KeyCorp have been able to attract investors with generous dividends. On May 28, KeyCorp sported a dividend yield of 6.9%, while Wachovia's yield was 6.1%. Yields from Fifth Third and Regions Financial were even higher, at 9.1% and 8.1%, respectively. Those high yields suggest some investors expect dividends to be cut so banks can hoard capital. Otherwise, an 8% or 9% return would be irresistible to most.

Baird's George said the tough credit trends mean KeyCorp probably won't earn enough in the second and third quarters to cover its dividend. However, he wrote, "It appears that [KeyCorp] has adequate capital to maintain its payout, provided the earnings challenges are temporary."

If credit troubles are brief, banks can afford to maintain their dividends. Bank investors might overlook a brief dip in earnings, however severe. However, the longer the credit crisis continues, the more questions are raised about whether they have enough capital.

Borrowers, particularly homebuilders, are clearly having a harder time paying off their bank loans. The best hope for banking stocks would be if the trends stressing out those borrowers—the weak economy and housing market—start to ease, or at least stabilize. Otherwise, it could be a long and gloomy year for investors in bank stocks.