First, the good news: According to the Federal Deposit Insurance Corp, troubled loans held by all US banks and thrifts continue to fall in the first quarter of 2005 from record-low levels in 2004, and this with few signs of asset-quality problems evident. Some specifics:

• Net loan losses totaled $7.2 billion in the first quarter, the lowest quarterly total since the third quarter of 2000, as the industry's net charge-off rate fell to its lowest level in six years. First-quarter loan losses were $2.0 billion (21.4 percent) lower than in the fourth quarter, and were $1.6 billion (18.1 percent) below the level of the first quarter of 2004.

• Net charge-off rates were lower than a year earlier in all major loan categories. The greatest improvements were in commercial and industrial (C&I;) loans, where net charge-offs declined by $911 million (57 percent), and in credit card loans, where charge-offs were $249 million (5.4 percent) lower.

Now, the bad news: We noted last week in our comparison of Golden West Financial (NYSE:GDW) and Washington Mutual (NYSE:WM) that loan default rates have no place to go but up. Call us bearish, cranky or negative, but the fact remains that reaching a record level for a cyclical indicator such as defaults usually means that the trend already is moving the other way - especially when the Fed seems intent upon delivering a flat yield curve to the markets by 2006.

Luckily, like shoe size and height, the possible values for most financial and economic indicators are bounded by the real world. Default rates cannot go below zero (unless Fannie Mae (NYSE:FNM) has a new program somewhere in the wings) but they can go much higher than recent experience, especially when a large proportion of "investors" don't have the staying power to ride out a down cycle. When credit is available to just about any consumer with a job and the ability to sign their name to a mortgage, the socialization of that risk is not far behind. Or as our friend Alex Pollock at AEI puts it, bank loan default rates always stay low as long as the banks are lending.

For some months now we have remarked on the fact that default rates for both residential mortgages and corporate bond issuers are at historic lows, but the credit quality of whole industries -- and the US economy -- seems to be steadily slipping. The auto sector is following the airlines and the steel industry into bankruptcy; the Fed is continuing to raise interest rates (this in order to prove that the US economic is healthy); and Uncle Sam faces a whopping financing task for Social Security and Medicare, both of which will begin to hit the bond market some time around 2008. Consider a couple of additional data points:

• Foreclosure rates in urban areas rose in 47 states in March according to a report in Washington Post yesterday. Citing a private mortgage firm, the Post reported that foreclosures in urban areas are soaring even as real estate values trace the pattern of the Internet Bubble into the stratosphere. The Post even quotes Julie L. Williams, acting U.S. comptroller of the currency, as saying that: "We are clearly seeing a spike in foreclosures in a number of our major urban areas."

• And as we have noted in several recent bank profiles, credit quality at some US banks is already deteriorating, in some cases by a full ratings notch during the LTM. "Tens of thousands of Barclaycard customers are on course to default on a record �900 million of credit card borrowings and personal loans this year," reports the Times of London. "Barclays, Britain's biggest credit card operator, warned shareholders yesterday that the number of people failing to make minimum repayments each month had increased faster than expected."

Indeed, concerned about evidence that asset quality is slipping at many banks, the relevant federal regulatory agencies just published a little booklet entitled "Home Equity Lending Credit Risk Management Guidance." This missive touches on such topics as origination and underwriting, third party originations and collateral valuation. The notice opines that "the agencies have found that in some cases credit risk management practices for home equity lending have not kept pace with the product's rapid growth and eased underwriting standards."

We think that US mortgage and corporate loan default rates are considerably understated. As the Fed raises short-term interest rates to positive real levels for the first time in half a decade, we believe that default rates could swing toward record levels. Only question: Is the coming wave of real estate and corporate defaults going to be a "typical," two-standard deviation event like 1990-1991, or a mega crisis a la 1982, when the banking industry's entire capital base was impaired in a single quarter by the caprice of a few Mexican politicians?

The Times of London noted last week: "But inevitably the credit cycle turns and the favourable conditions that created the credit splurge turn chilly. Then comes the reckoning. At the bottom of the last two cycles - in 1991-92 and in 2001-2002 - more than 10 per cent of junk bond issuers defaulted, failing to pay some or all of the interest and principal owed. That raises the chilling possibility that in the next global downturn or recession, issuers of perhaps $120 billion (�66 billion) of bonds could default."

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