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Credit Risk: Regulators Focus on C&I Lending; Sovereign, WaMu, Show Large Increases
May 4, 2006

Credit Risk: Regulators Focus on C&I Lending; Sovereign, WaMu, Show Large Increases

The conventional wisdom is that commercial banks no longer lend money to commercial�companies.� And that impression is generally true for the US banking industry as a whole.� But in particular, the conventional wisdom can be wrong, with potentially�negative implications�for investors, counterparties,�auditors and others who depend upon the asset quality of a particular financial institution.

It is well known that corporate borrowers today�have numerous alternatives to bank loans for�raising liquidity.� The market for commercial and industrial loans or "C&I" has become very competitive�in recent years, according to a February 2006 commentary by the FDIC.� "Not only do banks compete against other banks, but they also compete against capital markets, which have become a popular source of funding for corporations. Lending standards, and particularly the rates charged on business loans, have generally fallen because of this highly competitive environment."

At the end of 2005, the FDIC published its Quarterly Banking Profile and noted that while mortgage originations had cooled considerably, expansion of C&I loans, and commercial real estate lending, was still running at a brisk pace. "Residential mortgage assets (residential mortgage loans, home equity loans and mortgage-backed securities) registered their smallest increase in two years in the fourth quarter, rising by $24.0 billion (0.6 percent)," the FDIC noted.

"[Mortgage loans]�accounted for only 13.6 percent of the increase in total industry assets during the quarter. The slack was taken up by growth in C&I loans (up $35.5 billion, or 3.4 percent), real estate construction and development loans (up $31.1 billion, or 7.5 percent), and credit-card loans (up $26.7 billion, or 7.2 percent). Loans secured by commercial real estate properties increased by $16.9 billion (2.1 percent). Altogether, loans to commercial borrowers increased by $101.0 billion (3.3 percent), accounting for 57.3 percent of total asset growth," the bank insurance agency continued.�

We�have been hearing similar�reports from the channel, apocryphal tales which indicate that the growth in C&I lending may not be such a great thing.� We hear stories of community banks, thrifts and even credit unions which have expanded into C&I lending de novo, with no systems or credit staff to manage the origination process. Often times, the institution purchased the loans from a larger correspondent, one of the reasons that regulators are so anxious to expand reporting of "shared national credits."

We also hear tales of retired bankers being pressed into service by the primary regulators of these small banks, working as consultants to�institutions already operating under written memorandums, to help address problem loans before the become a problem. Call it pro active, call it remediation before-the-fact, but the regulatory community is clearly concerned about some of the later day entrants into C&I lending.

Using our research and screening tools, we rummaged through the FDIC's call reports to identify which banks and thrifts were among those which had seen the sharpest rise in C&I lending, especially from a low or no asset level. The lists and screening criteria are available to full subscribers to the IRA Bank Monitor.

Sovereign, WaMu Lead C&I Growth

At the top of the list in terms of assets was none other than Sovereign Bank (NYSE:SOV), the $63 billion total asset thrift which spent much of the last year embroiled in a dispute with a large institutional shareholder. SOV�is in�the process of acquiring an $18 billion asset thrift in the New York area, Independence Community Bancorp (NASDAQ:ICBC)�and also is selling a significant equity stake to Banco Santander (NYSE:STD) of Spain.�

We have written previously about SOV's below-peer financial performance and the bank's C&I portfolio is no exception, according to data from the FDIC. SOV shareholders might be interested to know that the bank's portfolio of C&I loans grew nearly 50% from $6.1 billion in 2003 to almost $10 billion at the end of 2005, ending the year at nearly 14.5% of assets and more than one fifth of the total lending base. The C&I default rate at the end of 2005 was 55bp vs. 10.2bp for SOV's real estate loans. Both loan categories carry gross lending spreads which are below peer and loss given default rates which are above peer at some 70%.

But the largest increase in a C&I portfolio over the past two years, both in percentage and dollars terms, came from the second bank in the Washington Mutual (NYSE:WM) group, the $34 billion asset Washington Mutual Bank in Salt Lake City ("WM UT"). The unsecured C&I portfolio of WM UT grew from only�$1.1 million at the start of 2003 to $9.1 billion at the end of 2005. As of that date, C&I loans represented over 90% of the lending base and 26% of total assets, yet the second largest bank unit of WM has somehow reported zero defaults since the end of 2003. Indeed, while its peers in the C&I peer group reported an average default rate of 32bp in 2005, WM UT reported a default rate just barely in positive numbers for its C&I portfolio through�all of last year.

C&I portfolios are samples of the macro economy.� The fact that WM UT is reporting virtually no�defaults on a $9 billion C&I portfolio seems remarkable, especially given the high rates of default reported�when the portfolio was considerably smaller.��The high rate of growth in the C&I portfolio of WM UT is also�notable given the fact that in its latest 10-K,�WM reports only $2.6 billion in C&I loans in its consolidated financial statements filed with the SEC for year-end 2005.��

In response to questions from IRA,�officials of WM explain that the different between the $9 billion in C&I loans on the books of WM UT and the $2.6 billion shown on the consolidated books of the parent WM is an "intercompany loan," thus the low default rate.� We suppose that this explanation�could�make some analysts feel better, but we wonder why WM needs to lend money to itself instead of funding in the marketplace.�

The funding for the balance sheet of WM UT is $5 billion in advances from the FHLB and $29 billion in equity, so WM is essentially borrowing�capital from an affiliate�that is not otherwise leveraged.� Thus our question: Why not merge WM UT with the larger thrift unit�in the WM group and clean up this strange arrangement?�

Rising C&I Risk Affects Many Constituencies

The remainder of the�more than 70 banks and thrifts�with large percentage growth in C&I exposure captured�by the IRA Bank Monitor are�less well-known�than the subjects mentioned above, but the reality is that C&I exposure is larger at many banks than consumers and investors may know or suspect. Whereas it remains true that the overall trend in commercial bank asset deployment is toward concentration in retail and consumer lending, there apparently remain pockets of C&I exposure which warrant close�attention.

High rates of change in any loan portfolio are important issues for credit officers and investors, but other constituencies should be concerned as well.� Recent rulings by bank regulators state that limitation of liability clauses are not permitted for either mandatory or voluntary external audits of any bank, public or private. These rule changes specifically mention that the regulators expect external auditors to be vigilant regarding issues concerning the "safety and soundness" of institutions.

The underlying risks facing�all commercial banks are increasingly less driven by market risk�and more by business model risk.� As banks shift portfolio allocations to chase business, analysts and investors must be vigilant to understand how these changes affect the stability of a given institution.� This change in emphasis�ultimately shifts risk analysis from the statistical methods such as VaR models�that work for market approximation analysis to discrete modeling of the business processes and returns. In other words, Basel II.

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