Low Loan Loss Reserves at Banks Could Cause Problems Ahead

Implications: Loan loss reserves at banks are at historic lows. At the same time, the credit cycle has turned viciously negative, particularly for mortgages. Banking regulators are likely to ratchet the pressure up on banks to raise their loss reserves. The most vulnerable are banks with outsized exposure to the mortgage lending business

Analysis: E*Trade Financial (ETFC) has announced that they will be exiting the wholesale mortgage business, tripling the loan loss provision and taking a $100 million charge for losses on its-available-for-sale securities. None of this should come as a surprise to investors - a review of the 2nd quarter 10-Q showed that ETFC's loan loss reserve was a miniscule 0.25% of loans receivable, the bank had racked up $199 million in unrealized losses that were plainly visible in the Accumulated Other Comprehensive account (but not in earnings because the securities were in available-for-sale which allows changes in fair value for debt securities to flow through shareholders equity rather than earnings - this is a commonly used category for banks).

Thus far, subprime mortgages have received all of the attention and banks have been considered safe havens.  With the E*Trade announcement, this has changed. The main driver of earnings at E*Trade was its banking subsidiary, E*Trade Bank. I believe that E*Trade's announcement is a sign that banking regulators are starting to put pressure on banks with low loan loss reserves to raise their provisions. Going forward, expect to see sharply higher provisions at banks with outsized exposure to the consumer. Thrifts, like Countrywide Bank, make predominantly mortgage rather than commercial loans. Thrifts that are also in weak housing markets and are seeing rising delinquencies in their loan portfolio are the most vulnerable. Downey Financial (DSL), a bank holding company is an interesting situation. Last week, the company filed an 8-K that showed non-performing mortgage loans were continuing to increase. At the same time loan loss reserves are very low. Add to this the fact that the majority of DSL's loans are negatively amortizing mortgages, which has constrained the cash flow, and the bank could be the next poster child for the banking regulators.