Regulatory Changes Pinch Bank Profits

Tighter reporting restrictions placed on U.S. banks are projected to cause a decrease in profits in the third quarter. In the past, banks were not required to classify …

Tighter reporting restrictions placed on U.S. banks are projected to cause a decrease in profits in the third quarter. In the past, banks were not required to classify modified real estate loans as “troubled debt restructurings” that required them to set aside more reserved funds. The Financial Accounting Standards Board is now demanding stricter classification of these troubled loans, which in turn will require banks to set aside more money that would otherwise be deemed profit – or used to make profit – in reserve. For more on this continue reading the following article from The Street.

Accounting changes requiring banks to report additional loans as “troubled debt restructurings” are likely to lead to additional reserving by banks, eating into profits beginning in the third quarter, according to a report by Fitch Ratings.

Banks refer to loans that have had rates or balance terms modified as troubled debt restructurings, or TDRs. The largest U.S. mortgage servicers, including Bank of America (BAC), JPMorgan Chase (JPM), Wells Fargo (WFC) and Citigroup (C), are under tremendous pressure by regulators and states’ attorneys general, to increase the number of residential loans modified for troubled borrowers.

According to Fitch’s report, 87% of outstanding TDRs as of December 31 were for residential loans, and the mix was changing, “with nonresidential mortgage TDRs growing at a significantly faster rate than residential TDRs.”

Accounting changes required by the Financial Accounting Standards Board (FASB) in the third quarter, “and increased regulatory scrutiny in 2011 are expected to make this shift more pronounced,” according to Fitch.

Fitch also said that “concessions by financial institutions on more recent TDRs have increased in their significance,” leading to more losses being recognized by the lenders, but “which should ultimately result in fewer redefaults on more recent TDRs.”

Beginning in the third quarter, banks will also be required to report the percentage of modified loans that default a second time after the loan is modified.

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With the new rules narrowing the definition of what should be considered a “concession” to a borrower, it is expected that banks will report significantly higher commercial real estate loan modifications, resulting in higher specific reserves allocated to the loans, which will directly affect banks’ earnings.

Fitch said that “50% of all CRE loans maturing in the next few years are anticipated to mature underwater,” since real estate collateral values have dropped. Since many commercial borrowers are “allergic to cash,” commercial mortgages, which usually have relatively short terms, generally need to be renewed, or they get classified as “nonaccrual,” and the loss-recognition and foreclosure processes proceed accordingly. This means that a very large percentage of the renewals over the next few years will be classified as TDRs.

The accounting changes are meant to mitigate the masking of credit weaknesses, especially on commercial real estate loans with a significant decline in collateral value, through “extend and pretend” practices of lenders who extend loan maturities without “without proactively dealing with clear credit weaknesses in the loan,” which Fitch says “artificially deflates current period nonperforming loans and credit costs but ultimately leads to increased credit costs in future periods.”

While Fitch said the coming portfolio-specific reports of redefault rates “are not expected to materially affect ratings,” certain lenders reporting “disproportionate growth” and higher redefault rates could see their ratings “negatively impacted.”

In its first-quarter 10-Q report with the Securities and Exchange Commission, Bank of America reported that it had completed 840,000 loan modifications. During the first quarter, the company completed 64,000 modifications, for loans with total unpaid principal balance of roughly $14 billion.

Bank of America reported that as of March 31, the unpaid principal balance of its impaired residential real estate loans was $20.6 billion, with a carrying value of $16.3 billion and specific reserves of $1.9 billion.

JP Morgan Chase said in its first-quarter 10-Q that “the Firm does not expect that the implementation of this new guidance will have a significant impact on the Firm’s Consolidated Balance Sheets or results of operations.” The company reported that as of March 31, it had completed 324,000 loan modifications since the beginning of 2009.

In reporting its impaired loans, JPMorgan separates out “purchased credit-impaired loans” or “PCI loans,” acquired when the bank bought the failed Washington Mutual from the FDIC in September 2008.

As of March 31, JPMorgan’s purchased credit-impaired loans totaled $19.1 billion, while other restructured residential real estate loans totaled $6.4 billion. Wholesale impaired loans, including commercial and commercial real estate loans, totaled $2.5 billion as of March 31.

Wells Fargo reported that 665,000 of its customers “were in active trial or had completed loan modifications since the beginning of 2009.” The company also separates out purchased credit-impaired loans, left over from its acquisition of Wachovia in December 2008. As of March 31, Wells Fargo’s PCI loans had a principal balance of $61.3 billion, with a carrying value of $40 billion.

Wells Fargo’s impaired consumer loans — mainly residential — totaled $35.8 billion.

For Citigroup, modified mortgages totaled $16.9 billion as of March 31. Impaired consumer loans totaled $28.6 billion as of March 31, while impaired corporate loans totaled $5.5 billion.

This article was republished with permission from The Street.

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