LOAN DELINQUENCIES PEAK!

Posted by jeff

Sat Aug 21st, 2010 09:20 AM

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**Since March 2010, Mr. Bernstein has served as Senior Vice President, Research, for AH Lisanti Capital Growth, LLC, a registered investment adviser. This commentary solely represents Mr. Bernstein’s views and opinions as of August 21st, 2010, does not constitute investment advice and does not depict the views of AH Lisanti Capital Growth, LLC.



Yes, believe it or not, according to data released by the Federal Reserve earlier this week, loan delinquencies appear to have peaked (View image). In Q2 2010, for the second quarter in a row, delinquent loans as a percent of all loans declined (on a non-seasonally adjusted basis). Delinquent loans began their ascent from a historical low of 1.5% of all loans reached in Q2 2005, climbing relentlessly until Q4 2009, when they hit a hellish 7.5% of all loans. During the previous real estate and credit crisis of the 1980s delinquency levels vacillated at very elevated levels above 4.6% for 6 years before peaking at 6.3% in Q1 1991. This was due to the rolling real estate recessions that swept across Texas/Oklahoma/Colorado, southern California and New England in the late 1980s, followed by the commercial real estate debacle of the early 90s. While two quarters of decline may not be indicative of a peak from a historical perspective (data back to Q1 1985), in this case I believe that charge-off patterns indicate cause for optimism. Just to review a few banking terms used to describe the formation of bad loans and their disposal:

1) Loans go delinquent, which means that people stop making their monthly payments.

2) Banks begin to reserve funds to cover whatever losses they believe are likely to form as a result of delinquency.

3) A small number of loans go from delinquent or "non-accrual" back to accrual status when the bankers remind the borrowers of the consequences of not repaying their loans.

4) Delinquent loans eventually go into the foreclosure process and are "charged-off" by the bank. Which means that the bank makes an estimate of what its loss on disposing of the loan is likely to be and takes a charge to its earnings to reflect the expected loss. The charge off is merely an accounting entry and does not necessarily indicate that the bank has disposed of the collateral underlying the loan. It does mean, however, that the bank is forced to prepare itself to take the eventual loss in terms of having capital in place to net against it.

5) The bank forecloses on the borrower, gets title to the property back and actually disposes of the property. The size of the loss incurred versus the amount loaned is referred to as severity. In some cases the amount charged off was larger than the bank's ultimate loss and some or all of the charge off is reversed. In some cases it is worse and an additional charge off is required.

As is notable from the chart of charge offs on all loans (View image) banks have ramped up the amount of loan charge offs much faster in this credit crisis than they did in the late 80s/early 90s, despite the ultimate peak in delinquencies being only a little higher (and potentially similar in magnitude as the prior stretch of high delinquencies lasted a very long time). This indicates to me that, despite what we hear about "extend and pretend", at least from an accounting and capital raising perspective, banks are being much more aggressive in preparing to deal with their delinquent loans (there are subtleties relative to extend and pretend related to maturity defaults we could discuss, but actual delinquencies are being dealt with). This lays the groundwork for expanding credit and general economic growth which would forestall another wave of delinquencies. Indeed as of the July 2010 Federal Reserve survey of bank lending practices we are already seeing bank lending loosening up just a little.

I would note that all the categories of loans I have been tracking for the last couple of years have seen delinquencies decline from recent peaks including credit card loans, commercial and Industrial (C&I) loans and most importantly residential loans, which have by far and away been the biggest problem for the economy and the banking industry.

This quarters' data from the banks supervised by the Federal Reserve (which include state-chartered member banks, bank holding companies, foreign branches of U.S. national and state member banks, Edge Act Corporations, and state-chartered U.S. branches and agencies of foreign banks) show that residential loan delinquencies declined quarter to quarter for the first time since Q1 2007, as illustrated in the chart below.




All thank god and say ye amen!

Perhaps with loan delinquencies finally headed in the right direction and banks aggressively reserving for and charging off their bad loan portfolios, bad loan disposition will begin to pick up and new lending can begin to accelerate. It is difficult to see past the current lull in the economy and the obnoxious action in the stock market, but with everyone looking for the end of the world, the contrarian in me prefers to focus on the positive data points that are being ignored.