How to Cover Wall Street

“SOVEREIGN is a fundamentally sound financial institution,” CEO Joseph P. Campanelli said, noting: “Importantly, our capital exceeds the levels defined as ‘well capitalized’ by our regulators.”

New York’s smaller, non-money center banks could soon be hit by a wave of defaults on loans for commercial real estate. Many of these regional banks have so far endured the crisis that toppled larger rivals such as Wachovia, IndyMac and Washington Mutual, but that may be about to change.

A sputtering economy may force other regional banks to face the same decision Sovereign Bancorp did this week: sell themselves to larger banks or fail. (hear the bank’s earning call below) With comparatively few toxic credit derivatives on their balance sheets, many of New York’s community-based banks, have relied on a conservative asset mix of mortgages, business and commercial real estate loans for revenue. Like Sovereign, which held half of its $57.8 billion loan portfolio in commercial real estate loans of as December 2007, many smaller banks assumed these loans would generate steady income until their maturity dates. Now that some economists are predicting a prolonged recession that would force businesses to go belly up, some of these loans may not be repaid. Banks will then have to tap their reserves to stay afloat but many of them may not have enough to cover their potential losses.

Last week, a UBS analyst cut his earnings estimate for U.S. banks by 26 percent because of the impending losses related to commercial loans, according to a Bloomberg article.  A number of regional lenders made the list of banks whose bottom lines would suffer: Sovereign Bancorp Inc., which agreed to sell itself to Santander, First Horizon National and Zions Bancorporation.

All banks are supposed to set aside money to cover future losses.  But the FDIC doesn’t specifically mandate that banks add to their reserves each time credit conditions worsen. The regulator leaves it up to individual banks to decide their adequate reserve levels.

And decide they do. In 2005, some regional banks cut their loan loss reserves to boost their bottom lines and little evidence suggests banks have reversed this trend.  Once the credit crisis began last August, many of these institutions should have begun strengthening their reserves to protect against a surge in commercial loan defaults.

In the aggregate, U.S. banks have set aside 1.80 percent of their total loans as a cushion in the event loans go bad, according to data provided by SNL Financial. The total amount of loans that all U.S. banks held as of the end of June stood at $8 trillion, according to SNL Financial.  Nonperforming and loans past due accounted for $197 billion, up nearly 40 percent from the same time a year earlier. After the nine largest banks get their share of the Federal Reserve’s capital injection, only $125 billion will be left for smaller institutions.  Without enough emergency funding to meet the need, some banks will fail—but it won’t be the J.P. Morgans of the world.