Rising U.S. Business Bankruptcies Seen Causing Pain For Banks

Danger is lurking for banks despite an economy that is inching towards improvement as U.S. business bankruptcies are expected to rise sharply well into next year.

Banks have so far suffered mostly from souring real-estate loans rather than from loans tied to large and mid-sized businesses. But Dan North, chief economist of Euler Hermes ACI, said he expects Chapter 7 bankruptcies to "ramp up."

"In a recession, even a business with a good management team can be wiped out because there is nothing to be put back together" through a restructuring under the Chapter 11 bankruptcy code, he said. That will drive up loan losses.

Credit insurer Euler Hermes predicts that U.S. bankruptcies will rise 45% this year from last, to 63,000 in an economy that the insurer is expecting to contract 3%. That jump is caused partly by banks tightening their underwriting standards, North said.

Credit rating agency DBRS Inc. said in a recent report, "Many U.S. companies are strapped for cash as consumer spending and business investment contracted resulting in a steep decline in revenue during the latter part of 2008 and into 2009. Combined with an inability to replace or renew bank lending facilities, many businesses are defaulting on their debt obligations."

That also means bankruptcies will continue to rise even when the recession is over, Euler Hermes' North said. Bankruptcies will taper off slightly next year but they will remain 40% above the already elevated levels of 2008, his firm predicts.

Banks will face political pressure, and perhaps from investors demanding to see returns from banks' high capital as the economy recovers next year, to lend more. But North said that those pressures will likely prove only an incremental positive to bankruptcy trends.

Bankers "want to get back to the business of making money" from lending, but only "at a manageable level or risk." Next year, bankers "will still be very aware of how severe the crisis was," North said.

The vast majority of bankruptcies were, and are expected to remain, personal bankruptcies. Still, while business bankruptcies last year were tied mainly to financial-services companies - 25 banks failed - and construction loans, some major industrial groups, such as paper, metal, and chemical, are now also struck by the recession.

How badly that will hurt the banking sector, particularly large regional banks and the nation's biggest banks that hold most of the commercial and industrial loans, is hard to gauge, because big businesses finance themselves through bonds and equity in addition to bank loans.

Still, losses in banks' commercial loan book have been ramping up - first slowly last year, and more pronounced in the first quarter, when commercial and industrial loan losses made up 1.8% of loans, according to data from the Federal Deposit Insurance Corp.

Overall, first-quarter loan losses were almost twice as high as a year earlier, the FDIC said. And, "The year-over-year rise in charge-offs was led by loans to commercial and industrial borrowers, where charge-offs increased by $4.2 billion."

DBRS wrote that business bankruptcies surpassed the peak levels of the previous cycle last year, and "there is little to suggest that business bankruptcies have reached their peak."

Stifel, Nicolaus & Co. analysts said in a research report that the rising business delinquencies trend "raises the question, is commercial the next subprime?"

Commercial and industrial, or C&I, loans totaled $1.4 trillion on March 31, almost 20% of total loans and leases among the 8,200 FDIC insured banks. According to the Federal Reserve's stress test for the 19 largest banks, C&I loan losses could total up to 4% over two years under its "baseline" economic scenario, and twice as much until its "more adverse" scenario.

Bank of America Corp. (BAC) is the nation's largest C&I lender, with a total of $241 billion in such loans on March 31. The loss ratio of Bank of America's C&I portfolio remained low at 0.46%, compared to 13.5% for small-business loans.

Wells Fargo & Co. (WFC), Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM) follow Bank of America as the biggest commercial lenders; Comerica Inc. (CMA), M&T Bank Corp. (MTB), and Zions Bancorp (ZION) are among the large regional commercial lenders, according to SNL.

-By Matthias Rieker, Dow Jones Newswires; 201-938-5936; [e-mail]