State's banks below norm in reserves

For years, financial experts and regulators have been warning banks to prepare for a dark day when a sudden collapse in real estate values would trigger a sharp rise in loan losses.

Now that day has arrived, and the question remains: How well did Minnesota banks heed the warnings?

Bad loans are rising at a rapid clip, and banks in the state are not setting aside as much money to cover expected loan losses as is the United States banking sector as a whole, according to data from the Federal Deposit Insurance Corp. (FDIC), which regulates about 5,100 banks.

Despite repeated warnings of economic trouble ahead, banks in Minnesota have failed to keep pace with the rise in bad loans. Among those banks, the ratio of past-due and nonaccrual loans -- or loans for which payment is in doubt -- as a percentage of total loans rose 50 percent since 2006, while the reserves to total loans ratio remained virtually unchanged.

None of this portends disaster, but it does suggest that Minnesota banks are less equipped than their national peers to handle a long and severe recession and the surge in loan losses that is likely to accompany a further deterioration in real estate values, banking experts say.

That's potentially troubling news for the state economy, which is limping along amid worsening job reductions. In December, Minnesota's unemployment rate jumped to 6.9 percent, compared with 4.7 percent a year earlier. If Minnesota banks are caught unprepared with more loan losses, they may have to further tighten the screws on consumer and business borrowers at a time when access to credit is urgently needed, say experts.

"If I'm a banker and I'm losing money, and my capital base is shrinking, then I'm going to have to shrink my loan portfolio," said Ben Crabtree, a bank analyst with Stifel Nicolaus & Co. "Clearly, that's not going to be good for the economy."

A bank's loan-loss reserves are supposed to represent a bank's estimate of current and future loan losses. But predicting which loans might go sour, and when, always has been an inexact science, driven more by personal judgment than rigid economic formulas, banking experts say. What might seem like a stable loan to one banker might appear dangerous to another, depending on the bank's asset mix, location and other factors. Banks with strict underwriting standards often have lower reserves than banks that are looser with credit.

"It's an art, and art is in the eye of the beholder," said Michael Carlson, a partner in the finance and restructuring group at law firm Faegre & Benson in Minneapolis. "If you have two bankers looking at exactly the same portfolio, and one is more optimistic than the other ... they will come to different conclusions about how much to set aside."

Last year, it became painfully apparent to many bank shareholders why the imperfect exercise of reserving against bad loans is so important. Many household banking companies, including Citigroup, Bank of America and Wells Fargo & Co., had to add billions of dollars to their reserves after dramatically underestimating the severity of the decline in real estate prices. Those additions to reserves led to huge losses, since they are subtracted from a bank's profit.

Now, many Wall Street analysts watch bank reserves more closely than bank profits, said analyst Crabtree in Minneapolis. "Earnings mean very little nowadays, because no one believes them," he said. "Reserve levels and capital ratios are by far more important."

A key number watched by state and federal bank regulators is the so-called "coverage ratio," the amount of cash banks set aside in reserves compared to loans that are noncurrent, or 90 days or more past due. Banks with low coverage ratios have less cushion against loans going bad. As of the third quarter, the average coverage ratio for Minnesota banks fell to its lowest level in nearly two decades.

Shakopee bank is lowest

According to an analysis by California resaerch firm Foresight Analytics of reserve levels at Minnesota banks, tiny Citizens State Bank of Shakopee, with assets of just $23 million, had the lowest coverage ratio in the state, with a reserve-to-noncurrent loan ratio of just 14.1 percent as of Dec. 31.

Forest Lake-based Mainstreet Bank was next with a coverage ratio of 15.6 percent. Its noncurrent loans were 12.9 percent of assets. Last month, Mainstreet Bank received an FDIC cease-and-desist order for "hazardous lending and lax collection standards," and was cited for keeping inadequate reserves to cover loan losses.

Nearly 40 of the state's 400 banks have coverage ratios below 30 percent, a level that is less than half the state average. Among the larger ones are First Minnesota Bank of Minnetonka, with more than $370 million in assets, and Minnwest Bank Minnesota Valley in Redwood Falls with assets of $510 million.

Bank executives gave different reasons for the low ratios. Summit Community Bank of Maplewood, which opened its doors in May 2007, noted that as a newer bank it has not had time to build large reserves. The bank has a coverage ratio of just 16.7 percent. But as it generates more profits, it adds to reserves. This year Summit plans to double the amount it sets aside each month to $40,000 from $20,000 in 2008, said President Kevin Whelan.

One reason Minnesota banks are reserving less than peers in other parts of the country is that the state experienced a boom in bank startups earlier this decade. So, like Summit, many of these banks are still building reserves.

Another theory is that Minnesota has a larger number of small, community banks than other states. Those banks made fewer of the subprime mortgages that defaulted in the credit crisis, but did more of the commercial real estate loans that have only just started to turn sour, said several bank experts.

Crabtree thinks many Minnesota banks "got lulled into a sense of complacency" because, for most of this decade, they could recover bad loans secured by property at a minimal loss as property values were rising. "Historically, real estate values here have been much more stable than in the rest of the country," he said. "The fact that we're not so stable anymore may have caught many bankers by surprise."