Big banks have a big credit problem

Bank of America and Citigroup have been sinking billions into rainy day funds, but problem loans are growing even faster.

By Colin Barr, senior writer

NEW YORK (Fortune) -- Banks are socking away funds for future loan losses at a record clip. But at the sickliest institutions, problem loans are rising even faster.

On Monday, Bank of America (BAC, Fortune 500) became the latest big bank to report a stronger-than-expected quarterly profit, posting net income of $4.2 billion, or 44 cents a share. Analysts had expected a profit of just 4 cents a share.

Like its rivals Citigroup (C, Fortune 500), JPMorgan Chase (JPM, Fortune 500) and Wells Fargo (WFC, Fortune 500), Charlotte-based BofA pointed to strong fixed-income trading results and a big rise in earnings from its mortgage business.

BofA managed to post the big profit even as it set aside more than $6 billion to cover future loan losses. The bank's loan loss reserve now stands at $30 billion -- double its year-ago level.

BofA expects more borrowers will fall behind on payments or default on their loans as job losses deepen and the economy struggles through its worst recession in decades.

"We understand that we continue to face extremely difficult challenges primarily from deteriorating credit quality driven by weakness in the economy and growing unemployment," CEO Ken Lewis said in a statement Monday morning.

Yet as much money as BofA is putting away, both it and Citi -- the two big banks that have received multiple infusions of federal aid over the past year -- are reporting sharp rises in problem loans, particularly on their big credit card portfolios. BofA posted a $1.8 billion loss in its global cards business in the latest quarter.

These high credit costs could weigh on the banks' earnings for many quarters -- and perhaps even affect the regulatory stress tests whose results are due to be revealed in coming weeks.

Not keeping pace

While BofA has doubled its loan loss reserve, nonperforming assets -- loans that are no longer producing income as borrowers fall behind on payments -- have more than tripled, reflecting the weakening economy and the acquisition of troubled Countrywide and Merrill Lynch.

As a result, BofA's loan loss reserve now covers just 121% of its nonperforming loans -- down from 203% a year ago.

That means the bank has a thinning cushion just as the industry braces for rising losses on commercial and industrial loans, as well as continuing declines in residential real estate.

Another bank with a thin cushion is Citi, which reported an unexpected $1.6 billion first-quarter profit Friday even as credit costs doubled from a year ago.

Though Citi's loan loss reserve has jumped 78% from a year earlier, nonperforming assets have more than doubled over the same span. As a result, Citi's loan-loss coverage ratio has slipped to 121%, from 177% a year earlier.

In contrast, the stronger big banks -- JPMorgan, which posted a $2.1 billion first-quarter profit last Thursday, and Wells Fargo, which said earlier this month it expects to make $3 billion in the quarter -- have healthier coverage ratios, thanks to extensive reserve building.

At JPMorgan, for instance, nonperforming assets have jumped to $11 billion from $4 billion in the span of a year. But the bank has been bulking up its reserves at a similar pace.

As a result, JPMorgan's loss reserves at the end of the first quarter amounted to 241% of nonperforming assets -- double the coverage at Citi and BofA, although down from 271% a year ago.

And Wells Fargo's reserve ratios have risen significantly over the past year, in large measure due to a $37 billion writedown of bad loans associated with its Dec. 31 acquisition of Charlotte-based lender Wachovia.

Wells' reserves were 255% of nonperforming assets at the end of the first quarter, according to estimates by analysts at Fox-Pitt Kelton, up from 134% a year earlier. (The bank has yet to report its full results for the first quarter.)

While coverage ratios are far from the only indicator of a bank's health heading into a prolonged period of economic distress, they are likely to be one factor in the stress tests being conducted by federal regulators.

The Federal Reserve and Treasury are expected to begin informing the 19 big banks taking the tests of their results in coming weeks. Those that with lower scores are expected to be forced to raise capital, though the terms and the timing aren't clear. Concerns about the health of the banking sector helped to send shares of most big banks down in midday trading Monday.

Still, even BofA -- the biggest loser Monday with a 15% decline -- has experienced a stunning rally since the sector hit its recent low in early March. At their lows Monday, BofA shares had tripled off their March 6 floor.  To top of page

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