Mortgage Default Risks Drag Banks, Data Shows

WASHINGTON (CN) - Though residential mortgage delinquencies and foreclosures dropped in the first quarter of 2012, banks still feel pressure from potential foreclosures down the road, the Office of the Comptroller of the Currency reported.

The quality of mortgage loans as assets improved for small banks, but big banks improved more quickly as they have been actively selling off their bad loans and improving programs to keep residential loans on track, according to the OCC Semi-Annual Risk Report for spring 2012.

This means smaller banks face higher loan costs and potential down side on existing loans. The OCC fears that this will drive them to increase profitability by taking greater risks.

Increasing the underwriting standards for residential mortgage loans has been a hallmark of regulatory reform since the bottom fell out of the housing market at the end of 2008, revealing risky lending practices, particularly in the subprime market.

There is some risk that these standards will fall as banks feel the need to attract borrowers, the report says.

Commercial lenders face similar challenges, according to the report. Even the low interest rates set by the Federal Reserve to decrease borrowing costs could not have improved commercial loan activity depressed by lack of demand for office and commercial space, the OCC says.

Low rates and lack of demand have created a negative feedback loop for banks that generate less income from the loans they do make.

In addition to lower revenue from loans, there are other factors that cause banks to have less cash available to invest or prop up their balance sheets. Compliance with Basel III and Dodd-Frank standards now mean limits on bank fees and increases in capital reserve requirements.

Though there is already some evidence of loosened underwriting standards for commercial loans, banks overall still adhere to the higher standards, the OCC says.

Since corporations are also hoarding large amounts of cash, they are less likely to finance expansion with loans, even as the economy heats improves, the report says.

On the risk side, big banks face huge exposure to European sovereign debt and the potential breakup of the Euro, which would force redenomination of loans made in that currency.

Even with all of the challenges and limitations outlined in the report, the OCC found that the net income of banks improved by 27 percent in 2011 over the previous year.

Small banks with assets between $1 billion and $10 billion did best with net income rising by 300 percent. Even smaller banks improved by 71 percent. The bigger banks, those with more than $10 billion in assets, improved by 22 percent.

Reduced expenses related to loan activity and increases in trading revenue likely fueled these increases, according to the report.

The report is based on data gathered at the end of 2011 and does not include any data on the performance of banks in 2012.

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