US banks prepare for oil and gas company loans to worsen

US banks are setting aside more money to cover bad loans to energy companies after oil prices plunged over the last year, raising the possibility that deteriorating loans could start to weigh on their earnings, some analysts said.

Loan credit quality for US banks has been improving since the financial crisis. In the first quarter, 2.49 percent of loans on banks' books were delinquent, the lowest level since the fourth quarter of 2007, according to the Federal Reserve, which hasn't released second quarter data. The rate peaked at 7.4 percent in the first quarter of 2010.

Weakness among energy company loans could be a sign that overall credit quality among US banks has little room to improve, analysts said. Executives from both JPMorgan Chase & Co and Wells Fargo & Co told investors last week, when posting earnings, that they were increasingly concerned about loans to oil and gas companies.

Texas bank Comerica Inc on Friday set aside about three times as much money to cover bad loans as analysts had expected, sending the regional bank's shares lower by more than 6 percent after the bank reported earnings Friday. Setting aside more money, known as "provisioning," hurts earnings. "The banks really have very low credit costs and those can go higher," said Fred Cannon, who heads research at Keefe Bruyette & Woods. While "energy overall is not a life threatening issue for the banks, it is earnings threatening," he said.

JPMorgan said on Tuesday it provisioned another $252 million to cover potentially bad wholesale business loans in the quarter, with $140 million of that related to oil and gas lending.

Oil prices rallied in March and April, but in recent weeks have fallen again on expectations that loosened sanctions against Iran create the potential for greater supplies. US crude oil prices fell below $50 a barrel on Monday for the first time since April.

US accounting rules require that banks set aside money to cover losses on loans only after the loan has shown visible signs of deteriorating, such as a borrower having missed an interest payment. The rules are subject to wide interpretation, however, so that such things as weaker oil and gas prices could potentially prompt some borrowers to increase their provisions.

The hit to earnings from banks' higher provisioning could pour cold water on shares of a sector that has been on fire recently. Since the end of January, US bank stocks have risen 18.7 percent, compared with a 6.6 percent gain for the broader Standard & Poor's 500 index.

Much of that optimism has come from investors preparing for the Federal Reserve to raise interest rates, boosting the rates at which banks can lend and therefore their profits.

Bank profits have been essentially stagnant in recent years, thanks to low rates and tepid economic growth.

JPMorgan CFO Marianne Lake said the bank "might expect" to add more reserves before this year is out. "It is possible we will be selectively downgrading some clients," she said. She described the increases in reserves as "completely normal" in the business cycle. "We are still very happy," Lake said.

CEO Jamie Dimon, interjecting as Lake spoke, said, "Those reserves do not mean we're going to have losses."

To be sure, credit quality is still good. Wells Fargo said that for its overall loan book, the balance of loans on which borrowers had stopped making interest payments declined $67 million in the second quarter, even though delinquencies rose among energy sector companies. Residential mortgage loans are performing better.

CFO John Shrewsberry predicted energy-related credit performance will remain weak.

"We're still resolving these issues," he said on a conference call with investors on Tuesday. "Some of them are just coming to light for certain borrowers, but it's a very contained portion of our loan portfolio and the aggregate impact should not be material to Wells Fargo."

Energy exposure accounts for just 2 percent of Wells Fargo's loan portfolio. However, as KBW's Cannon said, the total money the bank has provisioned for bad loans over time is even smaller— just about 1.2 percent. A Wells Fargo spokesman declined to comment.