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Managing Credit Risk
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Credit risk is a core part of the lending business. Investors can get a sense of a bank's credit quality by examining its balance sheet, loan categories, trends in nonperforming loans and charge-off rates, as "well as manage­ment's lending philosophy. (Nonperforming loans are those on which borrowers aren't paying, and charge-off rates measure the percentage of loans the bank doesn't think will ever be repaid.) The problem is that these measures are historical, which is the problem with many financial measures: They tell you where a company has been, not necessarily where it's going. Almost everything we know about the credit quality of a lending institution is learned after the fact.

This risk often rears its ugly head in the form of delinquent loans or outright defaults and could potentially be borne by anyone, not just banks.

Consider a commercial loan with a 7 percent interest rate. Banks know that some of their clients will default, so they build this cost into the price of every loan. But if you made a similar loan as an individual, chances are you wouldn't have enough capital to diversify. As a result, you'd either earn a 7 percent return or lose everything. Banks' giant balance sheets provide three major shields to insulate them against risk in ways that others can't achieve:

•  Portfolio diversity

•  Conservative underwriting and account management
3- Aggressive collections procedures

Here's how these techniques work in practice. The most straightforward way banks manage risk is to divvy up the amount they lend among many companies, industries, or geographies. In the words of oil tycoon J. Paul Getty, "If you owe the bank $100, that's your problem. If you owe the bank $100 million, that's the bank's problem." To manage this risk, banks can either originate a wide variety of loans themselves or buy and sell loan port­folios. By assembling diverse portfolios, banks reduce their risks.

Within the industry, banks can also distinguish themselves through solid underwriting and collections procedures. In other words, they figure out ways to avoid writing bad loans, and if a loan is in trouble, banks can chase down the deadbeats. Banks that develop these specialized skills better than others have an edge over their competitors. In contrast, large nonbank companies often lack the sophisticated credit approval systems and processes to reduce default risk. History is Uttered with giant corporations that at one time or another tried to make money by providing credit and ran into trouble because of their inexperience (e.g., AT&T and Sears).

One of the biggest challenges to investing in banks is spotting credit quality problems before they blow up in investors' faces. To help avoid getting stuck with a bank that blows up, investors should pay close attention to charge-off rates and delinquency rates, which are seen as an indicator of fu­ture charge-offs. Look for trends, not just absolute levels. The best regional banks saw their charge-off rates rise quickly in the latest economic downturn, but they remained fairly low—less than 1 percent of loans. (This measure is higher, for example, for a credit card company and lower for a savings and loan.)

Unfortunately, there's no absolute measure that can be considered good or bad, so investors must compare a bank's charge-off rates with those of its competitors and see how they have trended over time. Charge-offs, nonperform- ing loans, and delinquency rates are reported in press releases and can be found in annual and quarterly reports to the Securities and Exchange Commission. In addition, listen carefully to management. No manager knows exactly where charge-offs are headed, but a good management team should be able to accurately outline trends.

Finally, beware of super-fast growth. It's an axiom in the financial services industry that fast growth can lead to big troubles. Fast growth is not always bad—many of the best players have above-average growth rates—but any fi­nancial services company that's growing significantly faster than competitors should be eyed with skepticism.

Look for clear evidence that the credit culture is sound, is conservative, and has been tested. You can do this by examining charge-offs and delinquency rates, becoming familiar with the type of lending a bank does from reading the annual reports, and considering the economic environment in which the company operates. Five years of fast growth in perfect economic conditions doesn't really tell you much about credit quality, after all. If you invest in fast-growing lenders, watch them carefully.

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