Higher credit expenses at large institutions and narrower net interest margins at smaller institutions exerted downward pressure on earnings of FDIC-insured institutions in the first quarter of 2007. The industry reported total net income of $36.0 billion in the quarter, the fourth-highest quarterly amount ever, but it was $912 million (2.5 percent) less than the earnings posted in the first quarter of 2006. This is the largest year-over-year decline in quarterly earnings since the first quarter of 2001. A significant part of the decrease was attributable to a change in the way that earnings were reported in the aftermath of a large corporate restructuring, but lower operating results at a number of institutions also contributed to the earnings drop. Evidence of pressure on earnings was widespread, as a majority of institutions (50.3 percent) reported lower quarterly net income. Narrower net interest margins had a negative effect on earnings of smaller banks and thrifts, while higher expenses for bad loans were more significant for large banks. More than two out of every three institutions -- 67.9 percent -- reported lower net interest margins than a year ago, but only 36.6 percent of all institutions reported higher provisions for loan losses. Among institutions with more than $10 billion in assets, 73 percent raised their loss provisions. The average ROA for the quarter was 1.21 percent, down from 1.34 percent in the first quarter of 2006, as 59 percent of all institutions saw their quarterly ROAs decline. This is the lowest first-quarter ROA for the industry since 2001.

Increased Costs Contribute to Earnings Decline

Reflecting an erosion in asset quality, provisions for loan losses totaled $9.2 billion in the first quarter, an increase of $3.2 billion (54.6 percent) from a year earlier. Noninterest expenses were up by $3.0 billion (3.6 percent), as several large banks reported higher payroll expenses. These higher costs were partially offset by increased net interest income (up $3.3 billion, or 4.0 percent), higher noninterest income (up $1.2 billion, or 1.9 percent), and gains on sales of securities and other assets (up $852 million, or 127.0 percent). Lower revenues from securitization and servicing activities limited the year-over-year improvement in noninterest income.

Margins Fall to Sixteen-Year Low at Smaller Institutions

A combination of stable interest rates and a flat yield curve had different effects on margins at small and large institutions in the first quarter. The industry's net interest margin (NIM) was 3.32 percent in the first quarter, above the 3.20 percent average in the fourth quarter of 2006, but below the 3.46 percent average in the first quarter of 2006. The first consecutive-quarter margin improvement in the last seven quarters was concentrated among larger institutions. At institutions with more than $10 billion in assets, average asset yields increased and average funding costs declined from fourth-quarter levels, lifting net interest margins. At institutions with assets between $1 billion and $10 billion, average asset yields increased, but so did average funding costs. Nevertheless, the improvement in yields outweighed the rise in funding costs, and this group saw its average margin increase as well. At institutions with less than $1 billion in assets, however, average asset yields were lower than in the fourth quarter, while average funding costs were higher, so average margins were down. The 3.91 percent average margin for institutions with less than $1 billion in assets was the lowest level for this group in 16 years. Compared to a year ago, average margins were lower for all size groups. Because of the narrower margins, net interest income in the first quarter was up by only 4.0 percent from a year earlier, even though interest-earning assets grew by 7.3 percent. At many institutions, narrower margins contributed to lower profitability. Among institutions that reported year-over-year declines in quarterly ROA, 84 percent also reported declines in net interest margins. At institutions reporting year-over-year declines in quarterly NIMs, 72 percent also had lower ROAs.

Rising Loss Provisions Stay Ahead of Increase in Loan Losses

The $9.2 billion that the industry set aside in provisions for loan losses during the first quarter was slightly below the $9.8 billion set aside in the fourth quarter of 2006, but the $3.2-billion year-over-year increase was the largest since the first quarter of 2002. Loss provisions exceeded net charge-offs by $1.1 billion (13.1 percent), the fifth quarter in a row that provisions have exceeded loan losses. Net charge-offs totaled $8.1 billion, an increase of $2.7 billion (48.4 percent) from the first quarter of 2006. Charge-offs were higher in most loan categories. Net charge-offs of credit card loans rebounded from an unusually low level a year ago, increasing by $850 million (29.2 percent). Similarly, net charge-offs of other loans to individuals were $754 million (60.0 percent) higher than a year earlier. Net charge-offs of loans to commercial and industrial (C&I) borrowers increased by $470 million (78.6 percent), and net charge-offs of 1-4 family residential mortgage loans were up by $268 million (93.2 percent).

Noncurrent Rate Climbs for Third Consecutive Quarter

Since reaching a cyclical low of 0.70 percent at the middle of last year, the percent of insured institutions' loans that are noncurrent (90 days or more past due or in nonaccrual status) has risen in each succeeding quarter. At the end of March, the noncurrent rate stood at 0.83 percent, its highest level in two and a half years. During the quarter, noncurrent loans increased by $4.0 billion (7.0 percent). Noncurrent levels increased in most loan categories during the first quarter, with the largest increases occurring in real estate loans. Noncurrent residential mortgage loans increased by $1.7 billion (7.3 percent), while noncurrent construction and development loans rose by $1.5 billion (36.1 percent). The rising trend in noncurrent loans was fairly widespread; almost half of all institutions (45.7 percent) saw their noncurrent loans increase in the first quarter. The percentage of 1-4 family residential mortgage loans that were noncurrent rose from 1.05 percent to 1.13 percent during the quarter. This is the highest noncurrent rate for residential mortgage loans since midyear 1994.

Reserve Ratio Registers First Increase in Five Years

Insured institutions set aside $1.1 billion more in loss provisions than they charged off during the quarter, contributing to a $993-million (1.3-percent) increase in loan-loss reserves. This is the largest increase in loss reserves since the fourth quarter of 2002. The increase in reserves caused the industry's ratio of reserves to total loans to move up slightly from 1.07 percent to 1.08 percent during the quarter. This is the first increase in the industry's reserve ratio since the first quarter of 2002; the current level is the second-lowest the ratio has been since 1985. The increase in reserves failed to keep pace with growth in noncurrent loans, and the industry's "coverage ratio" of loss reserves to noncurrent loans fell from $1.37 in reserves for every $1.00 in noncurrent loans to $1.30 during the quarter. This is the fourth consecutive quarter that the coverage ratio has fallen. It is now at its lowest level since March 2003.

Dividend Surge Limits Growth in Equity

Insured institutions paid $26.2 billion in dividends in the quarter, an increase of $7.3 billion (38.7 percent) from the first quarter of 2006, as a few large institutions reported sizable dividend increases. Retained earnings totaled only $9.8 billion for the quarter, $8.2 billion (45.5 percent) less than a year earlier. Partly as a result of the lower retained earnings, total equity capital increased by only $19.7 billion, less than half the $44.5-billion increase in equity capital that the industry registered a year ago. This increase (the smallest in the last six quarters) was enough to raise the industry's equity-to-assets ratio from 10.52 percent to 10.58 percent. Average equity ratios increased for all size groups of insured institutions during the quarter. The industry's regulatory capital ratios remained largely unchanged, as levels rose slightly at smaller institutions and declined slightly at larger institutions. The divergence between the improvement in the equity capital ratio and the lack of improvement in regulatory capital ratios is due to an increase in the riskiness of industry assets that is reflected in some regulatory capital ratios, as well as the fact that one-fourth of the increase in equity consisted of goodwill, which is not included in regulatory capital.

Slower Asset Growth Is Centered in Real Estate

A slower growth environment prevailed in the first quarter, as total assets increased by $120.8 billion (1.0 percent), higher than the $106.7-billion increase in the fourth quarter of 2006, but still the second-smallest increase in industry assets in the last fourteen quarters. During the twelve months ended March 31, assets of insured institutions grew by 6.9-percent, the slowest 12-month growth rate in four and a half years. The slowdown in asset growth has been led by slower loan growth. Total loans and leases increased by $43.8 billion (0.6 percent) during the quarter, the smallest quarterly increase since the first quarter of 2002. Some categories of real estate loans experienced shrinkage during the quarter, while growth in other categories slowed. Institutions' residential mortgage loans declined for the first time in thirteen quarters, falling by $6.5 billion (0.3 percent), home equity lines dropped by $2.6 billion (0.5 percent), and real estate loans secured by multifamily residential properties declined by $1.1 billion (0.6 percent). Real estate construction and development loans grew by $16.8 billion, but this was the smallest quarterly increase for these loans since the second quarter of 2004. Mortgage-backed securities declined for the third quarter in a row, falling by $40 million. For the second quarter in a row, total mortgage assets of insured institutions (mortgage loans plus mortgage-backed securities) declined. Loans to commercial and industrial (C&I) borrowers were one of the few loan categories that had strong growth during the quarter, increasing by $35.1 billion (2.9 percent). Loans to individuals other than credit cards also grew strongly, rising by $20.9 billion (3.7 percent), with most of the growth occurring at a few large lenders. Fed funds sold and securities purchased under agreements to resell increased by $57.4 billion (10.2 percent).

Interest-Bearing Deposit Growth Is Strong

Total deposits grew by $70.0 billion (0.9 percent), the smallest quarterly increase since the third quarter of 2003. Domestic deposit growth was slightly stronger; deposits in domestic offices increased by $63.3 billion (1.0 percent), as strong growth in interest-bearing accounts outweighed a $43.8-billion (3.6-percent) decline in noninterest-bearing deposits. Among the interest-bearing deposits, time deposits increased by only $16.4 billion (0.7 percent), while other interest-bearing deposits were up by $90.8 billion (3.1 percent). Nondeposit liabilities increased by $31.1 billion (1.1 percent) during the quarter, with most of the growth occurring in short-term borrowings. Borrowings from Federal Home Loan Banks declined by $14.4 billion (2.3 percent), after falling by $11.7 billion (1.8 percent) in the fourth quarter of 2006.

Insured Bank Failure Is First Since Mid-Year 2004

At the end of March, there were 8,650 FDIC-insured commercial banks and savings institutions reporting financial results, a net decline of 31 institutions compared with the number reporting at the end of 2006. There were 41 new reporters added during the first quarter, while 72 institutions were absorbed by mergers. One FDIC-insured commercial bank, with $15.3 million in assets, failed during the quarter. It was the first failure of an FDIC-insured institution since June 25, 2004, the longest period without a failure in the history of the FDIC. The number of institutions on the FDIC's "Problem List" increased from 50 to 53 during the first quarter, and assets of "problem" institutions rose from $8.3 billion to $21.4 billion. During the quarter, two insured savings institutions, with combined assets of $1.6 billion, converted from mutual to stock ownership.

Chart 1. First Quarter Earnings Were Fourth-Highest Ever

Chart 2. The Increase in Loss Provisions Was the Largest in Five Years

Chart 3. More Institutions Are Having Trouble Growing Their Earnings

Chart 4. Margins Improved at Large Institutions

Chart 5. The "Efficiency Gap" Between Large and Small Institutions Is Growing

Chart 6. The Industry Is Taking on More Risk

Chart 7. Is the Credit Cycle Turning

Chart 8. Mortgage Activity Is No Longer Contributing to Growth

TABLE I-A. Selected Indicators, All FDIC-Insured Institutions

TABLE II-A. Aggregate Condition and Income Data, All FDIC-Insured Institutions

TABLE III-A. First Quarter 2007, All FDIC-Insured Institutions

Asset Concentration Groups

Asset Size Distribution & Geographic Regions

TABLE IV-A. Full Year 2006, All FDIC-Insured Institutions

Asset Concentration Groups

Asset Size Distribution & Geographic Regions

TABLE V-A. Loan Performance, All FDIC-Insured Institutions

Asset Concentration Groups

Asset Size Distribution & Geographic Regions

TABLE VI-A. Derivatives, All FDIC-Insured Commercial Banks and State-Chartered Savings Banks

TABLE VII-A. Servicing, Securitization, and Asset Sales Activities