Although many investors and commentators believe that we have passed the heart of the financial crisis and are slowly moving toward a recovery in the economy, our banking system is still chock full of bad loans that need to be passed through the system. This will cause much discomfort for the economy and the industry.

IN PICTURES: Digging Out Of Debt In 8 Steps

East West Bancorp (Nasdaq:EWBC) has 4% of its loans classified as "problem loans" as of the end of the second quarter of 2009. Problem loans are defined as all loan past due, non-accrual loans and other real estate owned (OREO). Despite the troubling problem loan ratio, East West Bancorp raised capital recently by issuing common stock in a private and public offering of stock, and the conversion of preferred stock to common. The net effect was to increase common equity by $249 million, and leaves the bank with a pro forma Tier 1 leverage capital ratio of 11.22%.

Flagstar Bancorp (NYSE:FBC) has 11.2% of its loans in this category, one of the highest among the large banks. The bank has raised significant capital this year, and just finished the final tranche of $50 million, and has raised $621 million in gross capital in 2009.

Other banks with high amounts problem loans include Marshall & Ilsley (NYSE:MI) and Synovus (NYSE:SNV), with non-performing loans as a percent of total loans of 5.01% and 5.40%, respectively at the end of the second quarter of 2009.

UCBH Holdings Inc (Nasdaq:UCBH) has a problem loan ratio of 13.4%. The bank just suspended interest payments on its trust preferred securities, and halted dividends on its common and preferred stock.

Things to Consider
One problem with these loans is that they will continue to suppress a strong recovery in residential or commercial real estate. As the loans pass through the bank's internal processes, the underlying collateral will eventually hit the market. This will be a slow bleed over the next couple of years, as the loans move from past due to workout to OREO and then to the market.

Another thought to consider is that just because a bank has a high problem loan ratio does not mean that it will fail. An investor should look at the capital cushion that the bank maintains to absorb losses, as well as the trend of the ratio.

The Federal Deposit Insurance Corporation (FDIC) reports that 2.6% of the $7.74 trillion in outstanding loans were in non-accrual status. The agency now has 416 problem institutions on its watch list. These institutions hold $300 billion in assets.

The Bottom Line
The panic phase of the financial crisis has certainly seemed to have passed, but they same can't be said for the pain caused by the indulgences of the last decade. We will continue to feel it for a few more years. (To learn more, see The Industry Handbook: The Banking Industry.)

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