Bankers grew so sloppy about risks during good times that they may now need to cut dividends and raise more capital to prepare for coming problems, Federal Reserve Vice Chairman Donald Kohn warned Thursday.
In remarks to the Senate Banking Committee, Kohn warned that weak earnings and asset value write-downs loom for bankers who didn't prepare in prosperous years for current problems with housing and other loans.
"The extended period of good times in the banking system bred a sense of overconfidence among many bankers and other market participants, causing them to underestimate risks and not fully consider the potential for those good times to end," Kohn said.
Kohn was on a panel of regulators who appeared before the committee to answer questions about how the banking sector was faring as a widening sea of problems engulfs the U.S. housing sector and raises fears of potential bank failures.
He warned that the quality of existing loans likely will keep deteriorating for some time.
Worse To Come
"House prices are still declining sharply in many localities and losses related to residential real estate -- including loans to builders and developers -- are bound to increase further, Kohn said.
"Weak economic conditions could well extend problems to other segments of lending portfolios including consumer installment or credit card loans, as well as corporate loan portfolios," he added.
The chairman of the Federal Deposit Insurance Corp, Sheila Bair, warned that weakening real estate markets could take down bigger banks than in the past because of their hefty lending for costly commercial projects.
"There is also the possibility that future failures could include institutions of greater size than we have seen in the recent past," Bair said. "Uncertainties in today's economic environment continue to pose significant challenges for the banking industry, households, and bank regulators."
Kohn said loan loss reserves that banks have set aside have not kept pace with growth in problem assets and should be bolstered.
Shareholders May Suffer
"In view of this uncertain outlook, additional capital injections and consideration of dividend cuts are still warranted for some of these companies and we have strongly encouraged supervised bank holding companies to enhance their capital positions," Kohn said.
A gauge of the strain that housing markets are under came from the Mortgage Bankers Association, which said on Thursday that home foreclosures and the rates of homes entering the foreclosure process hit record levels in the first quarter.
Leading the wave of failing loans were so-called subprime borrowers -- people with spotty credit records still able to get mortgages in the boom period before 2006 -- who now cannot keep up their payments.
A record 0.99 percent of U.S. loans were entering the foreclosure process in the first three months of 2008 compared with 0.58 percent in the same period a year earlier, the lenders' lobby group said.
Kohn said banks must pay more attention to the fact that market liquidity "may erode quickly and unexpectedly," so they need to maintain "more robust" liquidity and capital cushions.
"This is a key point supervisors are reinforcing strongly," Kohn said.
The Fed is one of several supervisory agencies that monitor the nation's banking system, in particular the big bank holding companies.
Kohn said the Fed intends to send strong supervisory messages to senior bank managers -- "perhaps with more force and frequency than in the recent past" -- to make sure they do not again lose their focus on the importance of sound risk management.
John Reich, director of the Office of Thrift Supervision, said in testimony that savings institutions were "generally" holding up remarkably well in the current climate.
Reich said the agency, which largely regulates mortgage lenders, found the number of problem thrifts rose this month to 17 from 12 at the end of the first quarter.