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As the credit downturn enters its second year, financial institutions are searching for evidence that the worst is over. Capital markets have regained some life, but most U.S. and European banks maintain a heightened sense of alert as difficult business conditions and substantial writedowns continue to weigh on financial performance.



Is this as bad as it gets for banks, or are more bleak times ahead? Current conditions demand intimate understanding of credit and liquidity risks and will require banks to make some tough choices as the downturn evolves. Government support and sovereign wealth funds' cash infusions have helped put the industry on a path to recovery. However, the rebound will be slow and painful.



Indeed, Standard & Poor's Ratings Services believes a return to a stable banking industry outlook is at least a year away in the U.S. Beyond the high-profile downgrades we issued during second-quarter 2008, our outlooks on U.S. banking groups shifted toward negative by the quarter's end. In the U.S., 22 of our 50 top-rated financial institutions had a negative outlook as of June 30, 2008, the highest proportion of negative outlooks in top-tier mature-market financial groups in the past 15 years. This means we may downgrade leading financial institutions during the next one to two years, on top of the 31 negative actions we've already taken since the beginning of 2008.



Of course, our future actions will depend on economic conditions and how individual companies handle the downturn. With the U.S. facing worsening economic prospects, in the opinion of S&P's Chief Economist David Wyss, further stress on the industry is likely. The news hasn't been all bad, however. A handful of financial institutions with strong balance sheets and robust capital are in a prime position to take advantage of the credit-market dislocation.



To provide insight into what might happen in the months ahead, Standard & Poor's analysts gathered on July 30 for a roundtable discussion of the most critical issues facing financial institutions, particularly in the U.S. and Europe. Excerpts from the discussion, moderated by Jay Dhru, global head of financial institutions ratings, follow:



Financial institutions worldwide have experienced a wild ride so far, from huge writedowns of asset-backed securities [ABS] to the disappearance of Bear Stearns to the recent failure of IndyMac Bank in the U.S. Could you put the seriousness of the situation in historical perspective and hazard a guess as to when this sector might right itself?



Tanya Azarchs, North American regional criteria officer: This will probably go down in history as one of the worst periods for banks, not only in the U.S. but potentially abroad as well. It's worse than 1998 and worse than 1994 in that it has not only caused very, very sharp drops in asset prices, but also has resulted in market illiquidity for more than a year now. Previous periods had lasted just a few months at a time.



The reason for the illiquidity is real asset price declines following a period of very sharp increases in those asset prices. These price declines have essentially telescoped into losses in a very short period that would have otherwise been taken by the banks during a long period under the accrual method of accounting. This has hit banks with large capital market activities extremely hard. In these harsh conditions, central bankers have done an excellent job of trying to alleviate some of the liquidity conditions, but we don't really expect those conditions to improve dramatically in the next year.



On top of that, we're now entering what we would call phase two of the problem, which is that the banks' loan books are starting to deteriorate very rapidly. This is hitting a wider array of financial institutions, not just those with capital-markets activities but also those with traditional banking activities. The problems are now hitting mortgage-related loans, but we expect credit losses to migrate into the other sectors of consumer lending. Eventually, they may also widen out into commercial lending as well, particularly in the real estate sector.



Rodrigo Quintanilla, head of North American bank ratings: The stress that the housing markets are enduring hasn't been seen since the 1930s, and unlike during other previous crises or downturns, the central bank has limited flexibility to conduct supportive monetary policies because of competing factors such as inflation, currency rates, and oil prices. So it's sort of a perfect storm.



I would also say that this cycle is unprecedented not only in terms of the types and amount of losses but also in terms of capital raising. We haven't seen in any previous cycle as much capital raising to match potential losses, and that's a positive balancing effect. How long this will go on and how much of this capital-raising capability smaller banks will have available to them are questions that remain unanswered. That said, as Tanya pointed out, we probably will see the lagging effect of consumer lending and commercial real estate delinquency flowing well into 2009. So we won't likely see the beginning of the recovery or firm signs of a recovery until very late in 2009 or the beginning of 2010.



What are our key credit concerns for the sector for the rest of this year and into 2009? Which segments of the industry will weather the current crisis well, and where are there still question marks?



Scott Bugie, global head of financial institutions criteria: There is still concern about market liquidity. Financial institutions have fewer options for raising funds to do business. Structured financing, which had been a big source of loan financing, is still very weak. Financial institutions' continued access to liquidity and their skill in managing shifting sentiments in the debt markets will be key rating factors in the future.



Otherwise, we have concerns about institutions with exposures to certain geographies and business lines that are under credit pressure. The U.S. is the first major economy to feel the heat, as it was in the sector downturn of the late 1980s and early 1990s. Back then, it took a couple of years before we saw problems to the same extent in Europe. Britain, Spain, Ireland, and Australia are feeling the strain as well. We expect other countries to have similar problems down the road with periods of overheated prices and market correction, mainly in housing. In terms of business lines, U.S. retail and commercial mortgage banking are continued concerns. Structured products are also weighing heavily on debt trading, particularly for investment banking.



Certain institutions that are outside of those geographies and business lines and some of the smaller bread-and-butter institutions in countries that I didn't mention -- in continental Europe, for example -- are looking O.K. So far they haven't had many credit concerns.



We're hearing a number of different estimates for total industry losses ranging from $1 trillion to $2 trillion. What are our current estimates for total financial industry losses?



Azarchs: The capital markets divisions of large financial institutions globally have taken about $300 billion in writedowns on mortgage-related and other market-disrupted instruments such as leveraged loans, commercial mortgage-backed securities [CMBS], and auction-rate securities. The mark-to-market writedowns embody a sometimes significant liquidity premium for those securities, which means that if the banks were to hold them to maturity, the actual losses could be lower. Mark-to-market losses should continue to be recorded in the next couple of quarters as banks begin to unload securities at distressed prices and work out deals for their exposures to debt [hedged by bond insurance].



In addition, the problems are spreading to Alt-A MBS. Together, these issues could produce further losses that should be material, but less than the amount taken so far. Regional banks that hold MBS in their available-for-sale portfolios may have to take impairment charges if prices don't recover. This doesn't include what we think will happen with the loan books.



The earliest signs of consumer stress have been in the home equity and first-mortgage arena, but it is spreading to other aspects of consumer lending. Auto loans are a smaller sector for financial institutions, but have some mild amounts of stress. Credit cards are a larger sector, particularly for the four banks that are heavily concentrated in that area, and we've seen loan losses start to climb steeply.



We're still relatively certain that the peak losses in credit cards will not be higher than historic norms. This is partly because it has been a concentrated area with a relatively small number of banks competing in a relatively rational way. We've not seen the same kinds of wholesale abandonment of prudent underwriting standards here that we've seen in the mortgage market. In addition, the credit card securitization markets don't seem to have exhibited the same kind of stress that the mortgage ones have, partly because banks retain a lot of skin in the game with credit-card securitizations. So, we just don't think that there's going to be evidence of the same kind of excesses that there was in mortgages.



The losses that we would estimate in the loan books of U.S. banks could be as high as $265 billion per year for the next two to three years, as opposed to the $30 billion in the more benign environment of 2006. Provisioning may be front-loaded into 2008 as banks build reserves to meet the higher loan losses they expected. The issue is that the loan book losses will affect a wider variety of banks, not just the large banks with capital-markets activities. We believe losses will center first on the residential mortgage-related loan books and then on homebuilder loans. All consumer loans will come under pressure, possibly spreading out to the normal commercial and industrial lending, and potentially commercial real estate later on.



Bugie: It's worth noting that the loan losses will occur during the next few years, in contrast to the first phase of this cycle, which saw an accelerated recognition of losses because of the mark-to-market requirements for securitized instruments. This makes the shape of the cycle very different from that of the late 1980s and early 1990s, where the mark-to-market issues just didn't exist.



Michelle Brennan, regional criteria officer [Europe, Middle East, and Africa] bank ratings: In Europe, wholesale banking losses and other writedowns of structured finance investment portfolios continue to be high, but the focus is now shifting to the emerging problems in traditional loan books as the European economies enter a downturn at varying speeds.



We expect to see these economic pressures reflected first in slower lending and in revenues before we see significant loan-loss charges emerge. Although traditional loan books are generally still performing well, we also see increasing signs of asset-quality pressures in some specialized books, and expect this to spread more widely depending on the slowdowns in the European economies. We expect asset-quality problems to be a feature of 2009 rather than 2008 results, but this has already led to negative rating actions or outlook changes in Britain, Spain, and Ireland during second-quarter 2008.