'Texas Ratio' Falls Short as Tool

New York-For years, regulators have relied on the "Texas ratio" to get a quick read on the health of banks.

But A.M. Best's researchers say that in today's economy, the Texas ratio may not be the best way to get a read on the pulse of a banking institution.

And deterioration in the housing and mortgage markets is one factor undermining the Texas ratio's diagnostic accuracy.

The Texas ratio is nonperforming loans divided by the sum of total equity and loan loss reserves. Essentially, it weighs a bank's bad loans against the bank's cushion against losses.

But since earnings are a bank's first line of defense against credit losses, A.M. Best says that earnings capacity provides an additional layer of support. Despite the weak economy, 81%, continue to post a positive return-on-assets.

But because neither housing markets nor the general economy appear poised to rebound in the next few quarters, Texas ratios and earnings are likely to remain under strain, A.M. Best said.

Analyst Khanh Vuong, co-author of an A.M. Best report on the subject, said that the Texas ratio was widely used by regulators during the last banking crisis in the late 1980s to decide when to focus on closing a troubled bank. But in today's market, A.M. Best is not sure the Texas ratio is a good gauge, because it assumes all delinquent loans will end up as losses.

"We believe there are a lot of implicit assumptions in the ratio which we think are not necessarily accurate," he said.

Because consumer mortgages are at the heart of the current financial crisis, he said larger banks - super-regionals and international banks that invested heavily in MBS and derivative securities - in general have been hurt worse than community banks. However, smaller banks located in hard-hit areas like California, Florida, Arizona, Nevada or the industrial Midwest also have suffered, Mr. Vuong said.

So far, a "spiral effect" has compounded the mortgage sector problems, he said. The first round of mortgage defaults led to foreclosures, which reduced property values in many areas, which in turn exacerbated the industry crisis and sparked more foreclosures. So far, regulators and policymakers have not done anything to stabilize the housing markets and prevent the next wave of foreclosures from occurring, he said.

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