Fewer cracks in their foundations

Central Bank & Trust Co. watched as competitors waded into the murky waters of subprime lending.

Unlike larger regional banks such as National City, Fifth Third and Wachovia, the Lexington bank resisted the urge for greater rewards from the riskier loans.

"If I could sum up in a word what's happened to the banking business it would be 'greed,'" said Luther Deaton Jr., Central's chairman and chief executive.

Subprime refers to mortgage loans made to homebuyers with low incomes or damaged credit ratings.

Those loans produced big fees for banks during the housing boom, but have gone bad in droves as the economy has nose-dived and homeowners have slid into foreclosure.

Defaults on subprime loans contributed to the recent problems of such diverse financial institutions as Indy Mac Bank, Bear Stearns, Fannie Mae, Freddie Mac, Lehman Brothers and Merrill Lynch & Co.

Subprime defaults also have bedeviled the bottom lines of smaller regional banks that have offices in many Kentucky cities.

"Generally, the large, major regionals have taken on more (subprime) risk ... and the problems with those risks are now coming home to roost, said Richard DeKaser, chief economist for National City.

Beyond the anguish felt by homebuyers, there's the damage to the banks:

■ Cleveland-based National City, which has the largest share at 8.5 percent of Kentucky's bank deposits, reported a second quarter loss of nearly $1.8 billion, or $2.45 cents a share.

■ Another regional bank, Cincinnati's Fifth Third, posted a loss of $202 million, or 37 cents a share, for the same period.

■ To the south, Wachovia had a second quarter loss of $8.9 billion, or $4.20 a share.

All three banks slashed stockholder dividends and raised more capital to rebuild reserves. Wachovia is also exiting the wholesale mortgage market entirely.

Two other regional banks that also have branches in Kentucky, U.S. Bank and BB&T, saw significant drops in profits.

Few Kentucky-based banks yielded to the allure of quick profits from subprime lending.

That's one reason a state that ranks 26th in population had the 11th most profitable banks in the nation in the second quarter of 2008, up from 16th in the first quarter, said Don Mullineaux, banking professor at the University of Kentucky. Kentucky also ranks near the top in bank profits in the Southeast.

In contrast, the average bank in eight states — Michigan, New Mexico, Florida, South Carolina, Virginia, Arizona, California and Nevada — is "losing money," he said.

The average bank nationwide is only about one-third as profitable as the average Kentucky bank, according to calculations by the Federal Deposit Insurance Corp.

"If we had National City and Fifth Third headquartered in this state," Mullineaux said, "the numbers would be different."

Deaton remembers being "pressed" to offer subprime loans, but "we didn't get caught up in that."

Central also refused to join larger banks in paying high interest to attract deposits, which would have meant higher loan rates. "Some deposits left the bank. Now we are getting them back," Deaton said.

Some Kentucky banks have run into problems, but not usually because of subprime loans. Regulators have issued cease-and-desist orders involving four banks in the last two years for questionable lending and management practices.

Most recently, Frankfort-based American Founders Bank and Bank of the Bluegrass in Lexington were cited by the Federal Deposit Insurance Corp. for their policies and procedures.

When it comes to mortgage loans, Kentucky lenders have benefitted from stability, DeKaser said. "The Kentucky housing market hasn't had the sort of boom-bust experience that other places have."

Overbuilding and price inflation have been less of a problem than in other states and the general economy has remained stronger than in "the Great Lakes auto land" to the north.

While home sales are down, real estate values have declined less in Kentucky and foreclosures — lenders seizing the houses of delinquent mortgage holders — have been far fewer than in housing boom states, DeKaser said.

Kentucky's good fortune is attracting national attention, too.

Sandler O'Neill + Partners banking analyst Kevin Fitzsimmons called Kentucky a "safe haven" on recently.

He recommended that investors consider buying the stock of Porter Bancorp, which is based in Louisville.

"That is a market that has held up very well," Fitzsimmons said.