Ranks of loan portfolios predict future decline in ranks of financial ratios

1. Ranks of Loan Portfolios Predict Future Decline in IDC Rank of Financial Ratios
IDC Rank of Financial Ratios
Each quarter, IDC Financial Publishing, Inc. (IDC), analyzes 40 financial ratios with specific ratio
scores summing to a rank of financial ratios ranging from 300 (the highest) to 1 (the lowest). The
IDC rating is, in turn, used to evaluate quality and safety with 200 to 300 being “Superior”, 165 to
199 “Excellent”, 125 to 164 “Average”, 74 to 124 “Below Average”, 2 to 74 “Lowest Ratios”, and
“Rank of 1” (the lowest rating). Over time, the investment community has established a rank of
125 or higher as investment grade, although some institutions use their own cut-off point for the
IDC rank.
Firms trading secondary Certificates of Deposit (CDs) depend on the rank to establish appropriate
yields for purchase or sale. New issue CD firms use the rating to establish which banks qualify for
issuance of CDs. Other than these investment firms involved in CDs, IDC clients use the rank to
determine the safety and soundness of a bank or savings institution or bank holding company in
their risk analysis.

2. Early Warning of a Potential Downgrade or Reduction in the IDC
Rank of Financial Ratios
IDC has developed and produced a rank of loan activity since 1989. The loan rank
varies from 300 (the highest) to 1 (the lowest). The rank attempts to mark-to-market the
loan portfolio yield. The reported gross yield is reduced by the expected loan charge-off
rate based on history. In addition, a rise in loan delinquency can increase the expected
charge-off rate. Finally, the gross yield less projected charge-off rate is reduced by the T-
bill yield as an expected cost of funds, and, separately, by the actual cost of funds.
Together with other key loan ratios, such as earnings coverage of projected charge-offs,
risk-adjusted loan yields are used to calculate the loan rank. A loan rank below 125
indicates potential risk.
The Macro View of the Loan Rank Illustrates Loan Rank Predictive Power
The most sensitive measure of housing and potential mortgage loan activity is the
Housing Market Index (HMI). The HMI measures market conditions for sales of homes,
the traffic of prospective buyers of new homes, and realtor sentiment. The HMI has been
a significant leading indicator of housing and mortgage activity plotted on chart I since
1988. Mortgage loan activity and the housing cycle forecast problems in bank real
estate loan portfolios.
In 2003, the average IDC loan rank for banks and savings institutions and, separately for
bank holding companies, peaked and declined prior to the peak in the HMI.

3. The HMI decline began in 2005 at a peak of 72 and fell dramatically in 2006 to 30, forecasting
the sharp decline in IDC loan ranks for banks and savings institutions. The significant decline
in average loan ranks from 200 in 2004 to 16 by year-end 2009 for bank holding companies
predicted a sharp decline in the IDC rank of financial ratios for bank holding companies. The
peak in 2004 in the loan rank for the average bank and savings institution at 170 and decline
to 36 by year-end 2009, forecasted the significant decline in IDC ranks of financial ratios for
banks and savings institutions into 2008 (see chart I).

4. A second macro view of the timely decline in the loan ranks of financial institutions
occurred as loan ranks peaked in 2003, declined sharply in 2005 and, especially, in 2006
and 2007. The loan rank decline in bank holding companies led the peak in bank stock
prices (KBW Index) which occurred in late 2006. By early 2009, the IDC loan rank
declined from a peak of 200 in 2004 to a low of 16 in 2009, preceding the dramatic decline
in bank stock (KBW) prices (see chart II).

5. A Micro Method Produces a Downgrade List
A 20% quarter to quarter decline in the loan rank with the loan rank below 125, or, by
itself, a loan rank of less than 75, triggers a projected 2 to 4 future quarter or longer
decline in the IDC Rank of Financial Ratios. The loan rank decline triggers a
downgrade if the following conditions are met:
•IDC Rank of Financial Ratios exceeds or equals 125
•Tier 1 capital is less than 12%
•Loans are 40% or more of earning assets
•Balance sheet cash flow is available and not N/A due to merger or change of
ownership
Not all of the banks and savings institutions have a subsequent decline in rank of
financial ratios, since loan quality can improve or the Tier 1 capital ratio increase
significantly. However, quarterly analysis since 1989 illustrates a vast majority of
institutions flagged by a 20% decline in loan rank to below 125, or, by itself, a loan rank
of less than 75, led to a future 2 to 4 quarter or more decline in the IDC rank of
financial ratios. A prolonged decline in the loan rank below 125 toward “1” flagged a
high risk financial institution (See lowest loan rank and quarter of occurrence on table
of largest financial institutions on downgrade list).

6. Loan Ranks Target a Select Number of Banks on the Downgrade List
The number of bank holding companies on the downgrade list reached a peak of
304 in the third quarter of 2009 and were normally less than 100 each quarter. The
number of commercial banks and savings institutions on the downgrade list
reached a peak of 1,280 in the first quarter of 2009 and averaged around 700 a
quarter since the fourth quarter of 1989. The bank holding companies and
commercial banks and savings institutions on the downgrade list were a fraction of
the number of institutions with “Ranks of Financial Ratios” produced by IDC each
quarter. As noted below, the largest five bank holding companies, and, separately,
individual commercial banks and savings institutions on the downgrade lists
demonstrate quarterly from 2005Q1 to 2007Q4 the value of targeting risk with the
loan rank.

7. Decline in loan Rank Preceded Stock Price Decline
A second way to evaluate the loan rank decline, as a forecast for a high risk-bank,
charts the loan rank with the bank’s stock price. See the chart below for National City
Corporation (NCC) from March 2003 to September 2008. Note, the NCC loan rank
declined significantly in 2006, before the stock price which declined sharply from
March 2007 to September 2008 (see chart III).

8. Largest 5 Financial Institutions on the Downgrade List Quarterly
from 2005Q1 to 2007Q4
During a period of a decline in the overall average loan rank from 2005 to 2007, IDC listed
the top 5 bank holding companies and, separately, the top 5 commercial banks and
savings institutions in asset size. The downgrade listing of the top 5 in this period
illustrates the success of the downgrade list as a predictor of potential risk. Identifying
Countrywide Financial in the fourth quarter of 2005 or National City Corporation in the
second quarter of 2006, as well as, many other bank holding companies, and other
individual banks, are examples of the predictive success of the loan rank (see attached
table).
Conversely, in periods of an increase in the average loan rank from 2009 to the current
period, fewer bank holding companies or individual banks qualify for the downgrade list.
The selective few on the target list for downgrade have potential loan problems in their
respective institutions.