When it came to handing out business loans, commercial banks and savings institutions continued to be ultraconservative in the third quarter of 2010. Balance-sheet problems lingered for many, especially in commercial real estate portfolios. Still, as an industry, banks managed to wring profits out of operations, according to the Federal Deposit Insurance Corp.’s quarterly report issued last week.

Commercial banks and savings institutions earned $14.5 billion in total last quarter, and only 18.9% of them had a net loss. But that was down from the second quarter’s $21.4 billion. Excluding Bank of America’s $10.4 billion goodwill impairment charge in the third quarter, FDIC-insured banks reported a modest increase in earnings.

But rising profits came from reductions in set-asides for loan losses, which are a charge against current earnings. Provisions for loan losses fell 45% in the third quarter, to $28 billion. Real sources of income, such as banking fees, fell 7.2% year-over-year, led by declines in servicing fee income and service charges on deposit accounts. The profitability of banks was also hurt by a 16% rise in noninterest expenses.

Business lending in the form of commercial and industrial (C&I) loans increased for the first time in eight quarters, but banks continued to report lackluster demand. While deposits increased, the loan-to-deposit ratio for FDIC banks fell to 86% in early November, the lowest number since 1994, says a report from CreditSights, a bond-market advisory firm.

So where are banks putting all their money? While total assets at FDIC-insured banks rose $163 billion in the third quarter, $113.7 billion of that was holdings in investment securities, which rose 13.8% compared with the same period last year. Banks are even playing it safe with these securities investments. The percentage of government securities in bank portfolios rose to 66% earlier this month, the highest level since 1994.

That, says CreditSights, indicates “a flight to quality in an uncertain economic environment” and “the pressure coming from regulatory uncertainty.” Lending numbers also imply that “banks are not fully capitalizing on the benefits of the steep yield curve, which the Federal Reserve’s monetary accommodation facilitated,” says CreditSights.

The good news is that poor-quality assets are rolling off or being sold off the books of some banks, potentially clearing the way for new investment. Noncurrent loans and leases (those 90 days past due or not accruing interest) fell for the second consecutive quarter, and banks charged off $42.9 billion in uncollectible loans last quarter, down $8.1 billion from a year earlier. Net charge-offs of C&I loans fell 41.8%, or $3.6 billion, while noncurrent C&I loans were down 4.3%, or $1.5 billion.

A Keefe, Bruyette & Woods research report last week found $16 billion of problem asset sales by banks so far in 2010. Regions Financial, Fifth Third Bancorp, First BanCorp, and Flagstar Bancorp were among the sellers of nonperforming loans.

While the total dollar amount of loan loss reserves across the industry declined by 3.8% in the quarter, almost 60% of banks and thrifts still increased their loan loss reserves, contradicting the idea that loan losses have already peaked.

In particular, portfolios of commercial real estate loans are still deteriorating. The ratio of nonperforming CRE loans increased to 5.78% in the third quarter, from 5.26% the quarter before, according to an analyst note from Susquehanna International Group. Net charge-offs also rose. The nonperforming ratio for the most toxic type of loan — construction and development — is still at an extraordinarily high 16.94%, says Susquehanna.

In another bad sign, the number of banks on the FDIC’s problem list rose from 829 to 860, the highest number since March 1993. One hundred twenty-seven banks failed in the first three quarters of 2010, and 2 more have done so in the current quarter.

The FDIC’s fourth-quarter report on banks and thrifts probably won’t look any rosier, analysts warn. Many banks take a loss at year-end as they try to clean up their balance sheets for the coming year.

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