Bad loans stopped soaring at large and mid-size banks last quarter, but whether the credit cycle has bottomed out or is just taking a breather might depend on the success rate for loan modifications.

At the heart of the discussion is the shadowy nature of modified loans.

Nonperforming assets — which have skyrocketed throughout the recession — fell at a handful of lenders, including JPMorgan Chase, KeyCorp and Huntington Bancshares. And they grew at a sharply lower rate at companies like PNC Financial Services Group, Bank of America Corp., and Regions Financial Corp.

On the surface, the better numbers indicate that the massive losses banks have taken in their consumer and commercial loan books are peaking. But skeptics worry that improving nonperformer totals are deceptive because they have been skewed by banks' rising levels of modified loans, which usually are not categorized as nonperforming.

Modified loans tend to drive down nonperformers in the short term because borrowers can continue paying on a loan after winning concessions on principal or interest rate. But over time, a good chunk of modified loans tend to go bad.

The redefault rate on modified commercial loans has been more than 50% in past cycles, and a federal report late last year showed that more than half of home mortgages modified in the third quarter of 2008 became delinquent within a year. Redefault rates vary from bank to bank. Fifth Third Bancorp, for instance, said in its fourth-quarter report that 25% of the $2.7 billion of loans it has modified since 2007 have gone bust.

Paul Miller, head of research at FBR Capital Markets Corp., said the poor success rate of modifications makes him worry that banks could be in for a second wave of nonperforming assets when their modified loans eventually sour.

"It is very difficult to determine any trends because of all the modification programs that kicked into high gear in the summer," he said. This may or may not be "a turning point" in the credit cycle, he said, but "we don't know" because it is not clear whether loan quality is stabilizing.

Tom Mitchell, a senior analyst who covers financial stocks at Miller Tabak & Co., agreed that banks' modified loans may be skewing the picture.

"We now have to consider the [modified loans] as a kind of shadow group of nonperforming assets," Mitchell said. "It's reasonable to say that for most banks, if the loans had not been [restructured], they would have been nonperformers."

Indeed, several large banking companies that reported a declining rate of fourth-quarter nonperformers also reported sharply higher restructured loans. Zions Bancorp.'s nonperformers fell 1%, quarter to quarter, and its restructured loans rose 79%, according to a report from Deutsche Bank Securities, BB&T Corp.'s nonperformers, meanwhile, rose 7% last quarter after shooting up 18% in the third quarter; its restructured loans more than tripled. And KeyCorp reported $225 million in restructured loans in the quarter after reporting none the prior quarter. Its nonperformers fell 10%.

Mitchell said modified loans may be good for the overall economy because they buy time for business and consumer borrowers to get back on their feet financially. But they make it difficult to determine the true financial health of a bank, he said, because banks have wide latitude in how they report modified loans.

"The question is: Are things getting that much better that much quicker for the banks, and the answer is 'probably not,' " he said.

Loan modifications are rising for a few reasons. Banks — at the urging of the federal government — have been modifying underwater home mortgages for more than a year now. More banks began turning their attention to commercial-loan modifications last quarter after regulators issued a policy paper urging them to grant workouts to business borrowers with the cash flow to make payments, even if the properties are worth less than the loans on them.

Still, some analysts say nonperforming assets are clearly moving in the right direction, regardless of whether they swell in coming quarters should modifications fail.

Mark Fitzgibbon, the director of research at Sandler O'Neill & Partners, said nonperformers were "better than we thought they" would be in the recent quarter and that the industry may be reaching a turning point, regardless of the impact of modified loans.

Banks are more aggressively charging off loans after raising lots of capital last year, he said, and tighter oversight by regulators is also keeping them honest when it comes to identifying troubled credits.

"The regulators have gone around and scrubbed a lot of the balance sheets of these companies and forced banks to recognize problems," he said. "I think it is helping the industry begin to heal."

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