For the first time in three years, Washington banks and thrifts as a group had two consecutive profitable quarters, a sign the industry may be stabilizing from its worst crisis in decades.

But can they keep it up?

Washington-based institutions broke a 10-quarter streak of losses in the first quarter this year, with a $36.3 million profit, according to data from the Federal Deposit Insurance Corp (FDIC). Then they made a $55.8 million profit in the quarter ended June 30.

It's a phoenix-out-of-the-ashes moment for an industry that got used to a profit every year from 1984 to 2007. Then their earnings collapsed: Washington-based commercial banks collectively lost $903 million in 2008, $1.8 billion in 2009 and $337 million in 2010.

The state's thrifts didn't escape the bleeding either, losing $209 million in 2009, FDIC data show.

But the industry still faces strong headwinds to future growth: Record low interest rates squeeze banks' margins. Bank stocks are trading so low that it's hard to put together merger deals.

And weak economic conditions limit the number of creditworthy borrowers.

"Loan demand is the biggest problem facing the banking industry," said Sara Hasan, an analyst at McAdams Wright Ragen, a Seattle brokerage.

Some banks' profits in the second quarter resulted from executives cracking open their piggy bank of loan-loss reserves, analysts say. Banks that have sold off troubled loans are now drawing down those reserves, which inflates their bottom line.

But they can't keep repeating that, said Tyler Hall, a senior analyst at SNL Financial. "It's certainly not a sustainable source."

Focus shifts to profits

Whereas a year ago, investors worried about the specter of bank failure and focused on institutions' capital levels and troubled loans, the focus has shifted to banks' profitability.

Most banks' balance sheets are brimming with deposits. Jittery investors are parking their money where it's insured even if banks are paying little or no interest.

"There is a lot of cash in the banking system," said Gary Schminkey, chief financial officer of Tacoma-based Columbia Banking System.

But the deposit boom hasn't boosted most banks' net interest income, their biggest source of profits.

That's because banks can't find enough quality borrowers, and the fierce competition for solid borrowers holds down the interest rates banks can charge.

As a result, banks' net interest margins are getting thinner and thinner.

Seattle-based Washington Federal, the largest thrift in the state, went through eight consecutive quarters where it had more loans paid off than new loans being made, said Chief Financial Officer Brent Beardall.

The thrift finally broke that streak in the second quarter. With the Federal Reserve's assurances that the nation's central bank plans to keep interest rates low for two years, "our pricing is more competitive today than it was six months ago," he said.

Buying failed banks' loans has buoyed profits at Columbia Banking and Washington Banking Co., the parent company of Whidbey Island Bank.

In the second quarter, about 15 percent of the quarterly growth in Columbia's net income was the result of its acquired loans, Schminkey said. The rest came from making new loans, partly by taking business from other banks, he said.

The focus going forward "is going to be trying to get some loan growth and managing through a difficult interest-rate environment," he said.

Signs of stress

Despite the industry's improved profitability, the second-quarter results show that some banks aren't out of danger yet.

Thirteen Washington banks — including Bank of Whitman, which failed Aug. 5 — had "Texas ratios" above 100 as of June 30, according to SNL Financial.

In other words, for every $1 in loan-loss reserves and capital these banks had, they had more than $1 in nonperforming and past-due loans.

The ratio, developed during the savings-and-loan crisis in the late 1980s and early 1990s, is widely considered a sign of stress.

Many of the 13 are in the Seattle area: Regal Financial Bank, First Sound Bank, Viking Bank, HomeStreet Bank, Eastside Commercial, Seattle Bank and Bank of Washington.

Viking Bank announced Sept. 8 it was selling itself to Spokane-based AmericanWest Bank, which is flush with capital from private-equity firms and other investors.

Banks with high Texas ratios can survive by raising capital and selling off the worst assets, SNL's Hall said.

But the light at the end of the tunnel?

"As the economy improves, so will the banking sector as a whole," he said.

Sanjay Bhatt: 206-464-3103 or sbhatt@seattletimes.com