Monday, September 1, 2008

Commercial Banking and Bank Failures

Last Friday officials closed the tenth commercial bank this year. It was a small bank in Georgia with $1.1 billion in assets. The problem…rising loan defaults. The FDIC now has 117 banks on its list of institutions that are in danger of failing. The probability of a large number of these banks actually failing is quite large.

The failure of these banks does not get a lot of public attention. The reason for this is that most of these banks are relatively small and the losses they amass are not as eye-catching as the billions of dollars in charge offs of institutions like Merrill-Lynch and Citigroup. It is reported that the FDIC believes that the cost to the deposit insurance fund of this most recent failure to be in the neighborhood of $250 million to $350 million…a drop in the bucket.

But, the numbers add up as the number of defaults increases and the costs of a failure rises. Legitimate concern grows over the ability of the deposit insurance fund to handle future bank failures as well as the ability of the FDIC to administer a large number of failures. And, this doesn’t even consider some large bank failures that a few analysts assure us will take place. In terms of the losses in all financial institutions, the numbers, at present, are dominated by the overhang of the $200 billion that is the estimated cost of the Fannie Mae and Freddie Mac bailout.

The closing of commercial banks will only work itself out slowly over an extended period of time and, in general, the working out of these closures will be smooth and orderly. We are not in a liquidity crisis at this time, we are in a credit crisis. A liquidity crisis is a short term phenomenon where one side of the market, the ‘buy’ side, disappears. A credit crisis is a longer term situation in which borrowers default on their loans over time, a situation in which both sides of the lending transaction attempt to “work things out”.

A liquidity crisis occurs in a financial market where financial assets are traded on a regular basis. The essence of the market is the ability to buy or sell financial assets in a short period of time without having to make much price concession in order to complete a transaction. The liquidity crisis takes place when buyers are reluctant to acquire the asset and sellers have to substantially discount the assets they want to sell in order to have any hope of finding a buyer in the market.

The credit crisis that we are now going through in the commercial banking industry is one basically related to ‘non-market traded assets’. These are primarily assets that are on the books of the originator so that there is no market price which can be used to value the assets. These are loans made by the bank to a customer in which the bank keeps the loan that it has made. The customer then gets into a financial bind and either is unable to fully meet the terms of repayment or cannot repay at all.

In terms of banking practice, the commercial bank initially does nothing to adjust the value of the loan for the failure of the customer to meet the terms of the loan. The loan will first migrate through the bank’s delinquency report going from 30 days past due to 60 days past due to 90 days past due and so on. Loan collection efforts lag this movement through the delinquency list, going from computer generated delinquency notices to calls to direct collection efforts to ultimately selling the loan to a collection agency.

In my experience within the banking industry, the psychology of the management of a commercial bank goes from a belief that the customer is just have some timing problems, to “things will work themselves out”, to “we may have a problem here so let’s see how we can work with the customers and get things back on track”, to “we have a real problem here and we need to get tough”, to… Bankers have a real tendency to postpone action on the loans that they have put on their books because they have trouble believing that they have made a mistake. The loans are “personal”, something that shouldn’t happen in business. Right?

The consequence of this behavior is that substantial time usually elapses before commercial banks act on their loan portfolio problems. Examination and regulation can only partially speed up this process because the bank exams only take place periodically. Furthermore, it is the banks records and documentation that the examiners review and so time for observation and follow up must be allowed for. This is the reason for “watch” lists, not action.

The bottom line…the identification of bad loans and the process for correctly valuing these assets takes a long time. Consequently, a situation like the one we are in cannot be expected to work itself out quickly…the affects of the credit crisis will last of awhile.

One other issue in the banking arena I would like to discuss…start up banks. The bank that was taken over on Friday was located in the Atlanta suburbs. A Wall Street Journal article, ( reports that sixty (60) banks were formed in the Atlanta area between 2003 and 2007! Sixty banks!!!

I live in the Philadelphia area. Just last night I passed a new bank that I had no idea where it had come from and who was running it. This just reminded me that new, small banks had been popping up all over the place in the last few years. The number of new start up banks in the United States must be astronomical over the last five years!

Why this is so astounding to me is that it indicates, to me, a real let down on the part of the regulators…on the part of the Federal Government. Putting many, many new institutions into markets that are well banked is extremely dangerous. Yes, big banks don’t serve local neighborhoods as well as do smaller banks with a local focus. Still, the smaller bank must establish a niche market and is usually desperate for quality loans. Emphasis is on growth so loan generation is a must. And, these loans are not made to sell because the new bank wants the balance sheet growth, so the loans are booked. “High quality” borrowers are generally taken up by existing banks so any effort to get these loans must include concessions on rate or term of some other element of the loan agreement that squeezes the new bank. More often the new bank must go after loans of lesser credit or into local speculative deals. The Wall Street Journal article says that the Atlanta area, during this expansion in banks, was “marked by overbuilding and loose lending practices during the real-estate boom.” The staff of the regulators had to keep up with all of these new banks at a time when the staffs were being contained for cost reasons and the bigger banks were going into more and more complex transactions.

This last comment raises another point. My experience is that many of these “professionals” that started up these new banks had a pretty high opinion of themselves. They think that they are pretty sophisticated. In one of the commercial banks I turned around, I was astounded by the Investment Policy the bank had concocted, the board of the bank had approved, and the regulators had never made mention of. This was a small startup bank that had been in existence maybe five years and had assets of about $100 million. Their investment policy allowed them to engage in some of the most sophisticated investment vehicles that existed at the time. In my review of the management that had been in place, there was no one…repeat, no one…in the institution that had any qualifications to transact in any of the investment vehicles they had the authority to invest in. And, this authority, written down and approved by the bank’s board of directors, had not seemed to bother the examiners and regulators at all! Why do I think that this picture could have been duplicated many times over in the last eight years?

One final point about the current situation: a credit crisis like the one that we are going through usually has an impact on the extension of credit going forward. Commercial banks that have just been burnt with charge offs and faced the possibility of extinction become risk averse and do not extend credit. Bank funds will not be readily available to support much economic expansion.

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