Small Bank Loan Problems

A set of findings that will be released today by the Congressional Oversight Panel which oversees the TARP effort highlights exactly the problem I have been focusing on for the past year. The problem is the health of small- and medium-sized banks.

“Nearly 3,000 small U. S. banks could be forced to dramatically curtail their lending because of losses on commercial real-estate loans.” This from the article by Carrick Mollenkamp and Maurice Tamman in the Wall Street Journal, “TARP Panel: Small Banks are Facing Loan Woes.” (http://online.wsj.com/article_email/SB20001424052748703455804575057851154035196-lMyQjAyMTAwMDEwMTExNDEyWj.html).

Elizabeth Warren, who heads the TARP oversight panel is quoted as saying, “The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures.”

My question is, why has it taken so long for this concern to surface at this level? This is vital information!

There are just over 8,000 in the United States. This means that from one-third to two-fifths of our banks face serious troubles with regards to their commercial loan portfolio, let alone any other problems they might face in their loan portfolios.

At the end of the third quarter, the FDIC had 552 banks on their list of problem banks. We will not get the report on the number of banks on the problem list for the end of the fourth quarter until later this month. The number of problem banks was expected to rise this year anyway before this information came out, but this is certainly not good news.

The rough rule of thumb is that one-third of the banks on the problem list can be expected to fail, and, using the third quarter figures, this means that two to three banks will fail each week for the next twelve to eighteen months. So far this year, we are roughly on track with this pace.

There are two problems here. First, the number of failing banks. The deposits and loans of these banks have to be absorbed into the banking system and this represents a de-leveraging of banks and the banking system that is consistent with the de-leveraging that is going on in the rest of the economic system.

Secondly, and this is what the Wall Street Journal focuses on, is that this atmosphere is not conducive to an expansion of loans. Whereas most of the big banks, (remember that the top 25 banks in the country have over 50% of the bank assets in this country) have become very active again, the small- to medium-sized banks do not have neither the resources nor the markets to pick up their lending or deal-making activity.

Unless you have worked in a smaller bank, you don’t realize the effort and the commitment of resources that is needed to work with troubled-lenders, especially if a substantial part of your portfolio is in loans that are having problems. You have neither the will nor the means to give much of your attention to making new loans.

Furthermore, even if you are not a part of the 3,000 banks facing a large amount of loan problems, why should you be lending much now? First of all, if you seem to be surviving, you are probably very, very thankful that you are not in the same position of these other banks and are feeling a great deal of relief. Yes, relief, but you are still wary, because the whole thing is not over yet.

Second, and I know this from my experience in turning around banks, if you don’t make a loan, that loan cannot go bad on you. The probability of this is 100%. That’s about as close to certainty that you can get in these very uncertain times.

The other side of this is something that I have said this many times before in these posts. The good news is that things seem to be pretty quiet on the banking front. Let’s hope that this quiet continues. Quiet is good, because it can mean that the bad and the not-so-bad situations are being worked out. And, if the economy continues to improve, some of the bad situations will become not-so-bad situations and some of the not-so-bad situations will actually become acceptable situations.

So, keep your fingers crossed.

This whole situation is further evidence of the extent that credit inflation enveloped the United States (as well as the world). In a credit inflation, it pays to go further and further into debt and to make more and more loans. At least, as long as the credit inflation can continue.

The leveraging and the moves to riskier assets usually begins with the larger institutions and then works its way through the economy. In most situations, the smaller institutions are the last ones to really follow the increased exposure that has been taken on by larger banks. However, more and more people and institutions succumb to the environment the longer the credit inflation continues. But, the increased risk taking does spread throughout the economy.

When the credit inflation stops, then de-leveraging must take place and this can be a long, slow process. And, again, the smaller institutions tend to trail the larger institutions. Thus, it is not surprising that the small- and medium-sized banks are still dealing with these problems even though the larger institutions have moved on.

Unless, of course, the government is able to “goose up” credit inflation again and eliminate the need to de-leverage.

The extent of the problem relating to “loan woes” is still substantial. The existence of this problem will weigh on the officials in the Federal Reserve System because a tightening of credit will just exacerbate the existing fragility of the banking system. The Fed does not want its “undoing” of the excessive amount of excess reserves in the banking system to be the “undoing” of the commercial banking system, itself.

The commercial banking system has always been a part of any economic recovery in United States history. It is hard to see how much of a recovery is possible if the commercial banking system, this time around, is “frozen”. At least for the small- and medium-sized banks.

Guess the loans to small- and medium-sized businesses will just have to come from the government!

(Please accept this last statement as being ironic!)