A couple of facts about small bank failures in the US

There are still a number of misconceptions with regard to the volume and the causes of most commercial bank failures in the US after the financial crisis. Here are a couple of facts that some may find helpful:

1. Although 2008 saw some spectacular bank failures such as Citi, WaMu, and Wachovia (note that Bear, Lehman, Merrill, and AIG were not banks), the actual number was dwarfed by the Savings and Loan Crisis in the late 80s. Nevertheless there were nearly 500 small and regional banks that failed over the last 5 years.

Number of US bank failures per year

2. Contrary to popular belief, the biggest reason for bank failures was not the losses associated with bad small business loans, derivatives, or even residential mortgages. Just like during the Savings and Loan Crisis, it was the overexposure to commercial real estate loans that brought many banks down. And it was the commercial real estate loans that saw the worst default rates. The chart below shows the delinquency rates by major loan type for smaller and regional banks (ex top 100).

Source: FRB

Some argue that smaller banks did more relationship-driven lending than their larger cousins. True, but that type of lending was exactly what often ended up in an FDIC takeover. Bankers' cozy relationships with local developers were prevalent and often ignored by the regulators.

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Bank ratings migration is an attempt to fix old errors

Here is a recent chart from Fitch that shows ratings migrations for US banks between 2007 and 2011. The trend makes sense in terms of what has transpired during this period as the whole ratings distribution was shifted down.

Banks ratings migration (Fitch)

But take a second look at these results. Ratings are supposed to represent credit risk. Therefore this is telling us is that there is more risk in the US banking system now than there was in 2007. Really?

The chart below shows the core capital ratio for all FDIC insured institutions. It represents tier-1 capital as a percent of average total assets (with some adjustments per FDIC). This is telling us that bank capitalization in the US has improved significantly since 2007.

US bank capital ratio (FDIC, Bloomberg)

The weaker banks - 417 of them - have been closed since 2007.  So how is it that according to Fitch US banks are more risky now? Maybe it has to do with bank ratings being incorrect to begin with - possibly off by several notches. And maybe this "rating migration" is simply an attempt to correct that error.

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The European bank failure hype from Forbes

Nigam Arora, a contributor to Forbes Online, wrote the following today: 

Forbes: It appears that a big European bank got close to failure last night. European banks, especially French banks, rely heavily on funding in the wholesale money markets. It appears that a major bank was having difficulty funding its immediate liquidity needs.

"It appears" Mr. Arora?  This certainly started a buzz in the market.  Arora continues: "The cavalry was called in and has come to the successful rescue."

And where exactly are you hearing about this supposed bank failure?  Maybe you can tell us how a 50 bp reduction in dollar borrowing rate would have averted a European bank failure?

Just because you are an engineer and a nuclear physicist, are we supposed to take your word for it? Absolutely no evidence of such an event has been provided in the article.  So congratulations Mr. Arora.  You get the Sober Look Hype Award.

We are doing well with the Hype Awards - two already this week, and that doesn't even count the La Stampa fiasco.

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The world according to Fed: resolving large financial institutions

In order to address the "too large to fail" issue the Fed has begun a campaign to promote their solution: some form of a resolution regime for systemically significant financial firms. The Fed's goal is to broaden their regulatory reach and to prevent the US Congress (filled with populist fervor) from trimming the Fed's power. What the Fed is proposing is actually a complex piece of legislation that will span beyond the banking industry. It has the potential to engulf large insurance firms, financial advisory and securities firms, and even asset management firms.

Dan Tarullo's speech (included below) provides a good outline of such legislation. Other Fed governors are starting to carry the same message as part of their campaign to vastly boost the Fed's powers. You can see it gently inserted on slide 26 in James Bullard's recent speech for example (see included). Here are the three pillars of this special resolution process:

1. When the Fed determines that a institution that is on their too large to fail list is about to fail (or take some other action that threatens the financial system), the central bank would invoke the "special regime" to take control of the institution. The Fed would then have a broad authority to dissolve or restructure this company, including liquidating assets and businesses, as well as the ability the ability to set up a temporary firm to purchase and "warehouse" certain assets. Note that this is similar to the authority the FDIC holds in dissolving banks they regulate.

2. The shareholders and some creditors of the failing firm would bear the losses associated with this process. It's not clear to what extent the creditors would be hurt by this, because The Fed would clearly have to step in and guarantee some of the liabilities of the organization (for example institutional bank deposits or repo financing). Otherwise such liquidation may be no different than what the courts would do in a bankruptcy scenario. The model may become similar to that used in restructuring the US auto firms - some form of direct negotiations with creditors. Depending on the level of Fed's independence, the process may even become politicized.

3. The Fed would set up an "insurance fund" similar to the FDIC's fund to be used in orderly liquidation operations. The "too big to fail" organizations (again not just banks) would be assessed ongoing fees to capitalize the fund. Over time the fund would be significant enough to support a failing institution through the restructuring/liquidation process.

Developing such legislation is a massive undertaking with numerous key unanswered questions such as which organizations would be deemed too big to fail, how will the creditors be dealt with, how would the regulation of these institutions be different, will this make the Fed too powerful, etc. The model of course is the FDIC's bank takeover process - but on steroids, as these institutions are infinitely more complex. Of course no matter what form this process takes, it does create a form of moral hazard by backstopping certain risks in the financial system.


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FDIC gets creative in bank liquidation

A typical FDIC transaction involves what's called "Whole Bank with Loss Sharing”. That means the bidder has to be a bank or be pre-approved for a bank charter. The acquirer takes over the failed bank, all of it's deposits and the bulk of it's assets. The FDIC shares in future losses on the acquired portfolio.

Banks willing to acquire other banks are few and far between these days due to significant capital constraints. Non-bank capital is sometimes easier to access. Therefore the FDIC decided to take a slightly different path with respect to Corus Bank in Chicago. The bank (11 branches) with most of it's deposits ($7 billion - mostly CDs) went to MB Financial Bank. The bulk of the assets however was sold to a consortium of private equity firms including Starwood, TPG, Perry Capital, and a JV between Wilbur Ross and LeFrak Organization. The consortium bought $4.5 billion of condominium loans and foreclosed properties.





By involving non-bank capital, the FDIC was able to get MB Financial to take over the bank. MB Financial did not have the resources nor the stomach to take risk on the $4.5 billion of condo assets. The FDIC will need to do more of this in order to place failed banks in the hands of someone who can operate them. It needs to be open for more non-bank capital to bid on bank assets in order to make it palatable for "healthier" banks to step in.

The question that still remains is how Corus (and banks like it) used taxpayer insured CDs to finance a concentrated condo loan portfolio and whether the condo developers "encauraged" the bank to lend.

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Political double standard in bank failures

In a recent post we discussed the fact that regional and small banks are overexposed to real estate, which has been the primary reason for their rapid failures. The latest failures in Georgia represent a good example of this exposure.

As the FDIC shuts these Georgia banks down, the state politicians are getting increasingly annoyed, as if the failures are the FDIC's fault. What happened to tough new regulation? Or does it only apply to those banks in New York?

WSJ: Just two days after Reps. David Scott (D., Ga.) and Tom Price (R., Ga.) chastised Federal Deposit Insurance Corp. Chairman Sheila Bair about the rapid number of banks failing in Georgia, a Georgian bank failed. Fittingly, its name was Georgian Bank.

It’s the 19th bank in the state to close so far this year. That means of the 95 banks that have failed in 2009, 1 in 5 have been in Georgia. Regulators have cracked down on banks in the state, in part because real estate losses are extraordinary. Georgia lawmakers are furious and blaming the FDIC in part for overreacting.

Many politicians in Georgia have received political contributions from banks and real estate developers, therefore this reaction should not be a surprise.

WSJ: Georgian Bank was the second-biggest bank headquartered in Atlanta. It had $2 billion in assets, five branches, and roughly 185 employees. It also had major problems tied to real estate. Its chief executive was pushed out in July. In the second quarter, problem loans accounted for 7.6% of its total portfolio.

In fact by the time Georgian failed, it's non-performing loans represented 17% of it's total loan assets. But what got them to that point to begin with was that 77% of it's total assets were for property.

This exposes the broader political issue with bank regulation. When the FDIC wants to be proactive in closing these institutions to limit taxpayer losses, the politicians jump in:

“...the people of Georgia would appreciate very much if the FDIC could review how they’re dealing with the banks in Georgia to work with a plan to see if we can’t stop this very terrible pattern. Because it’s — it’s — it’s just not fair nor right.” David Scott (D., Ga.)

"not fair"? It's easy to bash Citi for it's mess, but when banks in the politicians' back yard need to be dealt with because they put on speculative exposures using taxpayer insured deposits, the FDIC should be using white gloves?

These banks should be shut down quickly, because letting them linger not only puts the taxpayer at additional risk, but makes any economic recovery that much slower. The only way to deal with the bad real estate loan problem is to by auctioning off (repricing) the assets. Otherwise the "head in the sand" syndrome will continue.

“We felt along with most people that the real estate situation in Atlanta would have begun to correct itself by the summer of 2009,” Poelker, who replaced [Georgian Bank] founder Gordon Teel at the closely held bank last month, said in an interview today. “Nobody expected this downturn in real estate to be as widespread and deep as it turned out.” (Bloomberg)

Really Mr. Poelker? You expected real estate in Atlanta to recover by this summer? What planet are you from? And you were actually put in charge of a bank with $2 billion dollars in assets? And according to Georgia's politicians the FDIC should leave your bank alone? Incredible.



Yes you do.

The gap in the US banking system

We recently received a comment related to bank failures from someone pointing out that in Germany, with a population of some 82 million, there are only about 5 banks (there are actually more - but let's stay with this line of thinking). The question was why does the US need that many banks?

For one thing, banks in the US used to be quite profitable in the real estate boom days. They were also relatively easy to set up (particularly relative to Europe). The 2008 crisis however may have taken care of that, pushing the US closer to the German banking system, dominated by large national banks. The chart below shows the 2001 US banks sorted by total assets. It's a fairly continuous chart that may resemble other sectors with a relatively open competition.



But the crisis changed all that. The 2009 picture looks quite different, showing a large gap between the fourth (Wells) and the fifth (PNC) largest bank (when comparing total assets). The ratio of assets between these two is over 4.5, showing that the top four banks are massively ahead of the rest of the industry.



Large banks have tremendous advantages - from regulatory support to cheaper cost of funds and less reliance on deposits (ability to borrow interbank or in the capital markets). That advantage will continue propelling the larger banks ahead of the rest.

The gap some may argue is filled by institutions that have just become bank holding companies, such as Goldman and Morgan Stanley or non-banking firms such as MetLife and Amex (both of which have a bank holding status). But these firms don't significantly impact the consumer landscape, where the big three banks are beginning to completely dominate (it's unclear if the investment banks have any plans to get into retail banking). The chart below from the Washington Post illustrates the deposit growth at large banks (mostly driven by government arranged acquisitions, but also attracting nervous depositors leaving smaller banks.)



And here is a comparison to the deposits various institutions controlled in 2007 (from the Washington Post):



Unlike Germany, where regulators are quite happy with the large few (Landesbanks, Commerzbank, Deutsche Bank, DZ Bank, etc.) dominate the landscape, the US regulators are quite nervous. From the Washington Post:

Regulators' concerns are twofold: that consumers will wind up with fewer choices for services and that big banks will assume they always have the government's backing if things go wrong. That presumed guarantee means large companies could return to the risky behavior that led to the crisis if they figure federal officials will clean up their mess.

One solution the regulators are proposing is to increase capital requirement on the larger banks.

That [Obama administration's proposed] plan would impose higher capital standards on large institutions and empower the government to take over a wide range of troubled financial firms to wind down their businesses in an orderly way.

But capital increases will negatively impact lending, as banks would rather focus on fee businesses that require little balance sheet usage. Reduced lending is the last thing this economy needs. But that seems to be the direction large banks are taking as they continue to probe for weaknesses in the wall of regulatory rules to come up with solutions that require less capital (whether it's rating agency shopping or TRS).

On the retail side however, foreign institutions are starting to make inroads, trying to fill the gap. From HSBC to ING, foreign banks are trying to grab share of US deposits. Some are trying to get in by acquiring failed US banks. From the WSJ:

The sale of the operations of failed Guaranty Bank in Texas on Friday to the U.S. division of a Spanish bank signals that foreign banks can succeed in the auctions for collapsed U.S. lenders.

Banco Bilbao Vizcaya Argentaria SA on Friday became the first foreign company to buy a failed U.S. bank in this crisis; on Friday, federal regulators shut down Guaranty.

Other foreign banks with a U.S. presence interested in gobbling up failing U.S. banks include French bank BNP Paribas SA through its San Francisco subsidiary, Bank of the West; Toronto-Dominion Bank, through its Portland, Maine, subsidiary, TD Bank; and Rabobank, the El Centro, Calif., subsidiary of Rabobank Group of Utrecht, Netherlands.

With competition still in place in the US (for now), it's unlikely the US banking system will converge to look exactly like the one in Germany going forward (it's much harder for a new bank to make inroads in Germany). However the landscape, shocked by the financial crisis, will be changing rapidly, becoming almost unrecognizable in years to come.

Meredith Whitney: 300 more bank failures

Meredith Whitney is predicting 300 additional bank failures, putting continuing pressure on the FDIC. The FDIC insurance fund, which may already be in the red is going to require more taxpayer funds.

Many of the smaller banks played the same game that the Wall Street firms have, chasing more spread and loading up on real estate related assets. The chart below shows rapidly expanding real estate loan balances at small US banks.



source: the Federal Reserve Board


In fact in some ways many of the smaller banks have been more aggressive on their portfolios than the large ones due to limited devirsification. Now it's the taxpayer's problem.

FDIC's new rules on bank acquisition reek of socialism

The industry comments are in for the proposed FDIC rules dealing with failed bank acquisitions by private equity funds. If these rules go into effect as they are, the FDIC will not be able to sell another failed bank directly to an alternative investment firm - one of the few sources of private capital still available. And in some instances failed bank liquidation may become the only option, putting FDIC and the taxpayer deeper in the hole (see FDIC looking for half a trillion dollar life )

The rules, as proposed, make no sense. If a bank wants to acquire another bank, the target bank must have a post-acquisition capital ratio (book equity to assets) of 5%. If someone wants to start a brand new bank, the ratio needs to be 8%. But under the new proposal if a private equity were to purchase a bank, the capital ratio needs to be 15%.

One of the reasons the FDIC is pushing for this rule is their concern that private equity firms expect to make high teens to low twenties returns on their bank purchases. How dare they! Making money is a crime these days. So let's force them to put up more capital to bring the returns down to single digits. That will teach those PE firms. Now if you are a state pension fund and a private equity firm told you they are targeting an acquisition with a 9% expected return, would you invest? No way.

The other rule the FDIC is trying to impose is to force PE firms who have more than one bank in their portfolio to use profits from one bank that's in good shape to prop up another bank that may be struggling. If you are an employee or a creditor of the healthy bank and the regulator tells you that it's time to give up some profits to feed a failing bank that has nothing to do with you, you would call that socialism.

FDIC would also require that private equity firms hold on to banks they have purchased for at least 3 years. If you buy a bank, turn it around in a year, and now a larger bank offers to buy it from you, why should you be forced to wait?

Here is another example of a US agency cutting off the nose to spite the face. The FDIC should ensure that the new owners run the bank effectively and prudently, working to rebuild a failed institution. Setting up socialist type rules will only serve to keep private funds away from failed institutions, ultimately hurting the FDIC and the taxpayer.