News on the local banking scene is not good. There are some 8,200 federally regulated banks and savings institutions nationwide and most of them do not have huge office towers or massive branch networks. Instead, community lenders tend to be small institutions that operate on the basis of traditional financial values, but even so an increasing number are in trouble.
“As the number of banks closed by the Federal Deposit Insurance Corporation has grown rapidly this year, it has become clear that most of them had nothing to do with the strange financial products that seemed to dominate the news when the big banks were nearing collapse and being bailed out by the government,” says Floyd Norris, writing in The New York Times.
This year more than 80 mostly small banks have already gone under, an impressive total given that there were no bank closures in 2005, 2006 or 2007.
So how is it possible that small banks that stuck with traditional lending practices are failing? And is there a business opportunity in the midst of such chaos for you?
The banking system is generally seen in terms of its largest banks and with good reason: the top few banks control the overwhelming majority of all industry assets. The nation’s 7,037 commercial banks have assets valued at $12 trillion, but those assets are not equally shared. In fact, the industry can be neatly divided into three slices, macros, minis and micros:
- Macros: The largest 25 banks have assets of $7.7 trillion.
- Minis: There are 500 banks that each hold assets of more than $1 billion and together have total assets worth $3.05 trillion.
- Micros: There are 6,500 community banks with a total of $1.25 trillion in assets.
Given these numbers it might seem as though the nation’s small banks are irrelevant, financial mice in a world of commercial elephants. The truth is different.
“A lot of successful people are involved with small banks,” says Jim Saccacio, chairman and CEO at RealtyTrac.com, the largest source for foreclosure listings and data. “Community banks are everywhere and they have a lot of political power because they’re important, especially in rural areas where they’re central to local economies.”
Saccacio adds that “community bankers provide an alternative to the nation’s largest financial conglomerates. As community banks become less competitive it means there are fewer mortgage options, fewer opportunities to obtain small business loans and less local control of banking activities. Development and entrepreneurship are stifled at the very point where they should be robust and active.”
So how has it happened that little banks are suffering while big banks are getting bailouts? Let me explain.
Risk & Reserves
Banks operate on the presumption that most of the money they loan will be paid back. Since some loans will fail, lenders by law and as a matter of common sense set aside reserves to protect their interests. Required reserves vary according to the size of bank assets and other factors. General reserve requirements look like this:
- Nothing for banks with assets that total less that $10.3 million.
- For banks with assets between $10.3 million and $44.4 million, 3 percent of their assets must be set aside.
- For banks with assets above $44.4 million the general reserve requirement is $1,023,000 plus 10 percent of the amount over $44.4 million.
The government can increase lending — or reduce it — by adjusting reserve requirements, what lenders call a haircut. If you want more lending you drop the reserve requirement, if you want fewer loans you just require lenders to maintain larger reserves.
The danger, of course, is that as reserve requirements fall then risk levels increase. For example, in 2004 the Securities and Exchange Commission set up an exception to the “net capital rule” that would greatly reduce reserve requirements — but only for a few favored financial companies.
“The 11 firms we expect to apply under the rule amendments,” said the SEC, “could realize a total reduction in haircuts of approximately $13 billion.”
The new debt-to-capital ratio for these lucky 11 firms would be 30 to one. Unfortunately, no law or regulation can reverse the physics of finance. Leverage is great when values rise — and deadly if values fall.
Among the 11 companies favored by the SEC were the investment banks Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley. Lehman is now gone, Bear Stearns and Merrill Lynch were absorbed by JP Morgan Chase and the Bank of America respectively while Goldman Sachs and Morgan Stanley have become commercial banks. As a side note, it was Morgan Stanley that was retained by the Treasury Department to review the finances of Fannie Mae and Freddie Mac before their federal takeover.
It’s hardly a shock that more than 80 national banks have failed so far this year. Loans that once made sense are no longer workable when borrowers have lost their jobs. Foreclosure is not an effective remedy that can protect lenders when home values have fallen 20 and 30 percent — as is the case in some markets.
Not only have the sane lending practices of smaller banks been steamrolled by general economic trends, community banks themselves have been directly hurt by their bloated financial cousins.
For instance, last September the government nationalized Fannie Mae and Freddie Mac. Prior to this event banks were allowed to hold preferred stock in either or both companies as part of their capital reserve. The value of these shares essentially slid to zero because of the federal takeover, with the result that 800 community banks lost capital worth $16 billion according to a widely quoted estimate.
These small banks lost the income they received from their preferred stock, plus they had to either raise $16 billion in replacement capital or lend less. Meanwhile, the government gave out $199 billion to re-capitalize 600 larger banks, money that could power nearly $2 trillion in additional lending.
The government also gave other forms of help to big banks. For instance, the purchases of Bear Stearns and Merrill Lynch included government guarantees. Citigroup got $45 billion in cash plus federal guarantees of $300 billion to offset possible loan losses. And what about community lenders who did not take huge risks? They got to read about government programs in the morning paper.
Our 8,200 national banks and savings institutions pay for FDIC insurance coverage. Traditionally, the cost of such insurance has been minimal.
“From 1950 through 1989,” explains Donna Tanoue, a former FDIC Chairman, “the FDIC continued to charge the statutory rate of 8.33 basis points, but refunded up to 60 percent of excess assessment revenue in any given year.”
A “basis point” is 1/100th of a percent. A rate of 8.33 basis points would be 1/12th of one percent. If we reduce that rate by 60 percent then the real cost of FDIC insurance until 1989 was 3.33 basis points or 1/30th of one percent.
That might seem tiny but not to banks. They got an even lower rate after 1989, when the FDIC premium system was changed. With a typical insurance plan, premiums are paid in during good times and drawn down during tough times from reserves built up over a period of years. According to Tanoue, with the FDIC “in good times, banks pay zero, distorting incentives and allowing deposits to enter the system without any contributions to the insurance fund.”
Given the number of failing institutions this year it follows that the FDIC reserve fund is being drawn down. To pump up the system the FDIC demanded that member banks pay an emergency assessment against domestic deposits equal to 20 basis points.
Is this a big assessment? You bet. In the context of a banking system with $12 trillion in assets that’s $5.6 billion. Seen another way, that’s most of the $7.6 billion in net income earned by FDIC-insured lenders during the first quarter.
“The current assessment base unfairly burdens community banks by requiring them to pay a disproportionately high share of deposit insurance premiums,” said the Independent Community Bankers of America (ICBA) in a letter to the FDIC.
“Very few community banks,” they explained, “had anything to do with subprime lending, with structured investment vehicles, or exotic mortgage investments, yet they are being penalized by having to pay this onerous special assessment.”
Community lenders may soon face additional assessments because in the second quarter the FDIC reserves lost $3.7 billion — a figure which compares with $4.8 billion in profits a year earlier.
Given the problems faced by community banks is there an opportunity for those with an interest in foreclosures? The answer is yes and for several reasons.
First, community banks may have foreclosed properties they want to sell. These properties, by definition, will be local and nearby.
Second, community banks may be willing to finance foreclosure purchases, especially properties they own.
Third, community banks are here to stay. While 80 banks may have failed so far this year, that’s only 1 percent of the individual banking companies out there. Most community banks are stable, in business for the long term and would really like to do business with you — especially now.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.