Is Your Bank Safe?

(part 1 of 3)

Trickle down” bailouts aren’t working for smaller banks.

The U.S. government’s efforts have succeeded in keeping large investment banks out of the soup–for now. The big banks are raising capital reserves by issuing bonds. (These are loans that must be paid back by a certain date.)

The bigger banks are investing their new capital reserves in each other’s bonds and socking some of it away at the Fed. They’re also issuing new, risky, derivatives. All this, rather than return to lending on a large scale.

Larger banks have a huge asset. No matter what they do they’ve been deemed “too big to fail.”

Smaller banks have no way to create and sell their own bonds to raise more capital. Meanwhile the chickens of small bank lending and investing practices of the past are coming home to roost. Regional and community banks are folding at alarming rates.

Last year 25 banks failed. Already, with the last quarter of the year yet to come, the number of failed banks is close to 100. This year we could see a 500% or more increase in collapsed banks.

These banks range from small community banks to large regional banks serving multi-state areas. Some of these banks go back to Civil War times. Two regional bank failures in 2009 were among the ten largest failures (in terms of assets) in the history of U.S. banking.

Why are small banks failing?

Some smaller banks that needed ways to invest capital during boom times bought non-government-backed securities called “private issuer” or “private label” securities. They also bought derivatives called CDOs (collateralized debt obligations), and they purchased “trust preferred securities” (a hybrid investment made up of debt and equity.) These types of investments went sour last fall.

Home mortgages went bust too. The rate of sub prime loan defaults is now slowing, but unemployment is pushing up the rate of prime borrower defaults. According to the banking trade association, the Mortgage Bankers Association, nearly 1 out of 12 mortgage holders are at least 90 days behind on their payments. Colonial Bank (Alabama) is the 6th largest banking collapse on record. It failed in mid-July because of its real estate lending in Florida and other states. Colonial is the largest bank failure since Washington Mutual and IndyMac during the current financial crisis.

But smaller banks’ nemesis is commercial property. The Fed is now looking into banks’ exposure to commercial mortgages. Commercial mortgages and derivatives based on these mortgages are dead weight dragging down the banks. For example, Corus Bank (Chicago) failed after half its condo construction loans defaulted in April. These totaled about $2 billion. In mid-August, Guaranty Financial Group, Inc. (Texas), the 10th largest bank to fail in U.S. history, had $3.5 billion in sub-prime securities backed by adjustable-rate mortgages. The write-downs on these securities in just one month put Guaranty Financial up on the chopping block. These write-downs used up all the bank’s capital.

How bad is it?

Things in the mortgage market have become so bad for smaller banks, they’ve banded together to form their own trade associations to lobby on their behalf. Two new associations are The Community Mortgage Lenders of America and the Community Mortgage Banking Project. Consolidation is driving this move. The three biggest banks in the Mortgage Bankers Association, Bank of America, Wells Fargo, and J.P Morgan Chase, have gone from issuing 15% of new mortgages in the early 1990s to 37% in 2007 to over 52% this year. Small banks feel that the Mortgage Bankers Association can’t always represent their interests in Washington without some conflict of interest over what the larger banks’ want it to do.

Small bank failures are not the only grim statistic. The overall number of banks on the FDIC’s “sick list” has risen dramatically. Out of approximately 8,200 banks backed by the FDIC, the number of banks “at risk” rose from 305 to 416 in the second quarter of this year. Assets of these banks total around $300 billion. This month the Institutional Risk Analyst, a bank watchdog, said that its “F-rated” banks have total assets of about $4.5 trillion dollars at risk.

The only ray of light in this bleak picture is a slight resurgence in the market for “toxic” assets like mortgage-backed derivatives. This may mean banks that survive would be able to “write up” some of the value of their distressed assets. For many small banks this is too little too late.

Coming next: FDIC: Rescuer or Rescuee?

Copyright © 2009 Nancy K. Humphreys
http://twitter.com/nancyuno