Why Small Banks Are The Key To Recovery-Part 2


Part 2 of 2

There are three factors that will hurt bank earnings: weak loan demand,  spreads on interest income will narrow because of competition among banks, and it appears that many banks are concealing the true state of their balance sheets because of “extend and pretend” policies.

“Extend and pretend” and “mark-to-make-believe” have been a major factor in dragging out this recession and is a major threat to the economy. This article describes the problem well:

A big push by banks in recent months to modify such loans—by stretching out maturities or allowing below-market interest rates—has slowed a spike in defaults. It also has helped preserve banks’ capital, by keeping some dicey loans classified as “performing” and thus minimizing the amount of cash banks must set aside in reserves for future losses.

Restructurings of nonresidential loans stood at $23.9 billion at the end of the first quarter, more than three times the level a year earlier and seven times the level two years earlier. While not all were for commercial real estate, the total makes clear that large numbers of commercial-property borrowers got some leeway.

But the practice is creating uncertainties about the health of both the commercial-property market and some banks. The concern is that rampant modification of souring loans masks the true scope of the commercial property market weakness, as well as the damage ultimately in store for bank balance sheets. …

More broadly, the failure to get the loans off banks’ books tends to deter new lending to others. It’s a pattern somewhat reminiscent, although on a lesser scale, of the way Japanese banks’ failure to write off souring loans in the 1990s contributed to years of stagnation.

Banks hold some $176 billion of souring commercial-real-estate loans, according to an estimate by research firm Foresight Analytics. About two-thirds of bank commercial real-estate loans maturing between now and 2014 are underwater, meaning the property is worth less than the loan on it, Foresight data show. U.S. commercial-real-estate values remain 42% below their October 2007 peak and only slightly above the low they hit in October 2009, according to Moody’s Investors Service. …

In a large proportion of cases, modifying the terms of loans ultimately isn’t enough to save them. At the end of the first quarter, 44.5% of debt restructurings were 30 days or more delinquent or weren’t accruing interest, up from 28% the first quarter of 2008. …

But here is one positive note. It may be that these banks are finally recognizing that the CRE market is not going to get any better and that they need to more aggressively charge-off CRE loans. Also, the Fed has said that their new loan workout guidelines weren’t intended to foster “extend and pretend:”

In a May conference call with 1,400 bank executives, regulators sought to clear up confusion. “We don’t want banks to pretend and extend,” Sabeth Siddique, Federal Reserve assistant director of credit risk, said on the call. “We did hear from investors and some bankers interpreting this guidance as a form of forbearance, and let me assure you it’s not.”

We can expect these banks to have more problems with federal auditors which will force them to deal with their CRE loan problems.

But the results are a mixed bag so far and it is too early to see a definite trend. What we need to see is more CRE loan charge-offs by lenders. While the trend in Q4 2009 through Q1 2010 showed charge-offs declining, it likely that this is due to “extend and pretend” rather than improving fundamentals.

According to Moody’s latest report [Q1], charge-offs declined to 3.3% of all loans versus 3.6% in the prior quarter. Nonperforming loans stood at 5% of total loans. It noted that these percentages are still historically high, even going back to the Great Depression. According to Moody’s report:

U.S. rated banks have already charged off or written-down $436 billion of [all] loans in 2008, 2009, and the first quarter of 2010. That leaves another $307 billion to reach the rating agency’s full estimate of $744 billion of loan charge-offs from 2008 through 2011.

But they point out that banks have only charged off 45% of delinquent CRE loans.

According to Moody’s analysts, the decline in aggregate charge-offs was driven by commercial real estate improvement, which “we believe is likely to reverse in coming quarters,” they said in the report. … “The return to ‘normal’ levels of asset quality will be slow and uneven over the next 12 to 18 months,” said Moody’s SVP Craig Emrick.

I’m not sure where they saw improvement in the CRE market. From my review of Moody’s forecasting history, they have been consistently wrong about the direction of the economy. When this report came out in June, 2010, they said:

“More severe macroeconomic developments, the probability of which we place at 10 percent to 20 percent, would significantly strain U.S. bank fundamental credit quality.”

I suggest that the economy is already slowing down and will get worse over the next few quarters. And, from my analysis of the CRE market that would affect the types of properties which secure most regional and local bank loans, it is not getting better. If you look at the CMBS loans (CRE-backed securities) as kind of a proxy for bank-owned CRE loans, defaults have been increasing:

The percentage of loans backing commercial mortgage-backed securities (CMBS) that have fallen delinquent by 30 days or more increased to 8.7% in July, a new record and an increase from 8.5% in the previous month.

The delinquency rate has increased every month this year and is up from 3.7% in July 2009. However, the increases are beginning to slow. The 12 basis point bump in July came after a 17bps increase in June, which followed a 40bps hike in May. Since September 2009, the increase in delinquencies has averaged 37bps every month.

Lenders and special servicers are moving more commercial loans through the REO process, which is also putting downward pressure on delinquency rates. The amount of loans either 60-plus days delinquent, in foreclosure or in the REO process reached 7.95% in July, up 12bps from June.

According to Trepp, one other reason for slowing defaults is that loan modifications have increased 37% over the 2009 level.

This leaves us with mixed signals, but I believe the data shows that banks are more willing to deal with their CRE loan problems and “extend and pretend” will be less of a refuge for them as new Fed policies require banks to more fairly reflect the true values of the assets securing these loans. I also believe that banks are taking a more realistic view of the economy and realize that the CRE market is a long way off from “recovery.” I expect more banks to be added to the “problem bank” list in the near future as the economy declines. This will result in more bank failures.

The problem banks targeted by bank regulators are in the $1 billion to $10 billion asset range because of the large amount of loans made on CRE. The FDIC is taking a more aggressive approach to banks’ valuations of their CRE loans. A new round of enforcement actions is due in Q3 and Q4 2010:

The next wave of enforcement actions is expected to follow banks’ lowering of valuations on commercial real estate loans that come due later this year and in 2011. Those write downs have just begun, observers said. …

Enforcement actions are on pace to increase 64% this year, making bankers increasingly wary of further obstacles to their recovery. …

There are banks “that may still be reporting adequate or well-capitalized figures, but the regulators may be determining the banks are not reserving enough for future losses,” said Matt Anderson, managing director at Foresight Analytics.

The big question is: how long will this process take?

Because of rising competition among banks for customers, it is likely that ailing banks will wish to get their balance sheet in order, recognize and charge off more bad loans, and raise the capital needed to compete for good business borrowers. If they don’t they will fail either because of FDIC auditors or because of their inability to compete against more powerful competitors.

It is not as if there will be a rush to charge-off CRE loans, but rather a steady trend. It would be better for the economy if the process was done quickly. In that way capital malinvested in unproductive projects would be freed up and this would allow new lending to be directed toward profitable ventures, paving the way, as it were, to a recovery. While this is just one leg of a recovery, it is an important one. Keeping alive dead projects is what caused Japan to stagnate for so long. That’s when the term “zombie banks” was coined and it caused the “Japanese Disease,” which is long-term stagnation (average 0.6% GDP growth since 1990) and deflation.

Because of the large amount of CRE debt that is coming due this year and in 2011 (actually through 2014), and because it is likely that the economy will continue to decline for the next several quarters, this process of charge-offs, deleveraging, and bank failures could last well through 2011. This points to a slow recovery. But at least there will be a recovery.

But … What will the Fed do? This may be the key.

As the unemployment rate creeps upward, the Fed will pursue quantitative easing in order to attempt to stop deflation. I am quite sure that they have not figured out how much QE they will need to do and that they are unsure of its impact on the economy. I doubt that it will have the positive impact the Fed would like. It is unlikely that QE will aid the deleveraging process. All that will happen is that the new money will bid away goods by those who first borrow the new money and cause prices to rise without any increase in real wealth. Printing money doesn’t create wealth but it does distort the entrepreneurial process and, as there is no real wealth underlying the fiat money, production will actually fall after the new money is spent. As a result, we will likely experience inflation and a stagnant economy at the same time. It is an experience familiar to those who experienced the late 1970s–stagflation.

If the Fed decides to engage in massive QE, and here I am thinking in terms of $3 to $5 trillion, then we may well see inflation and the start of another boom-bust phase. I believe this scenario is unlikely because Chairman Bernanke, Secretary Geithner, and Mr. Summers, understand that such a policy would lead to hyperinflation and they will not allow that to happen. Think price and wage controls while they raise interest rates and we start over with the deleveraging process. Then you would see a real bust.


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