Bank Failures in Slow Motion

[Speech given at The Economic Recovery: Washington’s Big Lie, the Supporters Summit for the Ludwig von Mises Institute, October 8, 2010.]

Every Friday evening a few more banks are closed – seized by the various state banking regulators and handed over to the Federal Deposit Insurance Corporation (FDIC) for liquidation. This all happens rather quietly, barely making the news. We’re told these bank failures are no big deal. No reason to panic. The names of the banks change over the weekend and many customers don’t notice the difference.

We’ve only had 294 failures this cycle, but it is a big deal: adjusted to current dollars, the Depression banking crisis was $100 billion, the S&L crisis was $923 billion, and the current crisis is nearly $8 trillion.

So while FDIC chairwoman Sheila Bair said the current crisis would be “nothing compared with previous cycles, such as the savings-and-loan days,” it’s actually much bigger, because the financial sector had grown to be nearly half the economy by 2006 – as measured by the earnings of the S&P 500.

But the question is; why haven’t there been more bank failures? In 2008, there were 25 failures, last year there were 140, and so far this year 129 have been seized on Friday nights. The greatest real-estate bubble in history has popped – first residential and now commercial – and we only have 294 failures?

It takes easy credit to make a real-estate bubble and it was America’s commercial banks that provided most of it. It’s estimated that “half the community banks in America remain overleveraged to commercial real estate, and the possible losses that remain are about $1.5 trillion,” according to bank-stock analyst Richard Suttmeier.

The Moody’s Commercial Property Price Index (CPPI) has fallen 43.2 percent since its peak in October 2007. Raw-land and residential-lot values have fallen even further. Almost 3,000 of the 7,830 banks in the United States are loaded with real-estate loans where the collateral value has fallen over 40 percent, and yet less than 300 banks have failed?

We all know what’s happened to the residential-property market, but to illustrate how bad the situation is for the commercial market, over 8 percent of commercial mortgages that have been packaged into bonds are delinquent; more than $51.5 billion of such loans are at least 60 days late on payments compared with $22 billion a year ago.

If anything the commercial property market would seem to be getting worse. Losses on loans packaged into US commercial-mortgage-backed securities totaled $501 million in August – more than double the $245 million in April, and over 10 times the $41 million in losses of a year ago.

Past-due loans and leases at the nation’s banks and S&Ls increased 16.2 percent from second quarter 2009 to the second quarter of this year. Restructured loans and leases increased nearly 54 percent.

The delinquency numbers are bad anyway you look at it. So, they must be reflected in bank’s profit numbers, right? Well, no. Second-quarter earnings by the nation’s banks were the highest in 3 years – nearly $22 billion.

Based on these numbers, FDIC chair Sheila Bair claims, “The banking sector is gaining strength. Earnings have grown, and most asset quality indicators are moving in the right direction, putting banks in a stronger position to lend.”

And bankers must figure the coast is clear: they are cutting their provisions for bad debts. Yes, at a time when one out of four Americans has a sub-600 FICO score, a quarter of all homeowners are underwater on their mortgages, and commercial real estate is hitting the ditch, banks are dipping into their loan-loss reserves to report profits.

To illustrate, bankers have cut their ratio of loans to reserve coverage almost in half – that is the amount reserved divided by noncurrent loans (90 days past due or more and loans on nonaccrual). This ratio has declined from 120 percent in March of 2007 to 65.1 percent at June 30 of this year.

Banks added a total of $40.3 billion in provisions to their loan-loss allowances in the second quarter: that is the smallest total since the first quarter of 2008 and is $27.1 billion less than the industry’s provisions in the second quarter of 2009.

So, the banking industry made $21.6 billion in Q2 by not putting as much away for loan losses.

By the way, of the $21.6 billion in second-quarter profits, $19.9 billion was earned by the 105 largest banks in the country. The other $1.7 billion in profits was spread between the other 7,725 banks.

So the big banks are backing off on putting money in reserve and booking big profits only months after being rescued by government TARP moneys (by the way, 91 banks are behind on making their TARP payments to the government). More importantly, these banks were the primary beneficiaries of accounting-rule changes in April of 2009 – amendments to FASB rules 157, 115, and 124, allowing banks greater discretion in determining at what price to carry certain types of securities on their balance sheets and recognition of other-than-temporary impairments.

“The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets,” according to James Kwak, coauthor of 13 Bankers: The Wall Street Takeover and the next Financial Meltdown.

So the banks get some accounting breaks and are aggressively reporting profits at the expense of putting money in loan-loss reserves; still, why haven’t there been more failures?

Earlier this year, Elizabeth Warren and her Congressional Oversight Panel did a report that indicated 2,988 banks were in trouble because of real-estate concentration in their loan portfolios.

Ms. Warren noted that office vacancies had increased 25 percent since 2006-2007, apartment vacancy was up 35 percent, industrial was up 45 percent, and retail vacancy had increased 70 percent since 2006-2007. The report said the recovery rate for defaulted real-estate loans was 63 percent last year. Land-loan recoveries were only 50 percent. Development-loan recoveries were even worse at 46 percent.

Another banking expert who sounded a warning signal about the banking industry was bank analyst Chris Whalen, who, a year ago, estimated the number of troubled banks to be 1,900. The FDIC itself said there were 829 problem institutions on its top-secret radar by June 30, 2010 – almost exactly double the 416 announced by the FDIC a year ago at midyear.

In other words, problem loans are still causing problems. To be continued tomorrow…

Regards,

Doug French
for The Daily Reckoning

The Daily Reckoning