| Posted by stuart on June 28, 2010 |
First of all, we do NOT have a banking crisis in the U.S., we have a regulatory crisis. This will take some explanation. In typical government fashion of getting involved after it’s too late and screwing up a problem worse than if it had just been left alone, the commercial (and arguably residential) distressed loans crisis in this country has been made substantially worse by our government and the FDIC.
There are some undeniable facts in this current distressed banking situation.
- Commercial real estate values have fallen.
- Many of the loans backing this real estate are ‘underwater’.
- The FDIC has stepped its enforcement of banks and their lending practices.
While the fallen commercial real estate values and underwater loans cannot be changed at this time, the FDIC practices can and should be so this country does not wind up in a situation like Japan.
The FDIC has already created zombie banks
We already have zombie banks that have been created. Banks that have so many underwater loans that they cannot sell because doing so would cause them to recognize an immediate capital loss on their balance sheets. Instead the banks continue operating with minor write downs in value, as much as they can take against earnings per quarter. In the meantime, the FDIC has seriously stepped up its auditing and enforcement of banking loan underwriting and imposed loan classification limits based on bank capital, as well as increasing the capital requirements for the banks. All of this has been done ‘after the fact’ of course.
If these actions were taken pre-crisis, before the real estate crash and before complete deregulation which allowed banks to engage in derivative trading practices that their executive officers had no real understanding of, we wouldn’t be in nearly as bad of a situation as we are now. But, let’s not go back in time and do ‘what if’ scenarios. We are in the present and we need a current solution.
Why banks can’t make loans
Here’s a very simplified explanation. A bank can only lend money up to a certain multiple of it capital on hand. For example, let’s say a bank had a 5% capital requirement (we’ll ignore loan classification limits for now) and had a capital base of equity of $100 million dollars. To find out how much money a bank can lend, you simply take $100 million divided by .05%. That gives the bank loan making capacity of $2 billion dollars. Simple, right?
If we go back a few years, the FDIC had capital requirements in place for most mid size banks (less than $5 billion in loans) of around 3-4%. As the commercial real estate values fell, the crisis began, the public howled, and the politicians got on their soapboxes and pontificated their greatness, the FDIC started getting tougher on banks. The FDIC, at the politicians behest, did this at the worst possible time.
Thank you FDIC (and the politicians)!
As a result of the fallen commercial real estate market, the FDIC began (among other actions) to increase the banks capital requirements. Many banks saw their requirements arbitrarily increased from 5% to 12% for example. This has the effect of restricting a bank from making loans. In our example above, the same bank that had $100 million in capital, now at a 12% requirement can only make $833 million in loans, a $1.167 billion dollar difference!
But what if the banks already has that $1.167 billion dollars lent out? Well, the FDIC allows them to hold on the them (with a lot of restrictions of course) if they are performing. But what if these loans go into default? What if the loans don’t meet the FDIC restrictions? Then the bank has to sell them, increase capital, or get taken over by the FDIC and have the assets sold by one of five approved loan sale advisors (don’t get me started on this subject!). Unfortunately, since the bank is already way over the amount of money they have based on a new arbitrary ‘safety limit’, they can’t make any new loans…even to the most qualified borrowers!
No loans, no business, no jobs
So, if you and some recently laid off friends want to borrow some money to start a new business, you can’t! If you’re an existing business with great credit, great prospects, great employees, etc. and you want to expand and hire people, but need to borrow money to buy some commercial space or equipment, you can’t! Or let’s say your a well running existing business, never missed a loan payment, but your balloon credit line is up for renewal, the bank cannot renew the loan!
That’s OK though, just because your business goes out of business, and you lay off your employees, and they lose their homes…at least the politicians and FDIC employees have jobs and are busy.
Why the FDIC is doing the exact wrong thing right now
With The FDIC increasing capital requirements, getting tougher on loan underwriting, imposing strict loan classification limits (real estate, non owner occupied investment property, etc), it should be viewed the same as the government increasing taxes, the FED increasing interest rates, tightening the money supply, and cutting government spending during a recession! It’s unthinkable that the government would take all those actions, since everyone knows those are the precisely wrong actions to take during an economic contraction, and yet that is EXACTLY what the FDIC is doing to banks, and therefore all of us!
The FDIC needs to let the private sector solve this problem, with some caveats and intelligent oversight and regulation. There are already many hedge type funds, and pools of money looking to buy distressed bank loan assets, but the banks cannot sell at a price the investors are willing to purchase for. The reasons are mentioned above, the banks cannot take any additional ‘capital hit‘. And, with all due respect to bankers, they are NOT real estate investors, developers, or shrewd, market savvy, value adding business people. They are bankers, and should restrict their activities to making prudent loans!
Finally, how to fix the banking crisis quickly and put the economy back on track right now!
- Temporarily relax capital requirements for banks.
- Put in place regulations that require periodic progress towards better capital positions.
- Allow bankers to be bankers, let the C’s of lending come back somewhat.
- Let performing loans be renewed!
Temporarily relax capital requirements for banks
By temporarily relaxing the capital requirements for banks to near zero, banks will be able to sell their non performing or distressed loans at market clearing prices to investors. Since these loans are ‘dead’ on the books right now anyway; the loans produce no income, the underlying properties have to be foreclosed upon (which is expensive and time consuming), and then the OREO (Other Real Estate Owned) still has to be sold most likely at a loss, it is better for the banks to get what cash they can from the distressed loan sale and redeploy that money into an income producing loan to a qualified borrower. Right now the banks can borrow money from the FED to lend at nearly .25% and lend at 7% or better! That is a HUGE interest rate spread that will allow the banks to EARN their way back to a sound capital position quickly!
Put in place capital progress requirements for banks
Since having capital requirements for banks is a sound idea, relaxing the requirements to near zero can only be for a temporary time. The FDIC should work with each bank management to put in place attainable and reasonable time and capital benchmarks to get the newly cash rich banks back to very safe capital levels. For example, 1, 2, 3, and 5 year benchmarks seem reasonable.
Allow bankers to be bankers!
I got my first loan on my own when I was 13 years old for an ATV purchase from my local community bank. The lending officer knew my parents, knew my teachers and where I went to school, and knew that I worked bagging groceries and mowing lawns and doing whatever I needed to do to make money to repay the loan. In other words, it was a loan based on Character (one of the C’s that used to define bank loan making decisions). Bankers these days have been restricted and regulated down to customer service clerks where they have no decision making authority left. The bankers have no discretion. There are good, prudent bankers out there that make excellent loan decisions. We need to let them make loans, make the banks hold their loans, and stop them from trying to make profits packaging loans and trading derivatives.
Let Performing loans be renewed
If a business is making their existing loan payments, and their business future prospects look reasonably sound, then allow the banks to ‘roll’ the loan when it comes due. Many business lines of credit and/or loan have balloons or short maturity dates of a year or two. These performing loans used to be nearly automatically renewed (with new fees generated to the banks each time, of course), however, with higher capital requirements, these loans couldn’t be renewed by the banks. I can’t tell you how many personal stories we have heard from sound businesses that went bankrupt because their multimillion dollar loan was suddenly not renewed! These companies had never missed a payment, had customers, employees, and the personal guarantees from the business owners. The FDIC, at the behest of knee jerk reactions from the politicians, have destroyed more small and mid size businesses, their employees, and consequently caused more job losses and home foreclosures than most people realize.
This entire banking crisis is based on flawed, knee jerk, policies from the FDIC that run exactly counter to sound macroeconomic policy. While the above is a simplified version (in the interest of brevity) of the problem and solutions, it is nonetheless doable and would overnight fix most of the banking crisis, create jobs, stabilize if not propel the real estate market, and benefit the economy and government with increased tax revenue from the increased economic activity.