Message From FDIC Chairman Bair

Freddie Mac Loan Defaults

In September, Freddie Mac's loan defaults set an annualized record, after hitting a stunning 7.3%. Even worse, the rate of decline among single-family loans increased substantially month over month, from 3.13% in August to 3.33% in September, (and 1.22% in the prior year, just after the GSE's ended up being nationalized: a 270% increase YoY). The rate of defaults has now climbed for 28 straight months.

Freddie's holdings actually expanded by $4.8 billion to $784.2 billion in September, after four months of declines.

British Satirists Bird & Fortune on Banking

October Beige Book Highlights

Highlights from the Beige Book released by the FOMC today:

Summary

The weakest sector was commercial real estate, with conditions described as either weak or deteriorating across all Districts. Banking also faltered in several Districts, with Kansas City and San Francisco noting continued erosion in credit quality (often with more expected in the future). One bright spot in the banking sector was lending to new homebuyers, in response to the first-time homebuyer tax credit. Finally, labor markets were typically characterized as weak or mixed, but with occasional pockets of improvement.

Real Estate

Most Districts reported that housing market conditions improved in recent weeks, primarily from a pickup in sales of low- to middle-priced houses. Contacts reported that sales were boosted by the government’s tax credit for first-time homebuyers. Resale activity also edged up in parts of the New York District, although prices continued to be depressed due to a substantial volume of foreclosures and short sales. New and existing home sales remained flat in the Philadelphia District, and home sales continued to decline throughout the St. Louis District. Sales of higher-priced homes were very slow, according to Philadelphia, Cleveland, and Kansas City. Moreover, real estate agents in the Boston and Cleveland Districts were uncertain about the future of home sales once the tax credit expires. Availability of financing continued to be a concern for potential buyers in the Cleveland and Chicago Districts.

Residential construction activity remained weak in most Districts. Atlanta reported that construction remained very low, and Cleveland expected new home construction to proceed at a slow pace. Chicago indicated that construction on existing developments edged up, but St. Louis reported that construction activity declined. Kansas City reported that housing starts stabilized, although levels remained well below a year ago and were not expected to improve over the next three months. Philadelphia noted that builders continued to offer increased incentives to boost sales.

Commercial real estate continued to weaken across the 12 Districts, although even this sector had scattered bright spots. Each District indicated that demand for private commercial real estate was weak, with New York, Philadelphia, Cleveland, Atlanta, Chicago, St. Louis, Kansas City, and San Francisco all characterizing activity as declining further since the last report. An inability to obtain credit was often cited as a problem for businesses that wanted to purchase or build space. High vacancy rates were noted as a key concern especially for landlords who were not offering concessions. And, while industrial real estate in the Richmond District was generally weak, renewed interest by retailers to revisit postponed expansion plans was also noted. Finally, public nonresidential construction activity funded by federal stimulus projects was a source of strength in the Cleveland, Chicago, Minneapolis, and Dallas Districts, but gains were often offset by state and local government cutbacks.

Banking

Many Districts continued to report weak or declining loan demand, and many noted further erosion of credit quality. For example, demand was reported as stable or declining by New York, St. Louis, and Kansas City. Cleveland noted that commercial and industrial lending was soft and consumer lending was flat or reduced. In the Richmond District, modest signs of improvement in consumer loans were cited from banks in areas typically supported by the health care and education industries. Philadelphia also reported a small gain in consumer lending. San Francisco said that loan demand was largely stable or perhaps rose slightly. A major exception to the general pattern of weak or declining lending activity was in residential real estate. Most Districts cited the federal government’s first-time homebuyer program as supporting residential lending activity. However, Dallas reported that residential mortgage demand was disappointing, and St. Louis mentioned a moderate decline in real estate lending.

Credit quality continued to be a problem, and rising delinquencies were often noted. For example, credit quality was described as stable or declining in the Philadelphia, Cleveland, and Kansas City Districts. Half of the contacts for Kansas City expected loan quality to continue to erode over the next six months. Cleveland stated that the quality of loan applicants had deteriorated somewhat, mostly on the business side. Delinquencies were also widely reported to be up; New York particularly noted rising delinquency rates among both consumer and commercial mortgage loans.

Community Banks Can't Compete With The Federal Government

From USA Today:

Community banks are coming under intense pressure from a crumbling commercial real estate market, a weak economy — and lop-sided competition with banking goliaths deemed too big to fail, FDIC Chairman Sheila Bair said Monday.

As the Federal Deposit Insurance Corp. braces for the 100th bank failure this year — the most since 1992 — Bair warned that small community banks are struggling to compete against behemoths such as Citigroup and Bank of America. The reason: Last year's $700 billion bank bailout proved that the federal government is willing to spend whatever it takes to keep the biggest banks from going under.

" 'Too big to fail' has become worse," Bair told USA TODAY. "It's become explicit when it was implicit before. It creates competitive disparities between large and small institutions, because everybody knows small institutions can fail. So it's more expensive for them to raise capital and secure funding."

The left-leaning Center for Economic and Policy Research last month found that banks with more than $100 billion in assets paid 1.15% for funds, and all others paid 1.93% late last year and early this year. That amounted to an annual subsidy worth up to $34.1 billion for the 18 biggest bank companies.

"They compete against community banks all over the nation," says Camden Fine, president of the Independent Community Bankers of America. Community banks "didn't do anything wrong. They didn't cause this train wreck."

Another threat: Commercial real estate — small banks' bread and butter — is deteriorating because of the weak economy. "This is going to be a continued source of stress," Bair said.

She says things won't get as bad as they did when the savings-and-loan crisis claimed 1,373 banks from 1985 to 1992. There were 25 bank failures last year, and there have been 99 this year.

"One hundred will come shortly," Bair said. "These will continue at a good pace this year and next — but I don't think anywhere close to what we saw during the S&L days."

Joshua Siegel of private-equity firm StoneCastle Partners calculates that at least 1,200 small banks are "under extreme stress as measured by insufficient capital, poor liquidity, profitability and asset-quality problems."

Frederick Cannon, chief equity strategist at Keefe Bruyette & Woods, expects that bank failures might "exceed 500 banks and could go much higher."

He said regional banks are most vulnerable to losses in commercial real estate, which accounts for 32% of their loans vs. 10% for the biggest banks.

It seems that the government is working very hard to put an end to community banking and will be using CRE exposure as the means to do just that.

U.S. CRE Values Fall 3% in August

FDIC Failed to Limit CRE Lending

From Bloomberg:

The Federal Deposit Insurance Corp. failed to enforce its own guidelines to rein in excessive commercial real estate lending by at least 20 banks that later collapsed, reports by the agency’s watchdog show.

The FDIC’s Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency’s examiners didn’t identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed.

The failure to follow up on the 2006 recommendation, that banks avoid letting commercial real-estate holdings exceed 300 percent of capital, has emerged as FDIC Chairman Sheila Bair steps up her effort to expand the agency’s role in regulating the financial-services industry.

“We should ask the prudential regulators why they did not do more to push banks to pay attention to their guidance,” Representative Brad Miller, a Democrat from North Carolina, said in an interview. “If they thought their conduct was unsafe, it’s unsound, they certainly should have stopped it.”

Miller sits on the House Financial Services Committee, which oversees the FDIC and the banking industry.

“We are in process of addressing any existing gaps in supervisory policy with respect to commercial real estate lending,” FDIC spokesman Andrew Gray said in a prepared statement. “The FDIC has also stepped up our off-site surveillance program to assist our examiners in targeting those institutions with elevated risk profiles so that corrective action programs are instituted in a timely and constructive manner.”

Defaults on commercial real estate loans totaled $110 billion, or 6 percent of all such loans, in the second quarter. That’s 11 times the level in the fourth quarter of 2006 when the guidelines were released. Defaults may rise to $170 billion by the fourth quarter of 2010.

The risks are greater for community banks with assets of $10 billion or less because commercial real estate loans make up a bigger percentage of their business. Smaller banks don’t have the capital to compete with large banks for mortgages and consumer loans, so they turn to local-market lending, where they have an advantage.

Along with the OCC and the Federal Reserve, the FDIC in 2006 set a threshold -- 300% of a bank’s capital -- for safe levels of commercial real estate loans. The guidance was aimed at helping regulators identify banks with high loan concentrations that warranted greater supervisory scrutiny.

At the time, smaller and mid-sized banks opposed the guidelines. Bankers said they feared federal examiners would treat the thresholds as absolute limits, threatening a lucrative business for community lenders.

The regulators said the thresholds were not limits and that federal bank examiners would use the guidelines to identify lenders with risky levels of such loans.

The FDIC reiterated the importance of strong capital and risk-management practices for banks with high concentrations of commercial real-estate loans in a March 2008 letter.

“The supervisory process has to have more consistency in the good times and not just in the bad times,” said John Bovenzi, FDIC chief operating officer until this year. “It’s historically been harder to show effectively that changes need to be made when times are good.”

A surge in bank closings pushed the FDIC deposit insurance fund, which pays the cost of unwinding failed institutions, into a deficit, requiring the FDIC to replenish the reserve without overburdening hobbled banks. Last month, it proposed that banks prepay three years of premiums to raise $45 billion.

Bair told a Senate subcommittee on Oct. 14 that bank failures will continue to rise, reaching a peak next year, while costing the fund $100 billion through 2013.

“We should have been more strict,” Joseph Smith, North Carolina’s bank commissioner and chairman of the Conference of State Bank Supervisors, said in a telephone interview. “Had we required the reduction of CRE lending, it would have been thought of as an intrusion by regulators into the businesses of banks and to the operations of local economies,” Smith said. “Yes, it would have been the right thing to do. It would have caused a firestorm then. That might have been better than a firestorm now.”

FDIC to Issue Guidance on CRE Workout

In Federal Deposit Insurance Corp. Chairman Sheila Bair’s testimony Wednesday before a Senate subcommittee about the state of the banking industry she said that federal regulators “will soon issue guidance on commercial real estate loan workouts.”

“The agencies recognize that lenders are borrowers face challenging credit conditions due to the economic downturn, and are frequently dealing with diminished cash flows and depreciating collateral values,” Ms. Bair will say. “Prudent loan workouts are often in the best interest of financial institutions and borrowers, particularly during difficult economic circumstances and constrained credit availability. This guidance reflects that reality, and supports prudent and pragmatic credit and business decision-making within the framework of financial accuracy, transparency, and timely loss recognition.”

Institutionalized "extend and pretend"? What debtors are facing is a credit crunch. Loans put in place five years ago are coming due and they can't refinance them because loan-to-value ratios are falling and underwriting standards have tightened. Debtors will have to come up with more equity or lose the properties in foreclosure. Raising money in a falling market is tough to do.

Result: Banks will be allowed keep bad loans on their books on terms that fail any underwriting or solvency test. This "framework" financial accuracy, transparency, and timely loss recognition must indeed be a very loose one.

This policy will undermine confidence in the banks, delay the inevitable, cause more banks failures, and cause tighter credit.

Small Banks Failure Rate and CRE Loans

From the NY Times:

• About $870 billion, or roughly half of the industry’s $1.8 trillion of commercial real estate loans, now sit on the balance sheets of small and medium-size banks
• As a group, small banks have written off only a tiny percentage of the losses that analysts expect them to incur.
• Applying only the commercial real estate loss assumptions that federal regulators used during the stress tests for the big banks last spring, as many as 581 small banks were at risk of collapse by 2011. By contrast, commercial real estate losses put none of the nation’s 19 biggest banks, and only about 5 of the next 100 largest lenders, in jeopardy.
• Local and regional banks are exposed to about $870 billion in CRE loans. Not all of the loans will go bad, and the loss severity will be far less than 100%. So the losses may be in the $100 to $200 billion range; small compared to the residential mortgage losses, but still very significant.

Fed Worries About CRE

From the WSJ:

Banks in the U.S. "are slow" to take losses on their commercial real-estate loans being battered by slumping property values and rental payments, according to a Federal Reserve presentation to banking regulators last month.

The remarks suggest that banking regulators are girding for a rerun of the housing-related losses now slamming thousands of banks that failed to set aside enough capital during the boom to cushion themselves when the bubble burst. "Banks will be slow to recognize the severity of the loss -- just as they were in residential," according to the Fed presentation.

"More pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposures," New York Fed President Bill Dudley said in a speech Monday.

In another sign that many U.S. financial institutions are inadequately protected against potential losses on commercial real-estate loans, banks with heavy exposure to such loans set aside just 38 cents in reserves during the second quarter for every $1 in bad loans. That is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007.

Loan-loss reserves typically rise and fall during any credit cycle, being drawn down as losses mount. Some analysts and investors say the recession combined with inadequate loan-loss provisions when times were good have left banks dangerously vulnerable to the deteriorating commercial real-estate market.

The Fed presentation painted a bleak picture of the sliding real-estate values and enormous debt that will need to be refinanced in the next few years. Vacancy rates in the apartment, retail and warehouse sectors already have exceeded those seen during the real-estate collapse of the early 1990s. The report also predicted that commercial real-estate losses would reach roughly 45% next year. Valuing real estate has always been tricky for banks, and the problem is particularly acute now because sales activity is practically nonexistent.

These days, many U.S. banks have adopted a policy of extending loans when they come due even if they wouldn't make those loans now. In some cases, values of the underlying property have fallen below the amount of the loan.

Last month's Fed presentation supports criticisms that banks have been slow to take losses on bad commercial real-estate loans. The value of commercial real-estate loans as recorded by banks has declined at a much slower rate than property values since 2005. But banks have been slow to absorb losses on their loans partly due to "capital preservation" concerns, the report states.

Bank examiners are stepping up their scrutiny of commercial real-estate portfolios at U.S. banks. Michael Stevens, senior vice president of regulatory affairs at the Conference of State Bank Supervisors, said regulators are reviewing greater volumes of commercial real-estate loans than they did before the financial crisis erupted.

Commercial real-estate loans are the second-largest loan type after home mortgages. More than half of the $3.4 trillion in outstanding commercial real-estate debt is held by banks.

The Fed presentation states that the most "toxic" loans on bank books are so-called interest-only loans, which require borrowers to repay interest but no principal. Those loans "get no benefit from amortization," the report states.

"Today, most of the borrowers are paying because interest rates are so low, but the question is whether the loans will get paid off when they come due."

Regulators are zeroing in on banks that use interest reserves to mask bad construction loans. When such loans are made, banks typically calculate interest that would be paid and set that money aside, basically paying themselves until the loan becomes due or the property generates cash flow.

Regulators want to make sure banks don't have a false sense of security only because the interest reserve is paying the loan. Banks need to look at "the sources of repayment" to determine whether the loan will get repaid, says Darryle Rude, supervisor of industrial banks at the Utah Department of Financial Institutions.