Banking Industry Woes to Strengthen Some While Others Vanish

If you are a regular reader of StreetWise, you know that in New York City the community and regional banks have been the main driver of financing activity which has kept the sales market out of the morgue, especially for small to mid-sized assets. Ironically, these are the very types of banks which are suffering the most around the country, threatening our economic recovery. Banks are failing at an alarming rate and, as real estate professionals, it is important to be familiar with the status of this critical industry.

Last Friday, Bradford Bank in Maryland and Mainstreet Bank in Minnesota were closed by regulators marking the 82nd and 83rd US bank failures in 2009. This figure is greater than that seen in any year since 1992 and, what is most troubling, almost half of these have occured since July 1st. In 2008, 25 banks failed bringing the total during this recession to 108. It is expected that this number will grow to as many as 1,000 over the next 18 months before the smoke clears. The FDIC seizes banks on Friday afternoons and the banks are reconstituted over the weekend to open as part of the acquiring bank on monday morning. During the Savings and Loan Crisis, 853 banks failed and today’s conditions are widely considered to be far worse than the conditions we saw in the early 1990s.  The problems this time around will result in hundreds of failures with some of the stronger banks growing stronger as they emerge from this cycle.

The FDIC insures deposits at 8,246 banks and keeps a “watchlist” of banks which are candidates for insolvency. This figure comes out periodically and at the end of March it was 305. Last Thursday, the FDIC said the number had grown to 416 which is the highest number since 1994. In 1988 this number was a record 2,165. Given the relative comparision, the watchlist level is expected to soar during the next year or two.

Stronger and larger banks, in addition to receiveing TARP funds, have been able to raise $48.3 billion recently through a combination of strong earnings, dividend cuts, asset sales and equity raising. Unfortunately, it is estimated that $275 billion is needed to stabilize the industry. How did the industry get into this position? It did because far too many banks tripled-down on real estate investments. Here is the triple-down scenario:

First, and most obviously, banks made loans on residential real estate, commercial real estate and development projects. Unfortunately, the present speed of deterioration in loan performance is unprecedented – even relative to the early 1990s. Particularly, some banks deployed over 100% of their risk-based capital into development projects. Many of those banks no longer exist.

Second, we must look at how some banks handled their investment portfolios. Thousands of banks and thrifts purchased securities tied to the housing market. Banks bought $2.21 trillion of these securities which represents 16% of the industry’s total assets of about $13.5 trillion. 1,400 banks purchased “private label” securities which are those not issued by Fannie Mae or Freddie Mac. It has been estimated that small and regional banks presently own $37.2 billion of these private issuer securities.

Third, the industry has been battered by $50 billion of “Trust Preferred Securities”. These are financial instruments issued by banks which are a hybrid between debt and equity. Between 2003 and 2008, 1,500 banks issued these products. Wall Street purchased these securities, created CDOs, and sold the resultant securities back to the same pool of banks! As market conditions weakened, the performance of these banks and of these securities weakened. In the first half of 2009, 119 of these banks deferred dividend payments on these securities and 26 banks defaulted altogether. The consequences of these stresses are cascading down to the buyers of the securities (the banks).

This tripling-down effect has created the difficulties in the banking sector. As the sector weakens and more banks fail, tremendous stresses are being exerted on the FDIC and its insurance fund which takes a hit each time a bank is seized. As the FDIC seizes banks, it prefers to have a buyer in hand prior to the seizure so that a conversion can be implemented over the weekend. Unfortunatley, buyers, particularly for larger institutions, have not been plentiful in supply.

Two weeks ago, Colonial Bank, with $25 billion in assets, was seized and sold but there were surprisingly few bidders engaged in the process. When Guaranty Bank in Texas was sold, the FDIC, for the first time in history, sold the assets to a foreign bank. Banco Bilbao Vizcaya Argentaria, a Spanish bank, was the buyer.

The FDIC’s most important consideration is to limit the cost to its insurance fund, which covers losses from a failed bank’s troubled loans. In order to achieve this objective, having as many bidders as possible is in their best interest. Expanding the arena of foreign banks is part of this strategy and several have expressed interest including TD Bank (Toronto-Dominion Bank), Bank of the West (BNP Paribas), UnionBanCal (Bank of Tokyo-Mitsubishi UFJ) and Rabobank (Rabobank Group).

This past week, the FDIC also made it a bit easier for private-equity firms to purchase failed banks. Existing bank holding companies need a Tier 1 capital ratio of 5% to be a qualified purchaser while new banks require 8%. Private-equity firms were required to have a Tier 1 capital ratio of 15%. This has been reduced to 10%. By attracting private capital to buy these failed banks, the FDIC can reduce the number of liquidations and thus reduce the potential losses to taxpayers. The impulse to demand a higher capital cushion as proof of ownership commitment and staying power is exactly correct. The same goes for the requirement for non-bank holding companies to hold onto the bank for at least 3 years before it can be resold and the requirement that the buyer act as a financial backstop. The weak US banking system doesn’t need investors looking mainly for a quick spinoff that could leave a bank in poorer hands within a year or two.

Sheila Bair, the Chairman of the FDIC, has been one of the most on-point players in our financial markets during this cycle. She had the foresight to ask congress to provide access to a $500 billion Treasury line of credit several months ago. While she is reluctant to tap the line (for obvious reasons) it is good that the facility is in place.

We keep hearing from the Treasury and Congress that the US needs more and tougher bank regulation, even though regulators failed miserably to detect problems within the system. Yet the FDIC is being roughed up, by these same proponents of more regulation, for demanding capital and other standards from nonbank investors who won’t have to meet current bank holding company rules. This position is not the way to restore confidence in the banking system.

We need a healthy banking system to provide financing to our industry. There is a recycling process that it will have to go through but we remain hopeful that a stronger system will emerge from the rubble.

22 Responses to “Banking Industry Woes to Strengthen Some While Others Vanish”

  1. 1 ntfeldman August 31, 2009 at 10:58 am

    Excellent article, thank you. The valuation of assets will remain critical to the clean up of our banking issues.

    Recent changes within the appraisal industry may play a hidden but adverse role in exacerbating an already enervated commercial real estate market.

    The absorption velocity and in some cases integrity may be effected by these changes; not helpful additions.

    I look forward to more articles from you Mr. Knakal.

  2. 2 rknakal August 31, 2009 at 11:03 am

    Hi NTFeldman, Thank you for your post and kind words. It will, indeed, be very interesting to see how everything will play out. Changes are most accurately analyzed in hindsight.

  3. 3 MB August 31, 2009 at 6:47 pm

    What of the community banks and regional banks that have been keeping the NYC investment sales market out of the morgue? Will they continue to do so?

  4. 4 Neil Golub September 1, 2009 at 11:43 am

    Very interesting article (and quite scary)! Do you feel traditional fee simple real estate sales will become a thing of the past? Thx.

  5. 5 rknakal September 1, 2009 at 1:16 pm

    Hi MB, thanks for your post. The regional and community banks have consistently been pumping debt dollars into the marketplace, particularly in the multi-family sector. If you look at the deliquency rates at many of these lenders, they are well below national averages. If the bank started to diversify into construction and development projects, they are more exposed to market condidtions today. You would have to assume that healthy banks will continue to lend as they should be thrilled with the present environment in which to lend. Spreads 2 years ago were only 30 to 40 basis points because of all of the competition to put dollars to work. Today, those spreads are 300 to 400 over treasuries, making each dollar lent twice as profitable. Additionally, LTV ratios have receeded from 75%-85% down to 50%-60%. More profitability with less risk is the reason why we are seeing new banks being formed and why the strong banks will continue to lend.

  6. 6 rknakal September 1, 2009 at 1:28 pm

    Hi Neil, thanks for your post. Traditional fee simple transactions will always be around. Today, many transactions will be in the form of note purchases/foreclosures/short sales but this period will eventually pass. Notwithstanding the present climate we are still selling properties for private sellers in the tradional fashion. In the first half of 2009, Massey Knakal closed on the sale of 144 properties and 126 of them were sold in the traditional manner. We do, however, believe the percentage of non-traditional transactions will increase as the stress in the market becomes more evident and lenders begin to acknowledge the losses imbedded in their balance sheets.

  7. 7 jwm September 2, 2009 at 11:55 am

    Interesting article, thank you for sharing your perspective. Do you have any view on the effects to the banks of the maturing CMBS loans on commercial properties which they are holding in their portfolios and showing at par value, which would seem to be part of the reason they are showing such good profits. Instinct leads me to the conclusion that the unrealized (potential) losses on the write-down of the 80- 85% original LTV loans (placed during the run up of values) could result in the second shoe dropping. The premise being that the peak values were inappropriate and not real, as opposed to the same values being realized again, when the economy returns to form. IF hte latter proves out, it would seem that the banks could be okay, but if not, how does credit begin to flow again? Today the bank’s cost of funds are effectively non-existent, and the returns on existing portfolios are 600 bps or more which could be providing them with huge profits, even if those may not be sustainable. What might happen then and where does that put values of the underlying assets?

    Thanking you in advance for your thoughts.

  8. 8 rknakal September 2, 2009 at 7:33 pm

    Hi JWM, thanks for your post. You make some excellent points. The fact is that the distressed asset pipeline is chock full of thousands of assets which are in trouble. Thus far, they have only been trickling into the market. No one knows what will happen when the first large CMBS loan matures and cannot be refinanced. With so many layers in a typical capital stack on larger properties, it will be very interesting to see how this circumstance will be dealt with. Meanwhile, many lenders are ignoring their losses or soon-to-be nonperforming loans. Interest-only periods, interest reserves and rates which are floating over 30 day libor (about 34 bps today) will eventually come to an end and most of those loans will not qualify for refinancing without additional equity injections. Also, because maturities of a large percentage of 2006 and 2007 vintage loans will occur in 2011 and 2012, we should see forced selling well into those years. Ultimately, lenders will have to face the losses that are imbedded in their balance sheets.

  9. 9 Barry Smith September 2, 2009 at 8:10 pm

    Mr. Knakal, its Barry from

    You have expounded upon a great topic again!

    As loan sale advisors, we are speaking to these banks daily. It is quite a challenging time for many to say the least. I personally know several bankers who have been shut down, and fear that I know many who may be next.
    The FDIC is going to be busy for the next few years. I believe they are WAY behind schedule and doing all they can do to systematically shut down just a handful of banks each week.
    The surprising thing we are observing is the lack of acknowledgement from so many banks of the problems they are experiencing within their commercial real estate portfolio.
    I suspect that the FDIC is doing the same on a “public” level as far as harboring information on how dire the situation really is. But here is an interesting thought:
    Is it possible that the FDIC is actually wanting to cull out the weaklings? Do we really need over 8,200 banks? There is a big issue on Regulation and how best to do it in the future. Certainly whatever they come up with will be easier to implement on fewer institutions. It is interesting that the TARP program is NOT actually an option for most of the banks that are in the biggest jams. What a paradox that must be for a failing bank.

    On the opposite side of the spectrum, we are in fact dealing with many banks who are interested in buying loans for earnings. So, there are some bright spots.

    Lets all hope that things don’t get too out of control in the commercial real estate and banking sector and that lending will soon return to the market and help stabilize prices.

    From where I sit, I believe we have a way to go.

    Thanks for the forum.

    Barry Smith

  10. 10 JWB September 3, 2009 at 8:25 am

    We have gotten wind that FNMA is considering labling the entire states of NY and TX pre-review markets. We have had pre-review for some time in Houston. Aside from the ridiculous committee time frames, LTV’s are constrained at 65%. With rising cap rates and declining LTVs, it has become evermore challenging to get transaction based loans funded.

  11. 11 Carl Todd September 4, 2009 at 1:19 pm

    In the 1970’s I was consultant commercial appraiser to a local bank as well as their joint venture consultant appraiser.

    Every commercial property that was given me to appraise the mortgage officer gave me the the entire mortgage application file that contained the complete data about the subject property (account’s certified report of income tax page, lease abstracts, etc.) and the credit report of the owner/applicant with his or his superintendent or manager’s phone number to arrange my physical inspection. Each time he handed me the folder for the property to be appraised I was admonished by these words: “Carl, remember that a loan is a gift until it is repaid”.

    My first stop in my appraisal was to the Register’s or County Clerk’s office to read the property history and easements, etc. on record. The second stop was to the building department to check the zoning and property’s addition history and violation record and most important if there are any present open violations thereon.

    With that information I would the make my physical inspection and neighborhood analysis.

    If the bank made the loan periodically, about every year or two I had to do a repeat physical inspection and was again given the updated property financial data and before before my inspection inspection I repeated by building department search for any new filings therein.

    My report for properties that the bank intended to solely hold the mortgage to maturity was in semi-narrative form. When the amount of the loan was higher that the bank wanted to have they would act as initiating lender and seek other banks as partners in the loan. For those loans I would prepare a full narrative report that was very much akin to the appraisal reports that I did and still do for trial purposes.

    The last 20 years my practice was 90% litigation, the was balance consulting and now its 95% consulting and 5% litigation. I’m still in touch with many of my colleagues, most do bank work and none do the extensive research that was required of us in the past. I always believed that without doing an extensive demographic market study as part of a full narrative appraisal the procedure I did for the bank was a basic requirement for any commercial loan.

    I guess if your not responsible for what you sold to others (and that relieves you of any liability thereafter) you care less about the loan once you sold it for a profit also has one seek the cheapest appraisal that will either cover your butt and/or could be uses as a sales tool.

    Until the originator of the loan has full responsibility for the loan until its repaid we will always have the for failed loans buck passed to the taxpayers by our lobbyist controlled congress.

  12. 12 rknakal September 7, 2009 at 10:13 am

    Hi Barry, Thanks for the post. You make some good points and I agree that the FDIC has a long way to go before all of the problems have been dealt with. It will be interesting to see how many banks fail during this cycle.

  13. 13 rknakal September 7, 2009 at 10:15 am

    Hi JWB, thanks for your post. I am not familiar with “pre-review” and the ramifications of such a label. What does this mean?

  14. 14 rknakal September 7, 2009 at 10:26 am

    Hi Carl, Thanks for your post. I have been in the real estate business for 25 years and have never heard of an appraiser doing the things that you used to do. That would require a lot more work but would be well worth doing. Some lenders have many rights which they do not take advantage of such as receiving copies of plans, periodic financial statements, copies of all filings, information on contractors used, verification of expenses, etc. Most loan documents provide significant accountability on behalf of the borrower but follow up is sometimes lacking. Keeping liability with the originator of the loan makes tremendous sense as underwriting would be much more diligent. If you look at my article on CMBS and the need for “skin in the game”, this point is made clearly.

  15. 15 Carl Todd September 7, 2009 at 6:43 pm

    We still do the basics outlined in my comment for every single appraisal assignment even if it is a “preliminary” appraisal used for a clients internal use, guidance for the resolution of a minor value dispute or to decide if further action is needed and we then are assigned a standard or trial appraisal assignment.

    You are not valuing real estate, the physical land and what is attached to it you are valuing real property, the legal interests in the real estate. No wonder we’re up the creek if what you say about the commercial real estate appraiser you are aware of are doing and the lenders are loaning without that background analyzed and findings valued in the appraisal reports.

    Somebody is going to get rich selling paddles to those who want to get back down stream!

  16. 16 JWB September 8, 2009 at 7:57 am

    Pre-review is a term for certain designated markets (MSA’s usually) by FNMA, whereby their risk is “overconcentrated” or they consider the market “underperforming”. Typically, this results in LTVs starting at a max of 65% as opposed 75%.

    This also results in a “pre-review” process, whereby the DUS lender has to “pre-review” the deal with FNMA on the front-end. Additionally, this results in a longer loan committee time frame on the back end of transaction. (I’ve sat for 3 weeks in committee on my last Houston DUS deal with no UW questions). This has been problematic in pre-review MSA’s and now the rumor is FNMA is considering making all of TX and NY “pre-review”

  17. 17 Loan Advice September 13, 2009 at 2:05 am

    What a useful post here. Very informative for me.

  18. 18 Bill Bartmann September 21, 2009 at 12:10 pm

    Hey Mr. K, good stuff…keep up the good work! 🙂 I read a lot of blogs on a daily basis and for the most part, people lack substance but, I just wanted to make a quick comment to say I’m glad I found your blog. Your comments are well thought out and are right on track. This is a definite great read and I will instruct my people to read this every week. Thanks, Bill

  19. 19 rknakal September 21, 2009 at 9:18 pm

    Hi Bill, thanks for the post. I try to use as much factual information as possible. I appreciate your feedback.

  20. 20 Tony Brown September 23, 2009 at 6:35 pm

    Bob, very good stuff here…keep up the good work! I read a lot of blogs on a daily basis and for the most part, people lack substance but, I just wanted to make a quick comment to say I’m glad I found your blog. Thanks,

    A definite great read..Tony Brown

  21. 21 Allene Wirch March 29, 2011 at 9:41 am

    Nice post. I study something tougher on completely different blogs everyday. It will at all times be stimulating to read content material from different writers and practice slightly one thing from their store. I’d choose to make use of some with the content material on my weblog whether you don’t mind. Natually I’ll give you a link on your internet blog. Thanks for sharing.

  1. 1 Mallorca Property Trackback on September 16, 2009 at 6:07 am

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