I hate to be the bearer of more bad news, but hey, after 25 years of a growing economy, decreasing interest rates, low inflation, and generally sharing good news, I wouldn’t be doing my job if I misrepresented what I see coming, even if it’s more difficult times.
I’ve been talking to a number of bankers lately, and I’ve also been reviewing a couple of banks’ publicly available financial statements, as well as perusing the FDIC Web site, and the evidence I see indicates a coming capital crunch.
Let me explain:
In spite of an already tightening credit market, bank regulators are just starting to direct banks to reduce business loans and specifically to limit commercial real estate loans to no more than 300% of a bank’s capital ratio.
How will a bank reduce lending to existing borrowers who have loans? By cutting lines of credit, “re-margining” loans (that’s when a bank revalues an asset lower and then demands a partial pay down of the loan principal), demanding more equity when a loan comes up for renewal, and by rejecting a few loans that would otherwise be renewed.
For many banks, satisfying the regulators demands will be difficult and may jeopardize their ability to meet required capital ratios, which may, in turn, cause the regulators to clamp down on them even more — thereby reducing lending even further as the banks attempt to shore up their capital base.
Another reason that there will be less overall lending is because there will be fewer banks. The FDIC is currently hiring new employees in preparation for shutting down or forcibly selling hundreds of weak banks next year. For example, there are two banks right here in town that are under cease-and-desist orders instructing them to effectively raise more equity capital. If those banks fail to timely comply with the order, you can bet the FDIC is going to take some kind of action.
Fewer banks mean fewer loans.
The unfortunate part about all this is that small businesses, in particular family-owned businesses with a single banking relationship and entrepreneurs who own commercial property as a side investment, but lack liquidity, are going to get squeezed.
Less credit also means less economic activity as borrowers come to realize that securing a new loan will be difficult to impossible. Less lending activity translates into prolonging the recession, which is why my premise is that the federal regulators are going to cause a double-dip recession next year (everywhere except in Washington and New York). If credit, which is the lifeblood of economic activity, is choked off, there can’t be a recovery.
Likewise, in talking to dozens of business owners, I’ve learned that banks are also starting to increase borrowing costs by increasing interest rates as loans come up for renewal. On loans that aren’t up for renewal, business owners are telling me that some banks are using technicalities to squeeze the borrower and then renegotiate the rate, adding cost to the borrower.
On top of this, the recent decision by the FDIC to levy a prepayment of the next three years’ insurance premiums (necessary because the FDIC nearly ran out of deposit insurance funds in August), and the banks will again have less capital to loan out. This prepayment plus the prior special assessments mean that the good banks are paying the cost to bail out the bad banks. (In the first half of this year, the FDIC not only significantly increased the insurance premium, but also demanded a one-time special assessment.)
The combination of these additional costs may run into the millions of dollars for a typical medium-sized community bank. When you consider that a bank with one billion in loans may produce $4 to $5 million in profit has to pay millions more than budgeted in insurance premiums, you can see the impact on the bottom line.
My theory is that this policy of having the good banks pay for the mistakes of the bad banks is going to jeopardize the financial standing of many banks. As profits are reduced, capital cannot be replaced as fast, thereby jeopardizing the capital ratio, forcing the banks to curtail lending to shore up their ratios in order to prevent the FDIC from placing them on the “bad-banks” list.
It’s a vicious circle.
Of course, none of this seems to apply to the largest banks in the U.S. who got bailed out at taxpayer cost, many of whom don’t seem to have changed their behavior. Take Citibank for example. The bank got in trouble making risky bets using depositors’ money, bets that went south, forcing a bail out. Now we discover that the bank (through its Philbro unit) has a trader placing pure bets in the energy market. Sure, he made a lot of gambling wins that have temporarily helped the bank’s bottom line (and now he wants his $100 million payment). But what people on Wall Street forget is that he used depositors’ funds (and in this case, taxpayer funds) to place those bets. Had those bets gone wrong, the taxpayers would be bailing out Citibank again. Heads he wins, tails we lose. He has every incentive to place huge bets and no disincentive towards taking unnecessary risk. Is the bank in the business of gambling or making loans? Why are the regulators continuing to allow this kind of risk- taking with depositors’ funds?
Instead, the present policy by the regulators of making smaller banks on Main Street bail out the largest banks is a mistake and will lead to further tightening of overall credit in the marketplace, thereby weakening any recovery.
Remember, right now the government pretty much owns and controls much of the U.S. financial system. We’ve put all our eggs in one basket, and unfortunately that basket is controlled by a bunch of politicians who don’t understand the impact of their decisions on small-town America.
Tip of the Month: Renew your loans and lines of credit now; don’t wait. Prepare for unexpected surprises from your bankers, including a demand for more equity. Have at least two banking relationships in case one becomes unavailable.
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