Smaller Banks Are Going Nowhere

Includes: DIA, SPY
by: John M. Mason

Loans and leases on the books of the banking system rose by 4.2 percent over the past 52 weeks ending January 30, 2013. Loans and leases on the books of the largest twenty-five domestically chartered commercial banks in the United States increased by 5.0 percent. At the rest of the domestically chartered commercial banks in the United States, loans and leases rose by only 2.6 percent.

The data just released by the Federal Reserve System continue to point to the problems that smaller banks are having in the United States. Over the past 52 weeks, real estate loans at the less than large commercial banks have declined by almost $37 billion. Home equity loans have fallen by $15 billion, residential real estate loans have dropped by about $6 billion, and commercial real estate loans have declined by almost $16 billion.

We hear so much about the problems that the larger banks have in these areas, but, the dilemma faced by the smaller banks in the real estate area, in my mind, is what has really been plaguing the banking system. Real estate loans make up around 61 percent of the loans on the books to the less than gigantic banks in the country.

The value of houses has been depressed in a large portion of the country leading to borrowers that are "underwater" and have negative equity. High rates of foreclosure and bankruptcy have hit a very large portion of the country. This has hurt the residential mortgage market but it has also had a substantial impact on home equity loans. Bank managements, in my mind, have not really been able to be confident in the value of these real estate loans on their books because of the uncertainty of home prices and the uncertainty connected with the repayment of their loans.

And, then there is the deleveraging that many households are going through. One report I read last week indicated that households and individuals were about halfway through their deleveraging exercise. Consumer loans at these "smaller" banks have also been declining over the past 13-week period.

Another problem for these banks has been the commercial real estate loan area. I have been writing about this situation for about four years now. There have been severe problems in the commercial real estate loan area, but these "smaller" banks have not charged these loans off their books or written them down to any degree. One problem with these loans is that they often have a three-year or five-year maturity on them and they tend to be "bullet" loans in that the principal is not due until the loan matures. And, in many cases these loans are not paid off at the maturity. What the banks face is the problem these borrowers have in getting their commercial real estate loans refinanced.

This was a problem always set in the 2012 to 2014 time span when many of these loans came due. Will they are now coming due. Given that the loan balances at the "smaller" commercial banks has declined over the past year indicates to me that the problem is being dealt with but that since value of the loans is declining on bank balance sheets indicates that this is not the healthiest of situations.

Along with this information we also see that the "smaller" banks have also continued to increase the size of cash assets they hold on their balance sheets. (The largest banks have decreased their holdings of cash assets by substantial amounts over the past year.) This, to me, is another sign that these "smaller" banks are not doing that well and are not feeling aggressive at all when it comes to expanding their loan portfolio. And, my guess is that this situation still has a fairly lengthy time to run.

As of September 30, 2012, the FDIC reports that there are 6,168 commercial banks in the banking system. According to the Federal Reserve report, the largest twenty-five banks in the banking system control almost 56 percent of the assets of the banking system. Using the FDIC data, which are not quite the same as those of the Federal Reserve, we can calculate that the 526 commercial banks in the United States with $1.0 billion in assets control about 91 percent of the assets in the banking system.

This means that 5,642 banks control only 9 percent of the total bank assets in the United States! This gives you some idea of the way banking assets break out in the United States.

Also, the FDIC statistics indicate that since September 30, 2007, right around when the financial crisis hit, there were 7,304 banks in the banking system, 1,136 more that were in existence on September 30, 2012. Guess what? During this same time period, commercial banks with less that $100 million in assets, the "smallest" banks, declined by 1,099 banks. As of the latest date, there were only 2,034 banks of this size still in existence.

One of my arguments about why the Federal Reserve has pursued quantitative easing and why it continues to pursue quantitative easing is that the "smaller" banks in the country still have substantial problems with their loan portfolios. As mentioned above, these "smaller" banks have 61 percent of their loan portfolios in real estate loans. If they had to write down only 10 percent of the book value of these loans that would amount to about $150 billion which would be just about 4.0 percent of the total asset value of these banks.

Given that most of the 6,143 "smaller" banks in the banking system are OK and would not have this size of write down, the question then becomes how many of the other "smaller" banks would have to write down enough to make them insolvent?

I believe that one reason that the Federal Reserve is keeping the banking system extremely liquid so that these "troubled" banks can keep going for long enough so that they can be acquired or be closed by the FDIC in an orderly manner. Officials at the Federal Reserve do not speak of this problem. They only couch their discussions of the pursuit of quantitative easing in phrases relating to faster economic growth and lower unemployment. I don't believe they want to surface the issue of the insolvency of a large number of banks … even if they are very small in asset size.

Business loans (commercial and industrial loans) at the largest 25 domestically chartered banks are rising. They rose by more than 14 percent over the past 52 weeks. This is certainly good news and an indication, I believe, that these larger banks are certainly loosening the spigot. This is good new for the growth of the economy. Also, residential lending has risen over the past year. As mentioned in many posts during the year, this rise in lending at the largest banks seems to have contributed to stronger profits at these organizations. This is particularly true at Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM) and Citigroup (NYSE:C).

The Federal Reserve likes to see this increase in business loans and residential lending, and, I believe, they know that the only way that any kind of scale will be achieved in this kind of lending will be at the largest banks in the country. This may seem like the Fed is helping the big get richer and is helping the "smaller" to go out of business … and it is!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.