The Small Bank Problem: Why We Are 40,000 Properties Away From Recovery

Includes: KBE, KME, KRE, REM, REZ
by: Econophile

This article is one of a series of occasional white papers from the Daily Capitalist taking a detailed look at specific issues affecting the economy. In this paper we discuss bank credit, banks and their real estate loans, the so-called "liquidity trap," and why the economy is not growing. It attempts to quantify the problem that local and regional banks have with their commercial real estate loans. We also explain how, why, and when the economy may grow again.

The Effects of Gravity

Credit conditions are a symptom of a larger problem in our economy: the flood of debt that resulted from a Federal Reserve Bank that believed it could command the economy according to its wishes.

Alan Greenspan and Ben Bernanke are emblematic of that process. Greenspan, who professed to know better, was responsible for the policies that reallocated capital from savers to spenders in one of history's great expansions of fiat money and resulting destruction of capital. Bernanke was the unfortunate inheritor of that boom and bust and has proven incapable of preventing the effects of economic gravity.1

We are still facing the effects of gravity while the Fed and the federal government try to prevent the apple from falling to the ground. This article discusses one of those apples, credit conditions, which is a key to economic recovery and one of the reasons our economy is stagnating.

When we talk about apples and gravity, we are referring to the artificial growth (boom) created by excessive money and credit created or presided over by the Fed. Since most of the boom's money and credit flowed into real estate, which now no one wants, it is necessary to liquidate these failed projects and the debt that supported them. Why? Because they are tying up valuable capital that could be otherwise invested in profitable projects, because they are tying up the balance sheets of lenders and borrowers who must resolve these problems, because they are tying up time of productive people who are burdened with solving their problems, and because it is more difficult to create new capital if money losing projects are still being supported by both lenders and borrowers. The debt bomb has gone off and what's left is still radioactive.


As an indicator of the economy's potential for recovery and growth, the conditions of banks and other lenders are key. Since the Crash in 2008, credit has tightened making loans for businesses and consumers more difficult to get. On the other side of the table, businesses are reluctant to borrow, fearful of long-term commitments in an uncertain world. If we see that credit conditions are improving because lenders and borrowers' balance sheets are being steadily repaired, then that is very important data for determining where the economy is going. It means that the problems with malinvested projects are being resolved, balance sheets are being cleared, and banks and lenders can apply capital to profitable ventures. This paves the way for new growth.

There are, of course, other factors, which are important in gauging the future of the economy: Fed policies on money supply and interest rates, industrial production, the formation of new capital (real savings), the level of government spending and taxation, the devaluation of the dollar in an over-indebted world, government policies that impact the formation and operation of businesses, and the occasional Black Swan. But, credit conditions are critical indicators and it is those conditions that largely explain why monetary and fiscal stimulus have not worked and cannot work to revive the economy.

To get an idea of the problem, here is a chart showing total consumer debt created over the past ten years:

(Click charts to enlarge)

In 2001 when the Fed commenced lowering the Fed Funds rate from 4% to 1% by 2003, they created a huge, unparalleled expansion of money and credit into the economy, resulting in a doubling of consumer debt.

As well, business debt also expanded by about 75% through 2008:

Since the crash, we can estimate from the Fed's Flow of Funds report that approximately $10 trillion of household assets have been wiped out. Businesses suffered about $3 trillion of losses at the nadir of the Crash, but, because of QE, the stock market has recovered a substantial portion of that for public companies.

Banks were happy to accommodate this debt explosion. Total bank loans spiked from $3.8 trillion in 2001 to about $7.2 trillion to 2008:

Where did all this new money from the credit expansion go? As we know much of it (56%) went into real estate, commercial and residential, and fueled an unsustainable boom. What people mistook for wealth and prosperity was the result of money steroids, and, as history has proven time and time again, it doesn't last.

By 2008, 24% of those loans ($1.557 trillion) were just for commercial real estate, a 126% increase since 2001. As we can see from the above chart, it has since contracted by about $300 billion and seems to be stuck at its present level. Some economists refer to this as a "liquidity trap." It's not a trap; it is a reasonable response by lenders and savers to uncertainty.

It is commercial real estate (CRE) and real estate development loans that are now the main problems for many banks (much of their residential loans were sold and securitized). But which banks have been impacted the most? There are 6,453 banks in America per the FDIC, of which there are only 86 large national banks with assets of more than $10BB. In other words the overwhelming majority of banks in America are less than $1BB in size:

Those 86 banks account for 78% of total bank loan volume. All the rest do only 22% of all lending in America. Yet the local and regional banks (LRBs) almost exclusively serve small to medium business enterprises (SMEs). While the large banks also lend to SMEs, it has until recently been largely the domain of the LRBs. Smelling blood in the water, the large banks are now invading this territory.

While trophy buildings are the exclusive domain of the large banks and nonbank lenders, most CRE in America is financed by the LRBs. While the dollar volume of CRE loans by the large banks is significant, the point here is that such loans are relatively small in relation to their total loan volume; it is a much higher percentage of LRB loans. Thus LRBs have existential problems as these loans go bad.

Presently real estate loans comprise only 52% of large bank loan volume. For LRBs real estate loans went from 60% of total loan volume in 2003 to 74% of total loan volume now. CRE loans consist of only10% of large bank loan volume, yet for LRBs it represents about 44% of their loan volume. Real estate development loans comprise 3% of large bank loans, but it is 11% for LRBs. See this chart below to compare real estate loan growth for LRBs for three key years--2003, 2008, and 2011:

Why is this significant? The problems caused by real estate malinvestment have landed squarely on the LRBs who are the main lenders to the SMEs. SMEs do about one-half of the business in our economy and hire about one-half of American workers. Large companies do not have problems obtaining funds from banks or the credit markets, SMEs aren't that lucky.

If you ask the question of when we will recover, you have to first look to these banks and their borrowers.


There are two sides to banking though and SME borrowers aren't borrowing, at least in amounts that economists think they should be borrowing. Loan volume for LRBs grew about 40% from 2001 to 2009. Since then it has declined by about 14%. Part of that is due to tighter loan standards, but mostly it has to do with a reluctance of SMEs to borrow. The National Federation of Independent Businesses (NFIB) July Small Business Economic Report pointed out the obvious:

Ninety-one percent [of members] reported that all their credit needs were met or that they were not interested in borrowing. Nine percent reported that not all of their credit needs were satisfied, and 53 percent said they did not want a loan ...

The reason for this is that SMEs aren't optimistic about future business prospects. The primary concerns they had were poor sales and price inflation. The NFIB Optimism Index dropped 1% in June, and is still in "recession territory":

Some of the reasons for their pessimism per the report:

Reports of positive earnings trends were unchanged from last month, a net negative 24 percent of all owners, not a pretty picture, but the best reading in 42 months. The recent rise in the percent of owners successfully raising prices is contributing to some improvement in the bottom line, but sales growth is not helping. Corporate profits are at a record high level as a share of GDP, but the story is very different on Main Street. For those reporting lower earnings compared to the previous three months, 54 percent cited weaker sales (up 4 points), 2 percent blamed rising labor costs, 15 percent higher materials costs, 2 percent higher insurance costs, and 5 percent blamed lower selling prices. Five percent blamed higher taxes and regulatory costs.

Then you have to look at the SMEs themselves. A large part of their problem is the same problem that their banks have: CRE. It turns out that these business owners are substantial owners of real estate, including CRE. This data is from an NFIB study (Feb, 2010) , "Small Business Credit in a Steep Recession" (pdf):

The results of the study are significant: 49% of small business owners own their business premises and 39% own investment real estate. Here are some highlights of the report:

[A]pproximately one in six small employers (16%) have a mortgage on their residence that helps to finance the business. ...

Almost half, 49 percent of small employers whose businesses occupy commercial real estate, own all or part of the building(s) and/or land on which their business is located. Two-thirds (67%) employing 20 or more people own such property. The majority (55%) of small employers owning their business premises have a mortgage on them. Ten (10) percent with a mortgage also have a second mortgage on the property. Sixteen (16) percent of small business owners who own their firm’s real estate took out a mortgage to finance other business activities. ...

Almost four in 10 small employers (39%) own investment real estate, that is, land, developed and undeveloped, and/or structures that are neither the owner’s home nor the owner’s business premises. Two of three (66%) who own at least one own more than a singleinvestment property. ...

[T]he number of small employers who had mortgages on their business premises to support other business activities rose from 20 percent at the end of 2008 to 29 percent at the end of 2009. Similarly, the mortgages for that purpose on investment real estate rose from 11 percent to 23 percent over the same period. ...

Small business owner possession of real estate is a major reason why their firms have not yet begun to recover, why larger businesses have been able to recover more quickly than small businesses, and why this recession is different, at least for small business owners, from recent ones. It has damaged balance sheets and they will need to improve before small business can be expected to resume its traditional place in the economy. ...

While "regime uncertainty" (uncertainty over existing or future legislative impacts on business) affects SME business decisions, declining CRE prices can explain a lot of their pessimism and problems.

The Consequences

Trepp, LLC tracks data on banks and provides information regarding delinquency rates. It also provides data on the causes of bank failures. The primary cause of bank failures has been commercial real estate loans that have gone bad. For example in its June report, of the four banks that failed that month:

Commercial real estate (CRE) loans comprised $91 million (or 77%) of the total $119 million in nonperforming loans at the four failed banks. Construction and land loans made up $57 million or 48% of the total, while commercial mortgages comprised $34 million (29%)of the total nonperforming pool. The residential real estate loan category was second, with $25.2 million in nonperforming loans, or 21% of the total nonperforming balance. The remainder was comprised of C&I loans ($1.6 million, 1% of the total) and consumer and other loans ($0.9 million, 1% of the total).

This trend has been consistent since banks started failing at the start of this bust cycle in 2008.

Of the 6,900 lenders Trepp follows, about 1,000 are on its watch list (15%), and of those about 200 have high "Failure Risk" scores. The following chart from data provided by Trepp tracks the delinquency rates of various types of CRE real estate loans for all banks:

As shown, and as would be expected, loans for real estate development have had the highest rates of delinquency, followed by CRE loans and apartment loans. During the boom period, LRBs financed a large portion of housing and CRE development projects and the Crash wiped out most projects that weren't completed and sold before 2008. Many of them have been foreclosed and are held as REO properties of these lenders.

The following chart shows the number of bank failures since the crisis began:

This shows that LRBs have been struggling to deal with this high volume of bad loans, but that the resolution of malinvested projects is far from over.

A CRE Recovery?

This chart of CRE prices will give you an idea of the problem--it isn't getting better:

In preparation for this article we have reviewed a number of positive forecasts (pdf) and evaluations of the CRE market by large institutions and we have concluded that they are talking about a different CRE market than that of the CRE of this article.

There are several classes of CRE: Trophy properties, Class A properties, Class B and Class C properties. There are lower classes of properties, but for the most part we are discussing Class C properties, and perhaps Class B that are the loan turf of the LRBs. These are the properties you see when you drive around your town.

Institutional investors are involved with top drawer trophy and Class A properties. And there is a lot of competition for these properties because their sources of financing are cheap (e.g., insurers, pension funds, hedge funds, REITs). Those properties have shown price increases as shown in the NCREIF line on the chart, "Commercial/Multifamily Prices", above. Now, they are pursuing Class B properties in prime locations.

The LRBs finance Class C and even lower rated properties. Yes, there are properties larger than $5 million financed by LRBs, but by volume the bulk of CRE in America are Class C properties. And the trend of Class C CRE is still negative on a national basis. There are different markets in this large country, and some are doing better than others, but, for example, while we are getting some feedback of firming trends in the Los Angeles market, the Class C market there is still quite weak.

The positive signs are that LRBs are dealing with their problems as evidenced by the chart above showing declining delinquency rates. This following chart shows distressed properties sales for all banks:

Banks held $31.2 billion of REO at the end of Q1 2011.

On the other hand, this data from Trepp for loan maturities of CRE loans indicates that these problems will continue:

While these data are apparently related to mostly higher quality properties, we believe this maturity schedule is similar to what the LRBs are facing with their loans.

We also believe that the market is starting to find a bottom in Class B, and perhaps in Class C, properties. There are large pools of private capital awaiting "deals" in their local markets and they are starting to invest. Demand may be triggered by increasing strength in the absorption of CRE vacancies. In addition, sales volume is picking up, perhaps by as much as 20% to 30% in 2011. Pressure on Class B properties will also stimulate investment in Class C properties by smaller syndicates. In addition, more capital is being raised for CRE investment which will stimulate demand.

This is not to say that the market will take off, but we believe investors will be increasingly be drawn to the market, stabilizing the impact of properties entering the market from foreclosures.

The Forecast

But what does this all mean when we are trying to determine when credit will loosen, when SMEs will start borrowing, and when the economy will start growing again?2

Malinvested CRE debt must continue to be resolved through foreclosure, mark-to-market recollateralization (restructuring), or bank failure, or a combination of these. As discussed above,we believe that there will no imminent recovery of the CRE market to bail out lenders and borrowers.

Based on current Trepp default percentages, and the FDIC's data on nonperforming loans, the potential CRE loan defaults of the LRBs would be about $44 billion (±3%), or 7% of their real estate loan portfolio.

Based on the dollar volume of nonperforming loans, we estimate that the market has to work off perhaps another $30 to $40 billion of nonperforming loans before LRBs stabilize, assuming the market has presently found a bottom. A $30-$40 billion write-down would bring nonperforming loans down from its current 7% level to a somewhat historical 2% norm.

To determine how long it will take to write down $30-$40 billion of debt is a difficult question. From Q1 2010 to Q1 2011 nonperforming loans of LRBs declined from $50.7 billion to $42.5 billion, an $8.2 billion write down. As well, total loan charge-offs for LRBs were $14.5 billion in 2010. At that rate it would take another 4 to 5 years to reduce problem loans to 2003 levels.

These days $30-$40 billion may not seem like much when our government spends trillions of dollars in their attempt to stoke the economy. Yet for the economy it is a lot. To put things into perspective that would amount to 40,000 properties worth $1 million each, or 20,000 properties at $2 million each. Recall that we are dealing with smaller, less valuable Class B and C properties. Guesstimates aside, you see the point.

Based on our estimate, the CRE market would not start to recover until 2014, all things being equal. That means that LRBs will remain under pressure until then. It means that SMEs will not be eager to expand and borrow any time soon. And we won't see significant improvement in employment until the SMEs expand.

The government and the Fed have been doing everything they can to prevent this from happening. As we have found out, their efforts haven't worked. By delaying the inevitability of gravity, they have extended the recession. All signs point to stagnation.


1. We understand there are many economists and politicians who believe this boom and bust was brought upon us by greedy Wall Streeters and that the Fed doesn't figure large in their analysis. We believe that Wall Street had a large role to play in this cycle, but not for the reasons they would expect. Since greed is a trait always existing in human nature (a trait often conflated with ambition), it is an unsatisfactory explanation of why things all of a sudden took off, unless you are satisfied with J. M. Keynes's "animal spirits'" explanation (which is too mystical for us). Such a conclusion mistakes effect for cause. Only the effects of fiat money expansion can fully explain the phenomenon of boom and bust. The role that Wall Street did play was related to faulty risk models they used. Please see Taleb's Black Swan for a further explanation of this.

2. As noted in the beginning of this white paper, there are, of course, other factors which are important in gauging the future of the economy: Fed policies on money supply and interest rates, industrial production, the formation of new capital (real savings), the level of government spending and taxation, the devaluation of the dollar in an over-indebted world, government policies that impact the formation and operation of businesses, and the occasional Black Swan. Like all forecasts, they are based on assumptions which can and will change. Another way of putting it is, tell us what the government and Fed will do, and then we can be more assured of our forecasts.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.