Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Community Banks are Zombie's

There is a reason no lending is happening - Community Banks have become zombie's!

It is sad that Banks stuffed themselves with CMO's, CDO's, CMBS's and a whole lot in between, with incumbent management not fully understanding the products. They thought they were getting the best of both worlds - AAA to A credit coupled with high yields - higher than what they would otherwise gain by lending to business that are small and medium sized!

But alas, now they are taking gigantic hits to their equity, as the regulators woke up and started asking questions about value of these non-agency assets! Banks, not knowing what they bought, did not have a clue on how to value these exotic derivatives! So, all manner of Banks are making large loan loss provisions, or taking charge-off's on their investments in these derivatives. Enough write-off's, that almost all Tangible Equity is essentially wiped off.

Take an example of a hypothetical Community Bank, which raised $50MM in equity when it started and grew its deposit base to $300 Million.

Such a Bank, would mostly own Loans made for commercial real estate, residential real estate, construction loans, and some business loans - I would say on average about $250MM is in such assets. Also, on average these assets provided a bank with about 3.5% in net interest margin per annum. So the Bank made a reasonable profit.

But $100 MM was typically invested in cash, or in "securities" - and in many cases these were fancy derivatives (CMO's, CDO's, CMBS's and their ilk), because they provided a net interest margin in many cases of 3.8% give or take, and this was somewhat better than buying a GNMA security, in matter of yield - so non-agency paper.

So just for a little bit extra in yield, Bankers thought that these securities were equally or more liquid than making CRE loans, and the extra 30 bps was icing on the cake and must be owned. Sadly many did buy these assets. they were wrong on both counts - these were NOT liquid and NOT assured/insured for returns.

Now when the Regulators came asking, what is true value, many bankers found that there were no Buyers of these derivatives, to actually place value. So, in many cases, Banks are writing down or outright selling to arbitraugers who may buy - at discounts neighboring on 50% or more.

So using our Bank example, it just took a $50MM chargeoff, from the $100MM in toxic investments it held. All of a sudden the Bank Equity of $50MM, has gone poof! The Regulators issue a cease and desist ("C&D") order and mandate the Bank to go out and raise new capital in 90 days or else the Bank shall be closed. Find new Equity in 90 days? How? from whom?

In the meantime, all lending stops and Banks are saying NO mostly and have become Zombie's. Scores of Banks are in this predicament. No ability to lend. C&D.

Investors are gun shy of investing in these small Community Banks, given their choices to invest in other more profitable companies and industries. banks are traditionally slow poke way of making investment gains. Small dozes of profit are added, and that too if all Borrowers pay up! Banks cannot afford to take 50% hits in any asset class - ever!

Bank investing is next to zero.

No wonder we are still scraping bottom in this recession. The Engines need to be primed.

The large Banks also have similar issues so they too are stymied. For them Congress authored TARP. Bbut TARP is providing equity cover to the larger companies, but the smaller Banks (and there are far more smaller Banks than these few handful of large Banks), but they cannot qualify for TARP. So how will they get fixed?

Finding a funding solution for them is key to priming our US financial engine.

One solution lies, in having the Banks, sell for face value all of their toxic assets and NOT be required to take massive hits to their Equity. The only Buyer can be the Federal Government. So the Feds provide money from TARP, to fund the new equity. Spare the small Banks the odious task of finding private money where there is none to spare.

With Equity saved, Banks will begin to lend again.

Their problem isn't liquidity, but lack of Equity.

That is how I see it!