Bank regulators are getting a welcome late summer respite.
The Federal Deposit Insurance Corp. reported no bank failures Friday. That marks the first failure-free Friday since the weekend of July 4.
That's not to say fall will be a barrel of monkeys for bankers and their overseers. Already this year 118 banks have failed, and FDIC chief Sheila Bair has said she expects 2010 bank failures to exceed last year's tally of 140. With the economy softening and a third of the year yet to unfold, we could exceed the 179 failures recorded in 1992, as the savings and loan crisis abated.And because the FDIC tends not to close banks on a holiday weekend – reopening a day late could add to depositor anxieties the agency spends considerable effort minimizing – we seem to be on track for the first two-week stretch without a bank closing since the holiday Fridays of Dec. 25, 2009 and Jan. 1, 2010.
Fortunately, the 1989 record of 531 failures looks well out of reach. The FDIC will update the status of the banking industry and its problem bank list tomorrow morning.
FORTUNE -- Gadfly analyst Dick Bove rarely disappoints when he unholsters his guns. On Tuesday, the Rochdale Research VP put out areport accusing Sheila Bair, head of the FDIC, of completely misunderstanding her job. "Unlike the heads of the Federal Reserve (FRB) who have repeatedly acknowledged their failure to act before the financial crisis, the FDIC has never done so," he wrote. And he suggested that Bair, "knew what was wrong but did nothing about it." We caught up with Bove yesterday to get his dependably provocative view on Bair, Bernanke, and the state of the U.S. banks.
Is it really fair to blame the FDIC for the fact that banks went crazy during the credit bubble?
Yes, it is. You need to start with an understanding of the powers of the FDIC. They audit all the banks in the United States -- some 8,000 of them. Basically, they have the power to close a bank, to oust management or boards of directors, to change banks' lending policies, or to force them to adjust their capital ratios. They have total power.
Ms. Bair took her position in July 2006, which was more than two years before the September 2008 crisis. I had written in 2005 that the powder keg was going to blow. But the FDIC failed to live up to its requirements. Ms. Bair wrote that banks should not have put so much money into property loans but should have spent it elsewhere. Well, the FDIC has the power to force the banks to do that. It's not as if the FDIC was sitting on the outside and couldn't go into a bank and tell them to reduce exposures. So she is complaining that the banks were doing something that she had the power to stop. That's hypocritical, and it's just not right. The FDIC had a role to play in moderating the problems banks faced but did not play that role.
I gather you think she's not playing the appropriate role today either.
No, she's not. Fast-forward to the crisis, and the FDIC is called in to come up with solutions. They decided that the issue was capital, and that banks needed to increase their capital ratios. At the same time, the government passed a law that said banks could no longer use trust-referred securities [a hybrid security that paid dividends yet was considered equity for capital calculation purposes] in their capital ratios. I agree with that law -- banks were allowed to view the Trust Preferred's as equity but dividends were tax deductible as if they were bonds. Putting that issue aside, though, the net effect is that if you are a small bank in the U.S., you cannot now use Trust Preferreds but you must add capital.
In effect, the government is forcing capital down in small banks while demanding that they increase their capital ratios. So what can a bank do? It can only shrink.
If you are told that you cannot add capital with this instrument but you must increase capital ratios, then you are forced to shrink. When you force the bank to shrink, all sorts of hell breaks loose. The first thing they do is get ride of loans. In doing so, they reduce the money supply. And that's not helping anybody.
Give us a report card on Ben Bernanke at the Fed.
He's kind of in a tight spot, isn't he? The Fed has got this policy of quantitative easing. They are keeping interest rates as low as they can keep them. And yet the money supply is going down. Basically, the Fed is not controlling the money supply, the banks are. The banks are killing it because they are shrinking their balance sheets because the government wants higher capital ratios.
The American banking industry has more capital as a percentage of assets than at anytime since 1935. If you are at the second highest level in 75 years, you are way out at the end of the spectrum. You are the most overcapitalized than you have ever been in years, but the government is still demanding more capital. Citigroup (C, Fortune 500) has $180 billion in cash. $1 of every $9 in that company is cash or government-backed securities. Its Tier 1 ratio [the ratio of its core equity capital to total-risk weighted assets] is high because it has dumped loans and raised cash. If you look at the American banking system, roughly 8% or 9% of the assets are in cash versus 2% to 3% a decade ago. What we're seeing is the banks are readjusting their balance sheets to get these capital ratios higher by shrinking their balance sheets and shifting out of loans into liquid capital.
So the government is essentially acting at cross-purposes?
Exactly. What is the government doing? It is taking banking out of the picture as an element in assisting the economic recovery. That's why the leadership of the FDIC needs to be turned over. At least the Fed has Greenspan and Bernanke admitting that they didn't do their jobs in regulation leading up to the crisis. The FDIC didn't say a word. Nor did the Office of the Comptroller of the Currency. If they don't understand what they did wrong, how can they do right?
Shifting gears here, let's go to everyone's favorite topic, Goldman Sachs. The sound and fury of Abacus has died down. What's Goldman's business going to look like going forward?
I think that the mechanism and the structure will be different, but that the business will be the same. By that I mean that the proprietary traders won't be sitting on the desk anymore, they will be sitting in a hedge fund in the asset management division. Private equity will be another fund in the asset management division. Goldman (GS, Fortune 500) has already started shifting people over to those new venues to get away from the new Volcker rules. So the structure won't be the same. But will the company still do deals working with clients? Absolutely. What the hell does a corporate finance department do? One way or the other, someone is proposing a deal to be done. If both sides agree, they are going to do it. The functions will not change.
Where has Vikram Pandit gone and hidden? We barely hear from the guy. Can you give us a report card on his performance?
I give him an A+. I think the guy has done a phenomenal job. He walked into a company that had a decade of mismanagement behind it. Actually, it goes back even further than that -- to Walter Wriston [See Fortune's 1999 story "Don't Say Retired: Walter Wriston Is Wired"]. Wriston believed in survival of the fittest in the business world, so he created a culture where beating the guy down the hall was better than beating the guy across the street. It was dysfunctional. And then you had constant shifts in direction depending on who the leader was. Wriston liked international lending. John Reed liked technology and consumer lending. Sandy Weill liked cost control and acquisitions. Chuck Prince liked the capital markets.
When you keep changing the direction of the company, you keep changing what is important and who is important in that company. And you create confusion. And they ultimately drove that company into bankruptcy. There is no question that Citigroup was bankrupt in September 2008. Pandit had to change the whole culture, change the structure, and find businesses that can grow.
And he has done all of those things.
And how do you think James Gorman is doing at Morgan Stanley.
I don't have a report card on him for running Morgan Stanley (MS, Fortune 500) yet. But certain people are absolutely superior as managers -- Jamie Dimon, James Gorman, Dick Kovacevich. What makes Gorman one of that group is all these guys are detail-oriented. They have spent an enormous amount of time learning the functions of their business and how it operates. They have the ability to create a vision and execute on that vision. Gorman is particularly good at that.
One of the first things he did at Morgan Stanley was to review 500 executive positions. How they can be "executive positions" when there are 500 of them is beyond me, but he did it. And he brought in people whose skill set made them capable of the job. This is quite different from his predecessor John Mack, whose approach was more along the lines of if you were his buddy, then you got the job. Whether you knew what you were doing was irrelevant.
Then Gorman did town hall meetings all over the world. He is like Kovacevich in that he understands that motivating his people is the most important thing he can do to turn the company around. He put in a retail-oriented strategy based upon a humungous sales force selling consumer finance or small business finance products. He reduced risk on the trading desk. He is doing everything in the right direction. It won't show up in their third quarter earnings, but it will show up soon.
Bank stocks have been all over the place this year. What's with bank stock investors. Why can't they make up their mind?
The typical bank stock investor is a guy who recognizes that the company he is investing in his highly cyclical. Therefore he is always seeking out some piece of information that tells him where he stands in the cycle. The most important factor in that analysis is the quality of the loan portfolio. He doesn't look at the quality of management, the size of the franchise, or the power of the company. He is only looking to see if loans are good or bad. The fact that Jamie Dimon is a superb manager, nobody really cares. They should realize that Dimon's team will generate higher returns over time. All they do is say that commercial real estate looks bad, so sell the stocks. Or, wait a minute, the economy is looking better, buy the stocks! It gets farcical.
You don't have long-term investors in bank stocks. The core reason is that bank managements have failed to prove that they know how to deal with the cycle. If you look at their business results, they look like roller coasters at Coney Island. Banks never seem to be able to get out of the way of the economy. There is something wrong in the way these companies operate. They can't seem to avoid a down cycle. Wells Fargo (WFC, Fortune 500) has shown they could do that, which is why that stock traded at a premium.
I understand that banks don't control interest rates. I understand that they don't control the strength of the economy. And that their earnings are tied closely to both interest rates and the strength of the economy. But banks have the ability to do what [longserving Fed Chairman] William McChesney Martin said, which is to expand in bad times and contract in good times. They have the ability, but they do the opposite, and that's not the way to maintain earnings. They expand at the wrong times and contract at wrong times, and in the process they exacerbate the tendency of the cycle. Government regulations don't help.
What's the next surprise waiting to happen? Will it be a positive or a negative one?
The next surprise will be a big positive. The government will back off all of these laws they just passed on banking. They have taken the banks out of the economy with the rules they put in. But they need the banks. They will repeal parts of the Dodd-Frank abortion and recognize that they need banks to grow the economy. We're going to see a rollback of a bunch of these new requirements.
MB Financial's recently acquired branch, 900 W. Van Buren, formerly a branch of Broadway Bank, which was taken over by the FDIC on April 23. MB Financial has completed six FDIC-assisted acquisitions since 2007, the most among Illinois lenders.
Illinois has had 37 of its community banks fail since the start of the recession, a trend that will continue as the state continues to consolidate in the sector, experts say. Source: FDIC data.
Majority of MB Financial's net charge offs, a measure of losses from bad loans, last quarter were focused in commercial loans, a sign that the challenges in small business lending are still weighing heavily on banks focused in the Chicago market. Source: Company data and Raymond James & Associates Inc.
South Side's community lender ShoreBank the latest to fall
Bank regulators closed down ShoreBank, the ailing South Side lender known for its commitment to community lending, on August 20. Urban Partnership Bank assumed all deposits of ShoreBank, including its 15 branches located in Chicago, Detroit and Cleveland, the FDIC said Friday.
ShoreBank had roughly $2.16 billion in total assets and $1.54 billion in total deposits, as of June 30, and Urban Partnership Bank will pay the FDIC a 0.50 premium to assume all ShoreBank deposits.
Urban Partnership agreed to purchase all assets, except for marketable securities and fixed assets, according to the FDIC.
Additionally, the FDIC and Urabn Partnership Bank entered into a loss-share agreement on $1.41 billion of ShoreBank's assets, according to the FDIC.
ShoreBank, once a community development lender, has served Chicago’s South Side since 1973, when Ron Grzywinski, Mary Houghton, James Fletcher and Milton Davis set out to demonstrate that a bank could achieve positive social change by making profitable loans in an underdeveloped area of the city. ShoreBank later established a bank on the city's West Side.
Depositors of ShoreBank will automatically become depositors of Urban Partnership Bank.
While the backlash of the financial crisis continues to weigh heavily on the nation’s banks, Illinois lenders are in the midst of a major consolidation of their own, with a lagging Chicago economy propelling the trend.
Since 2007, Illinois has seen 37 of its community banks succumb to failure, with Friday’s ShoreBank closure being the most recent. Illinois places third behind Florida and Georgia in bank failures over the past three years, according to the Federal Deposit Insurance Corp., the agency that steps in to protect depositors when a bank fails.
Heading into the second half of 2010, roughly 35 community banks in Illinois had Texas ratios (a measure of a bank's charge offs and non-performing loans against its equity) of 100 percent or more, including ShoreBank, a key sign that a bank is struggling to stay solvent.
Furthermore, three of Chicago’s largest publically held bank holding companies (MB Financial Inc., Northern Trust Corp. and Privatebancorp Inc.) aren’t terribly optimistic moving forward, due to concerns about an underperforming area economy. Illinois’s unemployment rate was just over 10 percent in June, while the nation’s jobless rate stood at 9.5 percent.
“You’re not seeing the hiring that you’re used to seeing in this point in the recovery,” stressed Rob Wilson, president of Chicago-based HR outsourcing firm Employco USA Inc. “It’s still not a great business environment.”
It's become a vicious cycle of sorts, with businesses reluctant to borrow to expand and banks less than eager to lend to them. The result, industry observers say, will be more bank failures and bank consolidations in Chicago and the state as a whole.
Because Illinois was one of the last states to allow interstate banking, it's loaded with community banks, with just over 600, according to the FDIC. That's the most per capita in the country, estimated Jim McAveeney, a banking consultant in the financial services practice of KPMG LLP, an audit, tax and advisory firm. California, for instance, reports to the FDIC that it has nearly half that number.
“The strong are going to get stronger,” McAveeney said. “A lot of it is going to be at the expense of the weaker players.”
He classifies area banks in two categories: “dead” or “living dead,” according to McAveeney. The “living-dead” banks are well capitalized, still solvent, but too strapped to lend to businesses in the Chicago market.
The “dead” banks are those whose low capital levels got them into trouble, and either have been taken over or will be taken over by another banking institution through FDIC-arranged deals.
“So now the dead banks are doing nothing, the living dead are not able to lend because they’re still hoping and reserving and managing their existing assets to stay solvent.”
In its July 22 second-quarter earnings release, MB Financial caught analysts off guard by hiking its loan charge offs, a measure of losses from bad loans, to $67.2 million for the quarter, a 45 percent increase from first quarter charge offs of $46.5 million. MB Financial also set aside more money to cover future losses from bad loans, a sign of the bank’s lack of confidence moving forward.
“We found little basis for optimism regarding credit quality,” wrote Anthony R. Davis, banking analyst for Stifel Nicolaus & Co., in a research note reacting to MB Financial’s earnings. “Nor were we very encouraged by management’s outlook. In fact, when pressed for guidance on future loss rates and provisions, management was extremely reluctant to comment.”
“We believe – as we have for a long time now – that the economy will remain weak and volatile for an extended period,” said MB Financial CEO Mitchell Feiger in the July 22 conference call. “Furthermore, given the precarious state of our state’s finances and for other reasons, the state of Illinois and the Chicago area will probably underperform most of the rest of the country, economically,” he said. “Well into 2011 and likely into 2012.”
Perhaps part of the reason MB Financial reported heightened charge offs and provisions has to do with its aggressive acquisition of failed area banks.
The bank leads others in the state with six FDIC-assisted transactions since the start of the credit crisis -- including its April 23 acquisition of Broadway Bank, the controversial lender previously owned by the family of Alexi Giannoulias, the Illinois state treasurer currently running for the U.S. Senate.
“One good outcome - at least for us - of the weak economy,” Feiger said, “is that…there will continue to be a high rate of bank failures.”
Joe Hemker, a banking attorney for Howard & Howard Attorneys, a firm that represents roughly 130 banks, the majority of them in Illinois, said much of the pressure local banks are feeling is a result of a cycle – similar to previous banking crises in the late 1980s and early 1990s. He also was not surprised by MB Financial’s charge offs for the quarter.
“I don’t think that it’s unusual for a bank that has done as many transactions as they’ve done with the FDIC -- which by its nature, is going to have added a lot of non-performing loans,” Hemker said.
But other analysts are more skeptical.
“It will take another quarter or so before we get a real clean picture of what is happening to [MB Financial],” wrote Paul Miller, banking analyst for FBR Capital Markets Inc., in an e-mail.
However Privatebancorp, holding company for Private Bank Trust & Co., reported charge offs and provisions in line with most analyst expectations, down to $49.8 million from $56.9 million in the first quarter 2010. Yet Private’s CEO, Larry Richman, also found little room for optimism on the Chicago market during the company’s earnings call – and 70 percent of Private’s business is focused in the area.
“The uneven nature of the economic recovery is leaving our clients cautious,” he said. “We are seeing many businesses maintain high liquidity, causing new loan demand and existing line usage to remain low…as others have said,” Richman concluded, “we have a long climb up and this will take time.”
Even Northern Trust Corp., the $80 billion asset wealth management company that is less exposed to the local macro-environment due to its global reach and traditionally conservative nature, reported a slight climb in charge offs in its second quarter to $38 million from $30.6 million in the prior quarter.
Patrick Daugherty, a 30-year veteran attorney of Foley & Lardner LLP, said there are some signs the lending environment in Chicago is turning around, much of which has to do with the gradual return of cash-based lending, or lending using a company's organic cash flow as collateral rather than physical assets.
“When the economy gets bad, there is more collateral-based or asset-based lending,” he said. But the return of cash-based lending is not in full throttle yet; banks are waiting to see a trend in businesses ability to show sufficient lending capital on their books for longer than one or two fiscal quarters.
“The banks are basically saying to themselves, ‘that’s a good start, come back to us in six months,’” Daugherty said.
“The good banks,” McAveeney concluded, “have actually now had the regulators come in and layer some more stringent capital requirements. So…the regulators have come in with all good intentions to protect the shareholders to say, ‘alright, guys, we want you to have more capital on your balance sheet so that should future events like this bad recession come about, you’re better capitalized to weather this storm.’”
This scenario, according to McAveeney, helps bank shareholder confidence and forces banks to be much more diligent in their loan underwriting and approval process. Small businesses can’t get loans they would have gotten two or three years ago, he said.
This change in philosophy has forced banks to tighten their credit requirements, shrinking the population of businesses that are qualified to borrow.
“There are good businesses out there that banks would love to lend to,” McAveeney said, “but because of the uncertainly in the economy, a lot of them are not making capital investments that they would have traditionally made.”
Perhaps an even larger annoyance for the industry, however, is the local real estate market – a market that remains depressed, and should continue to weigh on banks’ balance sheets for the next several quarters.
MB Financial’s problem loans stem mostly from local real estate in the Chicago market.
Analysts describe construction real estate loans as the bank’s “nemesis,” accounting for an average of 52 percent of its net charge offs over the last four quarters leading up to its latest results. Miller of FBR notes that new problems in the bank’s real estate loan portfolios caused net charge-offs to account for two-thirds of MB Financial’s second-quarter losses.
“Chicago just had a bigger housing bubble” compared with other cities in the Midwest, said Ernie Goss, MacAllister chair & professor of economics at Creighton University in Omaha, Neb.
Goss studies agriculture banks in the Midwest, a sector that he said is less exposed to the banking woes caused by the burst of the real estate bubble. “When you climb a mountain, you just got a longer way to fall.”
And residential foreclosure rates are still on the rise.
Newly released data by Woodstock Institute, a nonprofit research and policy organization focused on the Chicago economy, shows that new foreclosure filings on condominiums in the six-county region grew by two percentage points to 19 percent from 17 percent of all foreclosure filings in the first half of 2009 and 2010. Many of these new condo foreclosures came from new activity in suburban Cook County.
Although there is no direct confirmation that the high volume of condo foreclosures in suburban Cook County is linked to MB Financial, analysts note that the bank’s “suburban exposure” in its real estate portfolio will “likely continue to weigh on” the bank’s losses.
Hemker of Howard & Howard said the Chicago market is simply behind others in the real estate recovery cycle.
“When I look at it in comparison with some of the other markets – large markets that we have clients in…they seem to be a little bit further along in terms of working through the problem loans,” Hemker said. “Almost all the bankers you talk to say that they’re still early to middle way through the cycle.”
During the height of the housing boom, these smaller banks jammed their loan portfolios with real estate as a quick growth source. Some, Hemker said, even extended to risky markets outside of Chicago like Florida and Las Vegas.
“Residential real estate development was really one of the only things they [small banks] could do to grow,” Hemker said.
The pace of home sales in the United States took a sharp turn for the worse in July, falling a record 27 percent from June and raising new concerns about the economy's health.
Sales of previously owned homes fell to an annualized pace of 3.8 million, down from 5.3 million in June and 5.1 million a year earlier. Sales volume fell in all regions of the country, while the median selling price was $182,600, similar to where it stood both in June and a year earlier.
What's surprising is less the decline itself – forecasters had expected sales to cool after the expiration of a special tax credit for home buyers – as the magnitude. Housing-market forecasters had expected about 4.7 million sales for July.
The July surprise is bad news for the economy in two ways. First, the housing market tends to mirror conditions in the overall economy, and this report amplifies concern that momentum is slowing in the second half of 2010. The stock market sagged further on the housing news Tuesday morning.
Second, in a look further ahead, the news suggests that working through a glut of unsold homes and foreclosed properties may take longer, and weigh more on consumer confidence, than some economists predicted.
The plunge in sales activity raises a stark question: What will it take to bring buyers back to the market?
Mortgage interest rates are at record lows, after all. There are plenty of homes available, at prices that in many markets are historically attractive. Yet July's sales volume for single-family homes was the lowest since 1995, when the US housing market was struggling to recover from another (milder) slump.
It appears that the main answer to the conundrum is jobs.
People who have jobs and who have a need or desire to relocate can buy homes, but about 15 million Americans are currently unemployed. A revival of the job market could also help boost the confidence of other potential buyers who have enough income to buy a house. Right now, they may be worried about their own job security. And some figure that there’s little urgency to buy, because home prices may fall further until jobs become more available in the economy.
The National Association of Realtors, which released the housing numbers, sought to cast the news in a glass-half-full light.
"A pause period for home sales is likely to last through September,” Lawrence Yun, NAR's chief economist, said in a statement accompanying the report. “However, given the rock-bottom mortgage interest rates and historically high housing affordability conditions, the pace of a sales recovery could pick up quickly, provided the economy consistently adds jobs."
That's the problem: After some promising months earlier this year, the economy hasn't been adding jobs lately.
"A sustained upturn [in the housing market] will depend on an improvement in the jobs market, which at the moment is slowing down rather than gathering pace," Nigel Gault, an economist at IHS Global Insight, said in a note analyzing the sales numbers.
Slower-paced sales mean it will take longer for the housing market to work through excess inventory. The estimate of the "months supply" of homes on the market jumped to 12.5 months in July, up from 8.9 months in June.
Most forecasters don't see the economy dipping back into recession later this year, but their concern about this possibility has been rising. At the very least, it now looks likely to many that the economy will be growing too slowly to generate substantial job gains in coming months.