Capital Markets

Not so Thrifty

The bust is starting to catch up with regional lenders.
Economist StaffApril 10, 2008

What price salvation? For Washington Mutual (WaMu), a Seattle thrift that grew into America’s sixth-biggest bank and came a cropper in subprime mortgages, the tab is $10 billion and counting. Having already scraped together $3 billion in fresh capital, this week it secured a further $7 billion from investors led by TPG, a buy-out firm. WaMu hopes the injection will help it through a horrendous year; loan losses for the first quarter alone will be $1.4 billion. The support comes at a cost: the deal dilutes existing shareholders’ capital by half and the dividend will shrivel. It is hard, too, on WaMulians, as employees liked to be known in happier times when their home-loans motto was “Be Bold”. Some 3,000 will go as 186 mortgage offices are closed.

Wall Street’s giants and their foolish forays into debt-market exotica have hogged the headlines—and most of the rescue capital doled out so far. But WaMu’s whip-round shows that the desperation is spreading to Main Street. As the economy flirts with recession, attention is turning to America’s more than 8,000, mostly small, regional lenders. Spared the worst so far, their first-quarter numbers will be ugly.

Most regional banks face different problems from WaMu. Muscled out of mortgages, credit cards and car loans by the big boys during the boom, they piled into what was left behind—in particular, commercial property. Growth in construction loans (for land purchases and home- and office-building) peaked at 36% a year in early 2006, leaving small banks horribly over-exposed.

Gerard Cassidy, of RBC Capital Markets, reckons that on several measures things look worse for banks than they did going into the recession of the early 1990s. Then, construction loans made up around 53% of their tangible equity plus loan-loss reserves; now the figure is 65-70%. During the benign past decade and a half, managements “forgot what a downturn looked like,” he says. That is certainly true of Chicago-based Corus Bankshares, more than 80% of whose portfolio comprises condominium-construction loans.

Recent cuts in short-term interest rates should help banks, by steepening the yield curve (the difference between long and short rates) and thus boosting the spread they can earn. But, as Brian Foran of Goldman Sachs points out, they are a mixed blessing. In the short term, rate cuts put pressure on “asset sensitive” banks whose loans are repriced faster than their liabilities. Most small and medium-sized banks fall into this category, whereas big banks tend to be “liability sensitive”. More worryingly, smaller banks have been slow to build their reserves against dud loans, even though these are coming off historic lows.

That is not all the banks’ fault. In the past, they had latitude to squirrel away extra reserves if they felt a boom was ending. With regulators more worried these days that banks might try to smooth their earnings, that has become harder to do. Accounting rules now encourage a backward-looking, quantitative approach. “We are told to take the past few years as a guide. But what good is that if they’ve been unusually good?” asks one banker. Some lenders complain that they were prevented from raising provisions in early 2007, at the first signs of trouble.

The regional banks do at least have plumper cushions than they did going into the last recession. According to the Federal Deposit Insurance Corporation, a bank regulator, banks with assets of less than $1 billion enjoy a risk-based capital-to-assets ratio of 15%, compared with a still-decent 12.5% for big banks.

But property losses are still hard to gauge. Ominously, builders are selling land for as little as 20 cents on the dollar. Mr Cassidy expects around 150 banks to go bust over the next two to three years, a small fraction of the number that failed in the savings-and-loan crisis of the 1980s and 1990s but a sharp rise all the same: just three have folded in the past three years.

Many others will survive only with fresh capital. The WaMu infusion has raised hopes that private-equity groups will serve the same role in shoring up regional banks as sovereign-wealth funds have done for the biggest (though perhaps with better timing). Kohlberg Kravis Roberts, a large buy-out firm, is said to be mulling an investment in National City, a beleaguered Indiana-based bank.

For banks that have resisted the temptations of the boom, this looks like a golden chance to snap up rivals cheaply. (JPMorgan Chase made a lowball offer for WaMu soon after buying Bear Stearns, but was rebuffed.) Regional banks can also hope to recapture market share from non-banks, as traditional sources of funding, such as deposits, become more important.

A few managed to show self-restraint. Westamerica Bancorporation, a Californian lender, was lambasted for backing away from high-yielding property loans and allowing its portfolio to shrink. But now it is reaping the rewards: its share price has risen by 20% this year while most rivals’ have slumped. It has been canny with its liabilities, too: over a third of its deposits pay no interest, a trade-off its small-business clients are willing to make in return for sharp service. As a result, its funding costs are half the industry average.

The lesson: build a cheap, stable deposit base, and don’t be shy not to lend. Or, as David Payne, Westamerica’s boss, puts it: “If it grows too fast, it’s a weed.”