Bank Failures: Then and Now

0:00Every Friday night we have a few more banks closed, but nobody really seems to know or care about it. In fact, there were three closed last night. I don't know how many of you knew that, but there was one in Michigan, one in Minnesota. And for those of you from Colorado, and I think there's a couple of people here from Colorado, The Southern Colorado National Bank actually was seized by the FDIC last night. And this all happens very quietly. The FDIC comes in, they wrap them in yellow tape. The senior management is interrogated and generally the FDIC has found another bank to assume the deposits of the bank that has failed so the new bankers come in and take over over the weekend so that the bank opens up as usual either on Saturday or the following Monday morning like nothing happened.

1:05And that way most people's deposits are still there, they don't care, they're not worried about the banking system and life goes on. But what's happened because we've had so many of these bank failures is that the FDIC is number one having trouble getting banks to assume the deposits, but they're really having difficulty finding banks to take over any of the loans. And in fact, the only way that the FDIC can get a new bank to take over the loans of a of a failed bank is to enter into a loss sharing agreement. Now loss sharing agreement means that the acquiring bank will take over the loans, they'll try to work them out, they'll try to collect them, but if they're not able to collect them, then the FDIC will cover what's not collected.

2:04And right now the FDIC has 300 million so far under Law-Sharing Deals, $300 million. And that's mainly because they're stretched, both logistically and financially. The FDIC, when things were good, no banks were failing. They trim their staff, but now the banks are failing. They need more people. They don't have enough people to shut down these banks. So they enter into these Law-Sharing Agreements. There've been 98 failures so far. Three that we had overnight have made a total of 98 this year, 25 last year. But there are 416 banks on the FDIC's problem list.

2:54And that was as of the second quarter. I'm sure it'll be higher at the end of the third quarter when those numbers are announced. So I just wanted to talk a little bit about the valuation and one of these loans in United States banking system because we've had some very instructive bids and markdowns on what these loans are worth. In the case of Colonial Bank, which you may be familiar with, big bank out of our backyard in Alabama down the road in Montgomery, Colonial Bank failed and BB&T took over that bank Bank, and they bought $15 billion worth of Colonial's loans. But to buy the 15 billion in Colonial's loans, the FDIC had to agree to absorb 80% of the losses that would come from liquidating those loans.

3:52And what that means is that if the Colonial portfolio went to zero, the most BB&T could If you lose, it's 500 million. And that means the FDIC would absorb the rest. Now, Colonial Portfolio isn't worthless, but the credit gurus over at BB&T are not terribly excited about Colonial's loan portfolio. In fact, they think that the construction loans in Colonial's portfolio are only worth 33 cents on the dollar. That means they marked them down 67%. They marked the commercial property portfolio down 31%.

4:38And they marked the CNI portfolio, that's commercial and industrial loans, down 15%. So all in all, after BB&T analyzed the portfolio colonial, They only thought that their loan portfolio was worth 63 cents on the dollar. Now that's very similar to the 68 cent valuation from when U.S. Bancorp bought PFF and Downey Savings and Loan in California. So we have a nice valuation that I think we can look to we can look to, especially banks with heavy real estate exposure. Now, this wouldn't be so bad if banks had a lot of capital, but they don't.

5:25Banks only have to have 6% capital ratio to be considered well-capitalized, 6%. So you don't have to lose much money, and you've gone through all your capital. So, let's take a case. If we have a bank and we're well capitalized, everything's fine, and we have a 6% capital and our capital is $10. It's a very small bank. So that means you have assets of $167 and your assets are mostly loans. So your bank was a very big real estate lender like Colonial, or PFF, or Downey, or most all of the banks.

6:14And imagine your loan portfolio is worth 63 cents on the dollar. Or in other words, you had to write it down by 37 percent. Well if you take 37 percent of a $167 loan portfolio, that means you have to write down your loan portfolio, $62. Now remember, our capital is only $10. So you don't go broke one time, you go broke six times. And that's the implications of these loan portfolios being valued as low as they are. And thus, that's why the FDIC is stepping in. Now right now, there are 3,000 banks in the United States that have real estate concentration in Commercial Real Estate of 300% of capital.

7:06So that, going back to our $10 capital bank, that means they have commercial real estate loans of $30. And if they're worth 63 cents on a dollar, that means all those banks under that valuation would be broke. Now in June, Wilshire State Bank took over Millbury Bank, Bank, also in Los Angeles, and the FDIC agreed to assume most of the future losses of that loan portfolio that took over. And in fact, Joanna Kim, who's chief executive at Wilshire said, quote, after we understood how the law sharing works, we were literally overjoyed.

7:58A veteran banker, Joseph Evans, told the Wall Street Journal, quote, From a turnaround guy's perspective, I've never had this kind of downside protection. I don't believe we would have ever been interested in or found interested investors to enter the banking industry at this moment absent FDIC assistance, end quote. So thus you have the FDIC, which at the end of the second quarter was nearly broke, entering into law sharing agreements of which they have $300 billion worth now. At the end of the second quarter, the FDIC had $10.4 billion. It sounds like a lot of money, except they're insuring $4.8 trillion worth of deposits.

8:53And things have gotten even worse. The other day, Sheila Baer, who's the chairwoman of the FDIC, admitted finally that the FDIC is running a deficit. So the 10.4 that they had at the end of the second quarter is now gone. And of course, she had a great idea to fix this. She thought, you know what, we're going to go borrow money from the banks we insure to shore up our reserves. Now imagine if you got a letter from your car insurer that said, the little green lizard, he sends you a letter and says, You know, we really need a loan to cover your car insurance.

9:41I mean, what would you think? That seemed to kind of drop off the radar pretty quick. And now they're talking about their next plan is to have the banks pay three years of insurance assessments in advance. And this is going to raise $45 billion to shore up their reserves, but all the banks only made $1.8 billion in the first six months of the year. So how could they charge them, even if they charge three years, there's no way the banking industry can come up with $45 billion. It would put just that many more banks out of business. So I'm not sure that plan is going to hold any water either.

10:28either. Now the positive thing about having these loans worked out by existing banks in the private sector is that private sector will tend to do a better job than the FDIC would have, but the bad news of course is that the FDIC is covering any losses and the FDIC obviously doesn't have the staff to dispose of these assets and the banks inquiring, failed banks don't want any of these real estate loans. So thus we have the valuations made by BB&T and U.S. Bancorp and it gives you an idea that really most of the United States banking system is really upside down.

11:15But how are they operating? Well, they're operating with deposit insurance. So what did they do? They increased the amount of deposit insurance. They increased while the FDIC is going broke, they decided they would increase the amount of insurance they need to provide, up to 250,000 for interest-bearing deposits and up to unlimited for non-interest-bearing accounts. So while their finances decrease, their obligations increase. And the loan portfolio and the loan valuations are not going to get any better. Charge-offs and delinquencies are exceeding 9% and they're still rising.

12:01And if you look at that measure during the S&L crisis, it topped out at 8% in the first quarter of 1991. Charge-offs alone are now approaching 3% and getting worse. During the S&L crisis, charge-offs never reached 2%. So for those who say things, this banking crisis isn't as bad as the S&L crisis, just plain not true. And by the way, a portion of the equity capital for some banks is debt. This isn't something that has gotten a lot of news. But many banks, while they were growing during the boom years, if they had trouble raising capital, would issue securities called trust preferred securities.

12:52Now trust preferred securities are essentially debt, but they have some of the attributes of equity. And any corporation could have issued them, but it was mainly bank holding companies that took advantage of this, and that's because the Federal Reserve Board issued an opinion in 1996 that allowed the proceeds of trust preferred to be counted as tier one capital. So under the Fed guidelines, a bank could have 25% of their equity in debt and have it be counted as equity. And so Wall Street, which issued the Trust Preferred, did a booming business and at the end of 2008, over 1,400 banks had Trust Preferred as part of their capital structure, $148 billion worth and for these banks, a good chunk, 25% of their capital structure is essentially debt, Something that's unprecedented in any of the past banking meltdowns, whether it be the Depression or the S&L crisis.

14:09Something else that's very prominent in the banking meltdown is the Federal Home Loan Bank. Banks during the property boom, when they had trouble attracting deposits, would go to the Federal Home Loan Bank, we used to call it FLUB, and we'd go borrow from FLUB. Now, you may wonder what federal home loan banks are. They were, like most bad things, they were established in the Great Depression, and they were to provide funding for savings and loans and thrifts. And the mission of FLUB is cost-effective funding to its members for the use in housing, community, and economic development, to provide regional affordable housing programs, which create housing opportunities for low and moderate income families, to support housing finance through advances in mortgage programs.

15:01Well, during the boom, Federal Home Loan Bank really provided liquidity. They provided, they had extended just over $100 billion in 1993, and by the end of 2007, they had extended $822 billion in loans to the banking system. Now, how this affects what the FDIC will collect is this. When banks would get an advance from FLUB, FLUB collateralizes its advance by filing a claim on a portion of the bank's loans.

15:46They'd file a UCC filing on a certain number of their loans, and they wouldn't take all their loans as collateral. They wouldn't take land loans, they wouldn't take construction loans, they wouldn't take loans involving petroleum, they wouldn't take any special purpose loans like bowling alleys or anything like that. Just bread and butter, plain vanilla, office buildings, generally owner-occupied loans. So when you see these bank failures and you notice that the projected hit to the FDIC Reserve is so much higher than it used to be. The reason is most of these banks, depending on FLUB for their advances. And FLUB would take those loans because they had them as collateral when the bank failed.

16:38Therefore, the FDIC didn't have those loans to collect, to offset what they had to pay to make the depositors whole. So it used to be that during the SNL crisis, The billion-dollar bank failed. Generally, the loss to the FDIC fund would be about 25%. Well, now it's over 30%, 33%. And it's probably going to go higher. Again, this is because of these advances from the Federal Home Loan Bank. Well, now it's likely that the Federal Home Loan Bank's in trouble. 6.30.09, it had a trillion won in assets. Assets. It only had 45 billion in total capital. That means FLUB is leveraged at 25 to 1. So if they take a hit of 5% to their assets, it will wipe out their capital base. So if you wake up one morning and say, the government is bailing out the Federal Home Loan Bank, and you'll know what happened.

17:47It may be the next Federal Veil app that no one's ever heard of before. Now we constantly hear that today's bank crisis isn't near as bad as the Great Depression. It's not near as bad as the SNL crisis. We hear that all the time. A little over a year ago, financial columnist David Widener wrote an article called Chicken Littles and the US Banks. and Widener went to Lawrence White to be his expert witness on this and Lawrence White actually served on the, you guessed it, Federal Home Loan Bank Board from 1986 to 1989 and it was the view of Mr. White that the current crisis just doesn't strike me as anything close to the period between 1982 and 1993 when Thousands of SNLs and banks had to be closed.

18:45And Widener said, he said, I don't think this crisis would even make the top 10. And certainly nothing like the depression when thousands of banks fail. So in the view of those gentlemen in a year ago, there was no problem. Now I attended the Hard Asset Conference in Las Vegas last fall and listened to a gentleman, many of you in the room know, I think, Dennis Gartman. And he said at the time, at worst, there will be 117 bank failures and it's no big deal. So quit worrying about it, he said. He repeated over and over and over that 96% of the homeowners were paying their mortgages on time and everything was just going to be fine.

19:32Don't know if he's changed his point of view, but he's coming up a little short on that bank failure number. Sheila Baer, chairwoman of the FDIC, she said after the IndyMac failure, there will be more bank failures, but nothing compared with previous cycles, such as the savings and loan days, that's what she said. And even today, Michael Menzies, he's the chairman of the Independent Community Bankers of America. He says, quote, community banks lend locally, they know their customers and continue to stick to traditional lending practices, all of which constitute the continued stability and strength of the community banking sector, unquote.

20:19So the experts say, gee, this isn't a big deal, it doesn't compare at all to the Great Depression, doesn't compare at all to the savings and loan crisis. So let's have a look. From 1929 to 1941, there were over 10,000 banks that failed, totaling $7.6 billion in deposits, which is roughly $100 billion in 2009 dollars. Now 10,000 sounds like a bunch of banks and it is, but branch banking in the Depression was virtually unheard of. have. Every single branch was its own bank. And so, it's hard to make the comparison between them and NAB. I mean, we've only had 98 failures this year, 25 a year ago, but consider Washington Mutual. Washington Mutual had over 2,200 branches. Colonial Bank Bank had 346 branches, Downey Savings and Loan and PFF had over 200 branches, Guaranteed Bank had 162 branches and so on.

21:26We've had over 3,700 bank branches that have failed in this current meltdown and that doesn't include Wachovia, which had 3,300 branches. Of course, Wachovia isn't counted as a failure because they were deemed systemically important and they were married to Wells Fargo and somewhat of a shotgun wedding there at the end of last year to keep them off the failure list. So we've really had about 7,000 branches fail during this meltdown. But the number of branches or banks doesn't reflect the complete impact.

22:11John Lounsbury of the street.com lays out the numbers. And this is as of the end of August, but adjusted to $2009, the depression banking crisis was 100 billion, as I mentioned before, the SNL crisis was 923 billion and the current crisis is 7.1 trillion. So on a per capita basis, we've had some population growth since then, The failed deposits in the depression were 821 per person, $821 per person. They were over $3,800 per person in the S&L crisis, and they're over $23,000 per person in the current crisis.

22:56And this was calculated before Corus Bank failed. Corus Bank failed a couple of weeks ago. Big Chicago bank, big high-rise condo lender, and they were a multi-billion dollar bank. So the numbers would even be worse at this point. So the SNL crisis was five times bigger than the banking crisis in the Great Depression. And the current crisis is 25 times bigger than the crisis of the Great Depression, both on a per capita basis and so on. Now, you may wonder how it could get that big, but the financial sector just grew huge in the last few years and making mortgages so everybody had a place to live with no money down and a very low payment, et cetera, et cetera.

23:48And so the financial part of the S&P had grown 45% and thus the meltdown has to be just that much higher. Now there are those that believe that banks should be making loans to get the economy going again. You hear that all the time. But banks can't lend because these credit losses are chewing away their capital. So there's no way they're going to be able to crank up the lending. That's why lending is down. I mean, what's clearly far from normal is the fact that the Federal Reserve has invented deposits out of thin air to buy toxic assets so that banks can keep a lot of cash on deposit at the Federal Reserve.

24:34And in most cases, these banks wouldn't keep it on deposit at the Federal Reserve, they'd go out and lend that money and then the money would multiply through the banking system and grow by ten times the amount that would be on deposit at the Federal Reserve. Federal Reserve, but that's not the case because they don't have anybody to lend the money to and they are losing money on real estate deals and other types of deals, which is eroding their capital. Well, the very same thing happened in the Depression. Despite what you may have read in Friedman and Schwartz, the Federal Reserve did all it could to inflate the money supply.

25:20Fed Governor Eugene Meyer persuaded Hoover and Carter Glass to push through Glass-Steagall Act, which allowed the Fed to use U.S. government securities, in addition to gold, to inflate as collateral for Federal Reserve notes. And this allowed the Fed to greatly expand credit, and it did. It did by buying $1.1 billion in government securities in 1931. Now, despite this attempt to inflate, the money supply fell. The banks wouldn't lend. Other banks were failing, just like they are now. The ones left standing were shy to take the risk. Also, the expansionary Fed policy lowered interest rates just at a time when loans became risky to make.

26:10Thus, the weakened bank's incentive to bear risk was very low. So if you make loans during the Depression, you had no incentive to because the rates were low and the risk was high. Same situation as now, rates are very low, risk is very high, so banks aren't lending. And they piled up excess reserves. So the government tried to browbeat the banks into making loans. Huber blamed the banks for not lending, and he was, quote, disturbed at the apparent lack of cooperation of the commercial banks of the country in the credit expansion drive, end quote. Ohio Democratic Senator Altie Palmerine denounced the laggard banks bitterly.

27:00He said, quote, I measure my words, the bank that is 75% liquid or more and refuses to make loans when proper security is offered under present circumstances is a parasite on the community." Hoover even got into the act. He railed against the public for what he called traitorous hoarding. We have a little of that now. You're supposed to go out and spend cash for clunkers. You're not supposed to be saving money. Everybody's worried about the savings rate going up and People Not Stimulating the Economy. Earlier this year, Barney Frank said that President Obama would require the banks to start lending to businesses and customers.

27:52Obama himself said, soon my Treasury Secretary, Tim Geithner, will announce a new strategy for reviving our financial system that gets credit flowing to businesses and families. So of course this inflating by the central bank and the bank brow beating by the government only serves to delay what is really needed. And that's the process of liquidation and reduction of costs needed to clear the way of the malinvestments made over the last few years, which were created by fractionalized banking during the boom. So just as the depression was extended and aggravated by the Fed and other government intervention, so it is again today with the current depression. As Murray Rothbard explained, quote, A dearth of bank failure should rather be treated with suspicion, as they witnessed the drop of bank failures in the United States since the advent of the FDIC. It might indeed mean that banks are doing better, but at the expense of society and the economy faring worse. Bank failures are a healthy weapon by which the market keeps credit inflation in check and

29:05And absence of failure might well mean that that check is doing poorly and that inflation of money and credit is all the more rampant. Now we've had the last 20 years be a boom for bankers and for banks. And they've morphed in size to a gargantuan proportion of the economy on what hopefully I've shown is the rickettiest capital structure that the world's ever seen. So the need for correction is equally huge and we are just getting started. Thank you.