Friday, August 28, 2009

This Week in Bank Failures

How many bank failures will there be? The CEO of BankUnited, which was formed by buying a bank out of receivership earlier this year, says he estimates 1,000 bank failures in the next two years, or 10 per week. In the past 10 months we have seen the pace go up from 1 per week to 5 per week, and the economy continues to decline, so what is to stop it from going up again? But it is hard to predict because so much depends on policy decisions in Washington. As it stands, there are more banks than the U.S. economy can support, so it is assured that some banks will have to close. If the government goes to extremes to keep the largest banks operating, it will put enormous pressure on all other banks, and half of them could fail. But if the government allows an orderly shutdown or contraction of the most troubled giant banks, then very few well-managed banks will go under.

One of the reasons it is hard to trust a bank balance sheet is that it is almost impossible to determine the value of many of the assets, especially when the assets are based on real estate. In banking, the value of real estate is determined by a very short paper trail that is easy to manipulate and hard to check up on. This came to light in the federal case against Stanford Financial Group, as its former chief accountant pleaded guilty. Stanford Financial Group’s too-good-to-be-true financial results were created largely by arbitrarily increasing the stated value of real estate and related assets held by Stanford International Bank.

The same accounting machinations could be used elsewhere on a smaller scale to make a bank look not as troubled as it is. A bank that is flat broke could be made to appear as if it is merely stumbling. These days, a bank could pull this off just by valuing troubled loans and foreclosed real estate based on the bubble value of the real estate three years ago rather than its current market value. It is not just the real estate itself that can be pumped up for the financial statements. Mortgage-backed securities are so convoluted that securities based on the same real estate could appear on the same bank’s books three or four times, or on the books of three or four separate banks. Combine these two effects, and abandoned rural land worth $2 million could turn into $15 million in bank assets — albeit assets that are completely illiquid. These assets cannot be sold to anyone, or the whole accounting house of cards would collapse.

I don’t think anyone knows the extent to which these phantom assets are propping up banks today, but whenever you hear anyone in banking complain about problems with liquidity, it is fair to be skeptical, and to imagine that the reason some of the assets cannot be sold is that they do not really exist, at least not the way they have been recorded.

A billion-dollar bank and two half-billion-dollar banks failed tonight. The billion-dollar bank was Affinity Bank, based in Ventura, California, with 7 offices in southern California and 3 in northern California.

Affinity started out in 1982 in the Chinese-speaking community of San Francisco. It changed ownership several times and expanded into southern California. In recent years it had been trying to emphasize business accounts-receivable lending and health care financing. But two thirds of its loans were in commercial real estate, where losses had been piling up since 2007. By the end of the second quarter of 2009 it was critically undercapitalized, and state and federal regulators had given it an August 20 deadline to repair its financial condition.

The locations, deposits, and assets are being taken over by Pacific Western Bank, based in San Diego, but operating across southern California. With the acquisition, it has over $5 billion in assets.

The two half-billion-dollar banks that failed earlier in the evening were Bradford Bank, with 9 offices around Baltimore, and Mainstreet Bank, with 8 offices around Minneapolis.

Bradford Bank had expanded rapidly between 2005 and 2007 by buying up smaller competitors, a strategy that left it in a financially weak position by the end of 2007. Its swing loans, which were meant to be repaid as soon as a building could be sold, ran into problems as the real estate market declined in 2007, and then other real estate loans went bad. Plans to raise capital in the stock market fell apart as stocks declined in 2008, and despite cost-cutting efforts, the bank’s losses continued to mount. A month ago, the OTS rejected a recapitalization plan submitted by Bradford Bank and gave the bank 15 days to raise capital by selling most of its assets or being acquired by another bank.

The locations, deposits, and assets are being acquired by M&T Bank. M&T Bank, based in Buffalo, New York, was already the second largest bank in the Baltimore area.

Mainstreet Bank reported a net worth of negative $5 million as of June 30. It had been losing money since 2008 and had been operating under a cease-and-desist order since January 2009. Observers had been watching for it to fail since at least May.

The locations, deposits, and assets are being taken over by another local bank, Central Bank.

The FDIC estimates costs of $450 million on these three bank closings, but the actual costs are likely to be considerably higher. The FDIC this month seems to be lowballing some of its cost estimates, probably in the hope of obscuring the rate of decline of the Deposit Insurance Fund. Observers say the fund is likely to be depleted around November. When that happens, the FDIC will continue to operate by borrowing money from the Treasury.

Another very small credit union failed today. Free Choice Federal Credit Union, based in Feasterville, Pennsylvania, had 400 members and less than $1 million in assets. The share accounts were purchased by another local credit union, Trumark Financial Credit Union.