Before the current bank failure episode got rolling, some of the more pessimistic analysts in the banking industry were predicting about 200 bank failures in the United States. The consensus now seems to be that there will be 200 to 500 more bank failures, in addition to the ones that have occurred already. The change in forecast is easily explained. At first, we were looking mainly at the risk of losses from “subprime” mortgages, including the subsequent securities, and the early estimates were based only on this one risk. This was expanded to include risks from all categories of mortgages. The main risk to banks now, though, is commercial real estate, and most bank failures since 2009 have been precipitated by loans in this category. Going forward, a few additional bank failures will be the result of bad business loans.
With so many banks failing, is it possible that we will run out of banks? No, not at all. At this point, only a small fraction of banks appear to be at risk. But even if most of the banks were to fail, they could easily be replaced. Setting up a new bank is a simpler proposition than setting up most other businesses. As evidence of this, you don’t need to look any farther than the high proportion of recent bank failures that have occurred among banks founded between 1999 and 2007. If through some calamity we found ourselves with no banks at all, it would take no more than a couple of weeks to set up new banks that could clear checks and process payments.
The state of Oregon is talking about setting up its own bank as a way to save money. Just the work of payroll checks for state employees is probably reason enough for a state to operate its own bank. The debate at this point is not so much about whether Oregon can or should create its own bank, or whether it can save money that way, but about the form the new bank should take: a full-service commercial bank using one of the bank buildings recently vacated in the state capital, or something less?
Since the failure of mortgage companies Fannie Mae and Freddie Mac, both companies have been kept going by the U.S. government, but no one has been able to explain why. Now change may finally be on the way. A report released today by Treasury, Reforming America's Housing Finance Market, recommends that both companies be wound down, and that the U.S. government’s other home loan programs be scaled back to a fraction of their current size. Fannie Mae is already shrinking its portfolio by almost 10 percent per year, and the report implies that this decline will continue and perhaps go slightly faster, even before Congress acts.
Today’s news headlines say that the report lays out three options, but for all practical purposes, it lays out only one road forward, and not the one that the government is likely to take. The proposal laid out in the report’s “Option 1” and “Option 2” calls for private investors to purchase mortgage-backed securities. In “Option 2,” the government would plan to step in to stabilize the housing market “during times of crisis.” “Option 3,” which calls for the government to backstop the country’s real estate market, is financially and politically unworkable on its face. The “catastrophic reinsurance” would put the government on the hook for real estate values to the tune of several month’s worth of GDP, payable only when economic disaster strikes. This fictional insurance — obviously, it could never actually be paid — would effectively subsidize all the real estate in the country, and it would lead to a national bankruptcy during a future economic recession. I don’t believe this option is meant to be taken seriously, but to steer politicians toward the space between “Option 1” and “Option 2.” Yet the actual path forward will have to be something different. The United States mortgage market will need an approach that involves a reduced reliance on mortgage-backed securities, which, as everyone recalls, helped to trigger the sharpest economic decline in the country’s history.
The government has already lost more than $100 billion on the Fannie Mae bailout, and the new report confirms that no one has a plan to earn that money back. Rather, substantial additional losses are to be expected as Fannie Mae is wound down.
What will happen to the mortgage business without Fannie Mae and Freddie Mac? The small down payments of the last 15 years will also be going away. Analysts are saying today that workers with steady employment histories will need to pay 20 percent of the price of a house in cash, and for freelancers and business owners, that might be more like 40 percent. (There will still be government support for loans for small farms.) Another very noticeable change is that mortgage rates will have to increase to better reflect the actual costs and risks involved in home mortgages. Rates for 30-year mortgages may go up by 1 to 1.5 percent, some analysts think. This, in my opinion, will price ordinary banks out of the mortgage business, a change that may come as a shock to many banks that have come to expect that home mortgages make up half of their revenue.
Banks, with the help of Fannie Mae, have thoroughly dominated the mortgage business in the last 12 years, but direct lenders and investors will have greater influence in the new mortgage business. One scenario is that investors set up a clearinghouse, similar to a stock exchange, and use it to make loans directly to mortgage borrowers. Banks or other local offices would do most of the underwriting work, but would earn a commission only for loans that are ultimately paid back. The investors, or their advisers, would make the final decisions about which loans to fund. This approach would create dozens of new issues for real estate brokers and regulators to consider. Alternative scenarios would create a lending environment even less like that of the past three decades.
The FDIC is confident enough that bank failures have peaked — in California, Arizona, and Nevada, at least — to announce the closing of its satellite office in Irvine, California. The office was originally authorized for three years and will shut down at the end of this year.
Bank failures continued tonight, with one in California. The OCC closed Canyon National Bank, with three locations around Palm Springs, California. The failed bank had $205 million in deposits. Pacific Premier Bank is taking over the deposits and purchasing the assets. Unlike most such arrangements, the FDIC is not sharing in losses on any of the assets. The purchase allows Pacific Premier Bank to extend its branch network east into Riverside County.
Elsewhere tonight, banks were closed by state regulators. In Michigan, it was the century-old, Hamtramck-based Peoples State Bank that realized, when it put its financial numbers together in January, that its net worth had gone negative in December. A bank isn’t officially allowed to be in a negative capital position, so its closing tonight does not come as a big surprise. It reported a loss of $18 million in 2010, and had $390 million in deposits and a similar amount in assets at the end of the year. The bank had continued to pay dividends up until two years ago, even though it was well on its way to financial ruin at that point.
First Michigan Bank is taking over the deposits and purchasing the assets. First Michigan Bank is promising “it will be business as usual” at the 10 former Peoples State Bank branches, but hasn’t yet determined whether it will be able to keep all 10 locations open in the long term.
Two smaller banks, with deposits totaling $195 million, also failed tonight:
- Sunshine State Community Bank, 5 locations, Port Orange, Florida, in the Daytona Beach area. Successor: Premier American Bank.
- Badger State Bank, Cassville, Wisconsin, along the Mississippi river in the southwest corner of the state. Successor: Royal Bank.