I'll start by recalling an interview I had almost three years ago with the president of a community bank now situated in the Outer Banks. When I asked the CEO what his game plan was for the OBX, he responded "We're not interested in commercial real estate loans, we want to do C&I loans". For the profane, C&I loans are bank shorthand for "commercial and industrial", which means any commercial loan not focused on the purchase or refinancing of real estate. I declined to even entertain the job because C&I loans are a thing of the past. Banks don't finance factory raw materials or equipment anymore, and most local banks in North Carolina do not want to lend on lines of credit secured by inventory to "mom and pop" retail stores, nor do they wish to make loans to those companies that demonstrate cash flow but possess no hard collateral...like real estate.
They still make loans on equipment like front loaders and dump trucks, but think about the volume. A dump truck might run $100,000 and the risks involved in the loan are great; the truck loses value rapidly, if its down for repairs the owner isn't earning revenue, and most businesses that use dump trucks are very susceptible to downturns in the economy. It would take twenty dump truck loans to make up the volume on one $2 million office building that is fully leased.
Three years later the bank in question is still around and by all press releases is not in trouble. So far, so good. However, its earnings are totally unimpressive, and the earnings they post come not from their banking operation but their mortgage lending side. As far as growing the local business economy here or any other place they reside, this bank is not going to be a player. It makes its money by funding mortgage loans and selling those loans in the secondary market. No entrepreneurial growth in the local economy will emanate from this approach to lending. What we have is a low risk-low return operation... a safe bank, for whatever that's worth.
In northeast North Carolina, the only game in town is real estate. If a bank is going to have impressive earnings, it has to be involved in most all facets of real estate; construction lending for residential and commercial property, permanent mortgage loans on commercial real estate (both owner-occupied and rental property), occasional "speculative" loans, lot loans (both commercial and residential), development loans on residential subdivisions, commercial office projects and industrial parks, and permanent residential mortgage lending. Take all of the above away, and you are left with virtually no other sources for a local bank to generate earnings via the act of lending money.
Thus, when the real estate market crashed, many local banks were left "holding the bag" on commercial and residential properties. The problems local banks are experiencing are not arising from bad residential mortgage loans; those were either made by large-scale mortgage lenders, or sold to those same lenders in the secondary market by the community bank. And don't blame the banks for not predicting the crash. No one can predict the future. The best method to assess risk, in fact the only method, is to assume the near and immediate term future will look similar to the near and intermediate-term past. One might expect real estate sales to drop 20% from a peak, or values to decline by the same margin. In the worst case scenarios over the last thirty years those numbers have been the benchmark. No one could have predicted real estate sales of 0% nor prices to decline 40% or more. Otherwise, the regulators would not have set LTV margins at 75-85% on commercial real estate.
What local banks are left with are residential subdivisions where zero sales have taken place in over three years, office buildings and industrial parks in the same situation, and retail and commercial buildings that are losing tenants as the real estate collapse began to affect affiliated businesses and even retail outlets and restaurants. When real estate dies, not only do attorneys, Realtor's and insurance companies close up shop, but local retailers and other businesses that rely on local patronage also fail as those affiliated with real estate become unemployed. A Realtor who was earning $200,000 and is now earning $30,000 is not likely to be patronizing the local jewelry store or a high-end restaurant.
So what are banks doing? When my phone rings, its the following scenario:
1) The bank has been ordered by some "regulator" to re-appraise all collateral they are holding, even if the client is paying the loan on time. In most cases, commercial loans actually "mature" every three or five years, so when these loans come due, the appraisals are ordered. The client is not only unaware of the appraisal being ordered, but the bank often sticks them with a $3,000 appraisal bill while refusing to renew the loan!
2) Because there are virtually no sales in the residential or commercial real estate market, the appraisers have no realistic "comps" and they devalue the property, often to a point where the new "value" is considerably less than the loan balance. For example, when a loan was made on commercial property, the banks typically would only loan 80% of the value. A property that appraised for $1,000,000 could therefore obtain an $800,000 loan, maybe $850,000 if owner-occupied. After three years, the loan balance is probably still well above $900,000, but the new appraisal reflects a value of $700,000.
3) The bank then demands the client make up the "deficiency", either in cash or by pledging more collateral. If the client cannot comply, the bank "accelerates" the loan and in essence, calls it due in full. Right now. Today. Some of the people talking to me are being asked to come up with $200,000 or more in order to bring the "loan to value" ratios in line with regulatory requirements. Not gonna happen. How many small businessmen have $200,000 cash laying around, or free and clear property worth the same sum? And even if you had the money, once the bank informed you that your office building is worth only 70% of what you paid for it, are you going to sink $200,000 into a white elephant?
In most of these cases, young bankers, apparently hooked on the technology revolution, inform the client of his new peril via email, sometimes tagged thusly:
Dear client: Your loan has now matured. We have ordered an appraisal of your property and the new value is $700,000. You owe us $900,000. Please send us $200,000 in cash or land, free and clear, and while you are at it, please pay us $2,500 for the commercial appraisal we ordered on your behalf. Be advised that if you do not comply, we will accelerate loan and commence foreclosure proceedings.No phone calls and certainly not a face to face meeting. And the next communication is likely to be a registered letter.
Sent from my Blackberry device provided by Verizon....
Even more strange is the faith Federal regulators are placing in appraisals. I can safely state from experience that few FDIC regulators (the one's most likely to shutter a bank) have any prior experience in making loans or loan decisions. Yet, they judge loans based upon a "programmed audit" that has been developed during an era where nothing we are seeing today has ever occurred. Certainly there is no surviving bank auditor remaining from the 1929 Depression. I doubt there are many left over from the 1980 S&L crisis, and even if they were, the situation then has nothing in common with the crisis in banking today. Thus, not one regulator today has any idea how to determine the way and manner a bank should navigate the current crisis. This is all new territory; for the bankers, regulators, and customers. Yet we seem to be utilizing a playbook that was designed for a time when problem banks were few in number, the economy stable, and the loss or one or two institutions a year was nothing more than a speed bump.
And, if the appraisals were so far off when these loans were made at the peak of the real estate boom, how can any regulator now claim that an appraisal made today, as the real estate market either continues to descend or scrapes bottom is valid? And how is the customer responsible for this state of affairs?
It's a similar scenario to the "mark-to-market" problem in the valuation of securities. If there are no buyers for securities at any price, how can you intelligently assign a value to the security? It is no different in real estate. Sales on the Outer Banks are virtually non-existent in both the commercial and residential markets. The sales we are experiencing are mostly "non-arms length" in that they represent distressed, foreclosed, or short-sale properties that are literally being dumped on the market by the banking industry, not a real price set in a robust market between motivated buyers and sellers. Many sales are cash sales as there is little financing available for properties that are investment in nature, making the new appraisals even more suspect as the universe of cash buyers is small and not representative of the market in general.
With all of that said, if a client is paying their debt, what possible good can come from a regulator forcing a bank to call a loan due in full (which almost always will result in a foreclosure) based upon an imaginary valuation concocted in a non-existent sales environment? And how many of these clients were actually courted by the bank, even fought over as other banks bid on the same deal to place their debt in the institution now refusing to work with them?
Someone is going to get very, very rich as a result of these actions. When we start foreclosing on those who are actually paying their debts on time based upon a quirk in the language of a promissory note that allows/requires a bank to place a borrower in a lose-lose situation, the logical conclusion is that things are going to get a lot worse before they get better.
So, OK, I lied. Somehow, when Obama was talking about the audacity of hope, did he exclude the small businessperson? Are we saying that we want to take a business away from the small businessman so a wealthier vulture can swoop in and buy the collateral at a fire-sale price? Did Obama and the FDIC mean to steal from the middle class and give to the rich?
It sure looks like it.