In a recent address to Congress, President Obama stated that Americans should know their money in U.S. banks is safe. He also stated that the country’s financial system needs to begin lending again. The challenge the banks face is the dueling requests of regulators, 1) lend money and 2) increase capital requirements; two diametrically opposed stances. At the core of the problem are the toxic loans from the housing crisis making their way onto the balance sheets of too many banks; which has created enormous unrealized losses and eroded confidence so sufficiently that banks are often hesitant to lend money to households, businesses or other banks.
Ensuring confidence in banks is, in large part, what TARP is about. The fundamental elements of TARP (Troubled Asset Relief Program) are the home loans associated with the rampant foreclosures. These loans have been devalued to the extent that they must be written down on a bank’s balance sheet and ultimately the bank becomes the new owner. Banks are particularly adverse to owning homes in this market as there is a lack of healthy, prospective buyers.
A peculiar factor about the recent home buying frenzy was that people were not just purchasing homes as a primary residence; a good many people became speculative investors and bought homes as investments. This risky behavior became the investment du jour. It goes without saying that the terms behind these mortgages, regardless of the motivation behind the purchase, were a substantial culprit in the crumbling of the house of cards.
Bill Oakley, president of Mutual of Omaha Bank, is of the opinion that Nevada probably didn’t do anything differently than any other high growth industry. Oakley elaborated by saying, “Some of the factors that led to the overbuilding and unrealistic appreciation rates included the belief that the demand was real, coupled with the shortage of available land surrounding Las Vegas.”
The risk to rewards ratio was invalidated when the bottom dropped out of the housing market. Suddenly, or not so suddenly, as a number of people saw it coming, there were more houses than there were buyers and a good many buyers who purchased their homes/investments with subprime loans, discovered they couldn’t pay for them after all. Many current homeowners knowingly engaged in the purchase of a home under fabricated income conditions or unsound financial background.
Foreclosure rates soared and Nevada led the nation. Nevada still leads the nation, with rates for 2008 as high as 7.7 percent in Lyon County, 3.9 Washoe and 8.9 percent in Clark County; which means banks are suddenly in the business of owning homes. Only banks don’t want to own homes, they would much prefer to only be banks, especially when the loans are dropping precipitously in value.
Bursting the Bubble
“Obviously the deterioration of the economy, which probably started from the burst of the housing bubble, has effected most financial institutions,” said Reed Radosevich, Nevada president of Northern Trust. “If a firm got caught up with collateralized debt obligations, which is basically a fancy way of saying they packaged up mortgages and sold them off to the market, then they are experiencing substantial corrosion of their portfolios. When those debt obligations went down in value significantly, it created billions of dollars of write-offs.”
So how do banks in the Silver State compare to those across the nation? According to Radosevich, Nevada banking currently runs the gamut from financial institutions closing to those being scrutinized by the Office of the Comptroller of Currency and bank examiners to those that are doing very well. Those doing well, for the most part, are the institutions that were prudent in their lending standards.
“While 2008 was a wild ride for banks, especially since they tend to mirror the state’s economy in terms of success, most banks are still well capitalized and positioning themselves to take advantage of the growth that will follow with the economic recovery,” said Jim Devolld, president, First Independent Bank of Nevada. “A few will not make it through this storm, but that will be a small minority. Most have made the needed moves to greater efficiency and credit quality.”
Dr. Keith Schwer, professor and director of the Center for Business and Economic Research at UNLV, believes that Nevada’s current economic problems are not the result of a perfect storm, but rather a series of waves that battered the national economy. “For Nevada, we were part of the housing bubble and because we were growing and had a lot of construction activity, when bank credit problems arose, we were adversely effected,” said Schwer. “Not all bank credit problems were directly attributable to banks in Nevada. The big financing needs of Strip properties, etc., were Wall Street funded and elsewhere. It was less so a perfect storm and more so a wave of economic difficulties.”
According to Oakley, Nevada finds itself in its current condition due to three warning signs. In retrospect the signs included: 1) Consumer debt to GDP increased to more than 100 percent; 2) The housing/mortgage market did not make sense with the offering of mortgage products that were not tied to sound underwriting standards; 3) High liquidity in the financial markets led to financial institutions reducing fees and interest rates while loosening credit standards in an effort to win business over the competition.
There should not have been any surprise when the surge faltered. There was talk through the latter half of 2006 and into 2007 that the residential housing bubble was bound to break.
The home price escalation began in the spring of 2004 and continued on through 2005 and into 2006. This was the height of investors buying single family residences as investments rather than homes. Individuals were buying two and three houses, banking on the ability to sell at inflated prices. Home prices shot up $20,000 or more in a single day in Northern Nevada.
The first dip in home prices came in the last part of 2006 and the first part of 2007. As expected according to some. “We really started monitoring things when the prices shot up in the spring of 2004 and knew that in about three years there would be difficulties,” said Schwer. “The three-year time line comes from the fact that the creative financing tool at that time was the three-year adjustable rate mortgage.” The declines didn’t stop there either, from September of 2007 onward it has been nothing but a continual downward spiral.
To make the situation even more discouraging, recent data indicates fewer people are moving to Southern Nevada and Clark County’s population actually declined between 2007 and 2008. Additionally, the Clark County Business-Activity Index, a measure of overall performance, peaked in late 2007, which means, at least in Southern Nevada, the state’s economy peaked and began a decline months before the national economy.
Battening Down the Hatches
What started as merely declines has turned into a full on recession. In addition to the TARP rollout, there was the recent bailout stimulus bill passed by Congress, but the economic situation on every level seems no less stable. When TARP rolled out late last year, most people believed the idea was economic relief in the form of loosening up credit and motivating banks to make loans. But only a small portion of those funds have trickled down to what was expected to be the end users: the public.
“I think people need to remember with TARP, the first wave, banks are paying interest on the money. It’s a debt instrument, 5 percent for the first five years and then it goes up and [the government] has an option at 10 years to convert to equity ownership,” said Dallas Haun, president and CEO, Nevada State Bank. “It’s important the public understands the terms and conditions on the money because people use the term ‘bailout’ like it means ‘free with no strings.’ That being said, our parent company did receive TARP money. We are using it as aggressively as the market allows to lend money to small businesses in our markets.”
“From a banking perspective, the economy is struggling and companies are seeing lower revenue numbers and projecting even lower numbers,” said John Guedry, executive vice president, City National Bank. “The prudent thing to do in this type of economy is to tighten down on lending and make sure you’re lending only to qualified borrowers and not issuing to borrowers who will put [the banks] in a deeper hole at a future date. I think most of our clients are following the model closest to what the banking industry is doing. They’re holding cash, they’re slowing growth plans down, they’re cutting back on expenses where they can and trying to focus on their existing client base.”
The majority of TARP funds have been used to capitalize banks. Most of the money went into preferred stock and to individual banks which pay a preferred return. The U.S. government gets back interest for that investment and after a period of time, the rate adjusts upward. Some wonder if this structure models Adjustable Rate Mortgages too closely as they are in large part what got a lot of home owners into negative equity situation.
“Right now, capital for banks is key,” said DeVolld. “What the government and media have been asking us to do is take the TARP money and lend it out.” But banks aren’t lending, and despite talk of a credit crunch, borrowers aren’t borrowing. “Borrowers aren’t that hot on additional debt,” said DeVolld. “They’re trying to refinance their existing debt. Banks are using the money to strengthen capital, strengthen the net worth of their companies.”
So when the question is asked, “Who was the end user of the TARP funds supposed to be? Institutions and businesses? Or Individuals? There is really no concise answer. The funds went to the banks to ensure the health of their balance sheets, which in turn should have led to more lending by the banks. Albeit theoretical flow charts do not always occur as intended in reality, there is still optimism on the part of Nevada’s top bankers. “It helps everybody if we can get the economy rolling again and the banks can pay back the preferred shares at a reasonable institutional rate,” said DeVolld. “Everybody will be better off if they can prevent large financial institutions from going under and stockholders losing investments. When the financial markets are in turmoil and the stock market is uncertain, wealth is lost. I think calming down the organizations is a good thing.”
Has there been an observable impact from TARP monies on Nevada? “On the surface, you would have to say no, but again it’s not easy to see what would have been if there had not been TARP,” said Schwer. While this analysis might not be as tangible as hoped for, Schwer makes a good point, that there is no way of knowing what the economy would look like if TARP had not occurred.
Oakley has a slightly different perspective, “TARP funds likely allowed a few banks to continue to remain open for business in Nevada. As such, they are employing people, paying rent, taxes, etc and contributing to the state economy which is always a positive thing.”
Peering Through the Fog
“Given the difficulties of all the loans that have been made and the risk-taking that was ongoing, in order to go forward we need to have financial institutions be adequately capitalized,” said Schwer. “In order to do that there are going to be some people who are not going to get loans who perhaps in another period of time when economic opportunities were different would have gotten loans.”
Without banks making loans, though, consumers aren’t sure how strong the banks really are. For years depositors have been reassured by FDIC notices in bank windows. Today FDIC tops out at $250,000 per depositor per bank, but some banks have found a way to better that for their customers.
“People are concerned about safety,” said Bruce Hendricks, president and CEO, Bank of Nevada. “They’re keeping up to date with changes in FDIC insurance. Last summer we instituted a special program that provides our depositors up to $1,250,000 in FDIC insurance coverage.” The bank did it by working with its sister institutions, including First Independent Bank of Nevada, placing CDs and money market accounts in all five sister institutions, each insured up to $250,000.
As banks continue to bolster their capital position, they’re being more conservative than ever with loan underwriting. Where banks have typically taken in deposits and lent out funds and had the capital to backup investors and depositors in case of loan losses with a loan to deposit ratio of 10 to 1, now banks are looking at 30 to 1 on the capital side. More capital, less risk is the special of the day – every day.
Looking to the government to bail us out is wishful thinking, according to Bob Barone, managing partner or Reno-based Ancora West, a registered investment advising institution.
The anticlimactic debut of TARP funds begs the question, what should the government be doing? “The government should be looking to try and stabilize the price of houses because once the price of houses becomes stable then the banks’ and financial institutions’ balance sheets can at least get some legs under it and stop falling. Once the price of housing has stabilized, then the mortgage asset values on bank balance sheets will stabilize and the bank capital crisis will end. Once the bank capital crisis ends, banks can start lending again,” said Barone.
There’s even a proposal, according to Barone, from a senator who suggests the government give new home buyers 15 percent of the purchase price, typically around $30,000 as the median home price is $200,000 currently, in either tax credit or cash. This incentive would only be available for homes purchased as a primary residence. “If we sold 3,000,000 homes as a result of that, you do the math. That’s $90 billion, and that’s a lot of money. But if they’re going to spend a trillion dollars, at least one tenth should go to attack the cause of the whole issue. Just throwing money around does the same thing they did last year and gives people money today, but at the expense of future generations who have to pay it back and pay interest on it.”
Oakley speaks in a similar vein when he says that, “In my opinion, the government is shooting from the hip because no one has seen a global economy like this one. Some of the decisions will undoubtedly help stimulate the economy while others may severely impact the lifestyles of future generations.”
