The US banking sector – an analysis of the prospects for smaller banks

Guest contributor – Jeff Spencer (Financial Institutions Credit Analyst, M&G Credit Analysis team)

Investors could be forgiven for thinking that the US banks are well on their way to recovery, with several big banks having redeemed the government preference shares and bought back the government warrants they received under the Capital Purchase Program (CPP) of the Troubled Asset Relief Program (TARP).  Away from the office towers of Manhattan, Charlotte and San Francisco, however, the banking system’s troubles are getting rapidly worse, even if the larger banks’ situation has stabilised.  Out of view of the bond markets, the Federal Deposit Insurance Corporation (FDIC), which insures US depositors, currently up to $250,000, is preparing for a wave of insolvencies among smaller banks, and is rapidly running out of reserves to absorb the losses those failures are likely to cause.

The FDIC deposit insurance fund dwindled to $10.4bn by the end of the second quarter, as reported on August 27, from $13bn at the end of the first quarter and from $45.2bn in 2Q08.  This decline followed a special assessment  approved in Q2, which was 5bp of each insured bank’s total assets net of Tier 1 capital (i.e., equity and retained earnings, preferred stock and some hybrid instruments).  The FDIC does have a line of credit with the Treasury, which it can draw on if it needs to, but it announced recently that it was opening the door – just a crack – to private equity buyers by easing some of the conditions it had imposed on non-bank buyers of banks out of FDIC receivership; the unspoken hope is to increase the buyer base so that the deposit insurance fund sustains fewer losses.

And it’s clear why this sort of move has become necessary.  The number of banks on the FDIC’s “problem list” rose by 36% from the end of the first quarter, to 416 from 305, representing $220bn in assets.  This is the largest number on the problem banks list since June 30, 1994, the FDIC says, when there were 434 banks on the list. $220bn is the largest amount of assets belonging to problem banks since December 31, 1993.

Does it really matter if many, all of or even more than the 416 institutions on the problem list fail?  After all, few of the institutions have bonds issued into the market, and healthy banks can pick up branch networks and insured deposits cheaply, in smaller echoes of JPMorgan’s purchase of Washington Mutual’s banks out of receivership.  But markets should still be concerned about the US banks.  After all, further special assessments, to raise money for the deposit insurance fund, cannot be ruled out, and that imposes a cost on every insured bank – and by definition the absolute cost is higher the bigger the bank.

More importantly, though, is the daunting mountain of real estate assets and non-performing loans that the FDIC will soon be tasked with auctioning off.  Given the disproportionate concentrations of commercial real estate loans (and to be clear, these are often low quality tertiary properties, not landmark ones) held by the smaller banks in the US, this is one asset class where downward pricing pressure may continue.  US banks with $1bn to $10bn in assets have 30% of their loan books in construction and commercial real estate loans – compared with just 6.2% at the banks with assets over $100bn.  In the nearby charts, we have plotted data from the FDIC’s website.  The chart on the left shows that severe problems in residential property persist.  It shows that prices achieved as a percentage of last appraised value, on properties sold are collapsing (to 66% compared with 160% at the height of the bubble), even with the relatively minor increase in the number of properties sold in 2008 (especially compared with the numbers sold during the Savings & Loan debacle).  The pricing of non-performing corporate loans (chart on the right) has not declined markedly over the past couple of years, which may be a reflection of the relatively lowly levered balance sheets of the commercial and industrial sector (i.e., compared with the property sector), though it’s not immediately obvious that this pattern will hold.

This ominous news continues to seep out from the stratum of smaller US banks, and contrasts strongly with the positive tone hummed by the larger banks (whose recent profitability has a lot to do with their extensive investment banking and trading operations).  It is certainly not a reason for investors to run for the hills, but it does indicate to us just exactly how much work lies ahead in repairing the developed world’s broken banking systems.  Recall, too, that crucial decisions – first and foremost, what to do with the mortgage behemoths Fannie Mae and Freddie Mac – have yet to be considered, let alone made.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Jeff Spencer

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