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Small Banks Not Immune From Housing Fallout

While most regional banks refrained from making subprime loans, analysts say SunTrust Banks Inc., bucked the trend and made these kind of loans in its Florida operations.
Erik S. Lesser
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While most regional banks refrained from making subprime loans, analysts say SunTrust Banks Inc., bucked the trend and made these kind of loans in its Florida operations.

As the financial crisis unfolds, some of the largest banks in the United States have been falling like dominoes.

Many of them — including Bank of America, Citigroup, JPMorgan Chase, Wells Fargo & Co., and U.S. Bancorp — have responded by swooping in to make opportunistic purchases of their faltering brethren: JPMorgan Chase bought up faltering Washington Mutual, while Wells Fargo elbowed out Citi to acquire Wachovia.

This supersized approach to survival seems to be grounded in a too-big-to-fail philosophy. Community and regional banks offer a contrasting model: They've weathered the storm by staying small and focused.

The government announced Tuesday it would invest $250 billion in preferred shares of stocks in U.S. banks and savings and loans. The Treasury Department invested half in nine of the most powerful banks in an attempt to loosen up lending throughout the industry. But it said the voluntary program was for banks of any size, leaving the door open for smaller banks to ask for a piece of the remaining $125 billion.

In exchange for its investment, Treasury will receive dividends of 5 percent annually for the first five years. After that, if banks have not repaid Treasury's investment, the rate jumps to 9 percent.

On Wednesday, President Bush said the temporary program was designed to "preserve" and "not replace free enterprise," adding that "there won't be government officials sitting on the board of the private companies."

Bank trade associations — including the American Bankers Association and the Independent Community Banks of America (ICBA), which represent a broad spectrum of banks — said most of their institutions don't need this infusion because they have enough capital.

Meanwhile, some in the banking industry say bulking up comes with a price.

"This whole turmoil really started because the policy of the federal government was to allow institutions to grow to unlimited size, which then created institutions that had systemic risk inherent in them," says Camden Fine, ICBA president.

Fine says that allowing mega institutions to keep on growing will create "even greater systemic risk to our economy." There will be four institutions "controlling well over 40 percent of the total deposits in the United States."

He says he'll advocate to have these giant financial institutions broken up because it "puts the entire United States economy at the mercy of essentially four CEOs, and I think that is very dangerous."

Big Or Small, All Feel Credit Squeeze

All banks engage in lending to consumers and businesses. Banking analysts say that megabanks, which have national name recognition, typically have assets that range from close to $250 billion to $2.1 trillion. Regional banks, with operations in multiple if not dozens of states, typically have assets from $10 billion to $150 billion. And community banks — which may serve a single town or community — have, on average, assets of about $200 million, according to the ICBA.

Regardless of their size, banks' lending activity has been at a near-standstill. To help fill the lending void, the Federal Reserve announced last week that it would purchase the commercial paper, or short-term debt, that companies issue to help fund their daily operations.

Increasing foreclosures and decreasing housing prices have also put pressure on banks that made riskier residential loans. Fine says that all banks operating in California, Florida and Michigan have been especially hard hit because of the economic fallout from the housing booms there.

Small and regional banks made far fewer risky home loans than the megabanks. But that doesn't mean they're immune to the housing bust.

"Home equity and construction loans — that's where a lot of the pain is for community banks," says Bert Ely, principal for Ely & Co., a financial services consulting firm.

Analysts also remain concerned about commercial real estate and commercial and industrial loans.

Exposure To Risky Loans And Investments

Analysts say community banks and larger regional banks typically have minimal exposure to the toxic mortgage-backed securities at the heart of this financial crisis.

With megabanks, it's a different story. Their securities portfolios are much more complex, and that's what led them to include investments in mortgage-related bonds.

Many regional banks wrote down loses from such investments a year ago, says Erik Oja, an equity analyst who covers the banking industry for Standard & Poor's. These losses, however, were relatively small compared to the multibillion-dollar losses sustained by Wall Street financial institutions and giant banks.

Community banks have about 13 percent of their assets invested in mortgage-backed securities, says Fine. Only about 1 percent of these investments are in private-label securities — a term that refers to securities issued by a company other than Fannie Mae or Freddie Mac.

Fine says that the majority of the 8,000 community banks are "well capitalized and well run" and are responsible for making approximately 45 percent of all the small-business loans in America. Most are also privately owned and the idea of the government taking a stake in their business has little appeal to them, he says.

The conservative lending practices these banks engage in aren't just a knee-jerk reaction to uncertainty about the economy. Fine says it's part of the culture: "They never got into these exotic mortgages and these exotic investments. They stick with plain vanilla banking."

But Oja warns that the coast is not entirely clear for community banks. He worries about their exposure to troublesome residential development loans, as well as to commercial and industrial loans.

Regional banks, he says, may be better positioned. They typically make about 45 percent of their loans for nonresidential commercial and industrial purposes; 45 percent for residential mortgage and residential construction; and 10 percent for personal loans and credit cards.

Foreclosures And Home Price Declines

Several states had high percentages of loans that were deemed "seriously delinquent" at the end of the second quarter, according to the Mortgage Bankers Association.

Florida led the pack with 8.4 percent, followed by Nevada (7.6 percent), Michigan (6.2 percent), Ohio (6 percent), California (6 percent) and Arizona (5 percent).

Foreclosures go hand-in-hand with housing price declines. Oja says that some of the worst declines measured by Standard & Poor's Case-Shiller home price index have been focused in three states: Arizona, Florida and California. As a result, banks that have made a lot of residential development loans there have seen "a lot of credit quality decline," he says.

The loans that have been most troublesome for regional banks are not residential mortgages, but residential construction loans — which are made to builders or developers.

Typically, regional banks refrained from making riskier subprime or Alt-A loans that called for less documentation from borrowers.

"They don't touch anything with nonprime lending," says Oja. That means they make loans only after verifying an individual's income and obtaining a credit score. As a result, many have been insulated from losses that have plagued other banks.

But that's not the case for the two largest regional banks — National City Corp. of Cleveland and Atlanta-based SunTrust Banks Inc. — which did make these riskier loans in Florida, Oja says.

While smaller banks have survived, analysts like Oja say dependence on one city or economic region can also be a liability.

"A small bank with just a few branches — they don't have the diversity in their loan portfolios that will help them overcome this credit cycle," says Oja. "Large regional banks have well-diversified loan portfolios in general and well-diversified deposit bases. In this environment, it's better to be a big size or large regional bank."

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