Local Banks Part II
In the last post I discussed the overall market conditions and unique nature of our banking market in the NW that is causing so many problems in this state. 2010 will be the year of reckoning for our local banks and in addition to the market forces there are regulatory forces causing problems. In November of 2008 as the TARP money was being put together and the legislation finalized two crucial regulations were enacted that have caused problems. Both of these regulations seem good on the surface but they have hampered the work out process. The first regulation was that you could not keep advancing funds on a loan that had gone into default. The purpose of this regulation was to appease the legislators in Congress that didn’t want the TARP funds used to keep promoting bad behavior. Sounds good on the surface but in the terms of real estate construction lending it can be disastrous. What this means is that if you have a partially finished lot development or a partially completed new construction home then you cannot advance funds to finish it. In the case of a speculative construction home, the home has no real value and cannot provide any use until it is completed. As an example let’s say you have a new construction home finished that would be worth $1,000,000 when completed. All that is needed to complete the home would be an additional $200,000 in funds however the builder can’t make his interest payments any more so you have to stop construction and foreclose. You would think that home would be worth $800,000 since $200,000 is all that is needed to finish it. However that is not the case. The home has probably degraded during the foreclosure process or worse but that is not the problem. The problem is that a new buyer has to go out and get construction financing which is not readily available and then hire a new contractor and then complete the home. There may be problems with code inspections or even worse the permit may have expired and the building codes changed in the meantime so the home has to essentially be rebuilt. Instead this home sells for about $400,000. A huge loss for the bank. I have even seen a case where a large condo project lost all of its approvals because the bank was not allowed to advance $5,000 to renew the Master Use Permit in the City of Seattle. What happened in the eighties during the S and L crisis the better capitalized banks would advance funds and see the project was finished. The only thing worse than taking a project back is taking back an uncompleted project. Just a few of these large projects can really hammer a bank and selling some of them is almost impossible not to mention the liability and blight to the community.
The other factor that really hurt is that the regulators wanted to stop “risky” lending. Again another good idea but with unintended consequences. What this meant is that the bank who took back the partially completed asset cannot lend on it. Again I go back to my experience in the eighties and generally what a bank would do, would be to move good assets from weaker borrowers to stronger borrowers by providing new loans to these stronger borrowers who often brought new money to the table and the expertise to better manage the project. It gets worse. Now given the devaluations caused by these restrictive regulations the stronger borrowers now are required to drain their funds just to manage what they have since the value of their assets are in a downward spiral. The effect of this is to create massive liquidity problems that were never intended to happen. Most of these state chartered banks would be in better shape if they were allowed to enhance the value of the asset and to provide new loans to more capable borrowers. Most of these state chartered banks did not receive any TARP money. Also the better borrowers are seeing their sources of financing disappear before their eyes with no replacement. This will tank many small businesses.
But it even gets worse. Now the these assets sit because the value has declined so much the bank can’t afford to sell it since it will be such a big hit to their balance sheet. The bank cannot enhance the value of the asset by completing it nor can they sell the asset. So guess what happens. The bank goes under and the FDIC takes receivership of those assets, since any receiver bank in their right mind won’t touch these assets now comes the ironic part. The FDIC is stuck with the assets so guess what it does? They provide financing to help “create value” for the sale. Sounds like a good idea. As an example when CORUS Bank in Chicago went under Starwood Capital bought the assets for a fraction of their book value. The FDIC provided financing. For the most part the financing was 5 Years at 70% of the value of the asset with an interest rate of 4% on some pretty bad stuff. However on much of the uncompleted projects the FDIC was forced to acknowledge the problem it created by doing financing up to 10 years at “0″ percent interest.
So there you have it the hedge fund guys win again. They get to hold the asset for no interest for 10 years. There is not much incentive to finish the asset and they will hold it and just sell it back to some local developer in the future. In addition the message this sends to those interested asset purchasers is chilling. Why buy the asset from the bank? They can’t provide financing so you have to pay all cash and the bank can’t improve the asset or discount it enough to make it saleable because of the regulatory environment so if your a large asset player just wait for the FDIC to take the bank out and shoot it in the head so you can get that great deal with financing. The local purchaser is shut out and the lending institution is trashed along with all of the jobs but most importantly for the long term that source of community based lending is gone. These community based banks will be instrumental in funding any future recovery. There is a solution and that will be addressed in the next sequel.