One of the questions I hear a lot these days relates to why banks are not lending, especially when there are plenty of qualified borrowers out there who need loans (which there are). For most banks the reason is a capital shortfall driven by the ailing residential real estate market. Below is a simple example to explain this. As with my other posts this is an over-simplified example that is only designed to explain a concept and not qualify you for an advanced degree of some sort.
The fictional bank I will use as an example is called “Startup Bank” that opened its doors in 2005. I don’t think there are actually any banks that have that name but if there are this is not intended to describe that bank or any other bank; it is just a random name I picked.
Startup Bank raised $10M in equity capital from various investors. Generally, the regulations allow banks to lend 10 times the amount of capital they hold so, in this case, Startup Bank could lend up to $100 Million. In order to keep this simple, assume capital remains exactly the same throughout this entire example at $10 Million and that the maximum amount Startup can have in outstanding loans is $100 Million.
Startup Bank had a great first year in 2005 and loaned $50 Million, or half of its maximum amount. Startup generated another $50 Million of loans in 2006 to reach $100 million in total. At this point the bank could not make new loans unless existing loans paid off or unless they raised additional capital but they were pleased because they made so many new loans so quickly.
50% of Startup’s $100 million in loans were to businesses & individuals and the other 50% of their loans were related to the residential real estate market which includes land acquisition, lot development (streets, curbs, water, sewer, etc.), and construction of new homes. As of late 2006, all loans were paying as agreed and Startup Bank felt well secured, especially on their residential real estate loans because house values had continued to rise for so many years in a row.
By early 2007 Startup started seeing some trouble developing in their residential loans – small at first but getting much more troublesome as 2007 wore on. Houses were selling much less quickly which, in turn, meant developed lots weren’t selling and, of course, that meant sales of undeveloped land stagnated too. All of this was caused by the collapse of the securitized debt market which I covered in previous posts (Sub-Prime Primer Parts I and II).
Without sufficient levels of sales in land, lots, and houses, Startup Bank’s borrowers started to face financial difficulties. At first, some of the borrowers tried laying off part of their staff and started using savings they had been able to accumulate during the residential boom years………but for many the slowdown lasted too long and they allowed their assets to go into foreclosure. As more and more borrowers did so Startup Bank began realizing losses on these loans.
By late 2007, $90 million of Startup’s loans were still paying as agreed but $10 million had gone into foreclosure. Startup was afraid that the market would continue dropping (which it did) and decided to sell the foreclosed assets for a deeply discounted price of $6 million and booked a loss on these loans of $4 million ($10 million loaned out minus $6 million received from the sale of assets).
This loss of $4 million was deducted directly from capital which was then reduced from $10 million to $6 million. As a result, the maximum amount of outstanding loans was decreased from $100 million down to $60 million. The problem was that they still had $90 million in outstanding loans ($30 million more than allowed) and Startup was then classified as severely “undercapitalized”, a classification that bears many problems including dramatically increased funding costs, intense regulatory scrutiny, and bad PR that can lead to many depositors withdrawing their funds. Startup Bank needed to return to a status of “adequately capitalized” or “well capitalized” in order to have any chance of survival. In order to do so they had two choices:
1) Raise additional capital of $3 million. Probability: Low. It is very difficult to raise equity capital from individuals that either don’t have funds to invest (due to other investment losses at that time) or, if they have the funds, don’t want to invest in a highly uncertain banking market without some significant return – a return so high that the bank is unwilling to pay it.
2) Reduce loans from $90 million down to $60 million. Probability: Extremely Low (at least in the short-term). The average borrowing client would respond very poorly if the bank approached them and asked them to pay their loan off early. It is simply not feasible for most borrowers.
[Note: there is a third way to improve equity which is through retained earnings, meaning that the bank keeps profits in-house vs. paying them out in dividends. The problem is that very few banks are making profits right now because of the current interest rate environment, which I’ll write about later. So earning your way back to health is not likely for banks these days.]
With a $3 million capital shortfall and very poor prospects for quickly returning to an acceptable level of capitalization, Startup Bank was in a very precarious situation. The FDIC (which insures Startup’s deposits) took a keen interest in the bank because they believed Startup’s problems were even deeper than reported. Compounding the drama, the rate at which Startup borrowed from other banks to support operations skyrocketed since they were undercapitalized. Additionally, borrowers started pulling deposits at an alarming rate as word got out that the bank was facing financial difficulties. Startup was forced to increase depository rates in an attempt to save the deposits they had but this further reduced the bank’s profitability (or created a larger loss).
The problems with the FDIC, increased borrowing rates, and loss of deposits all stemmed from Startup’s deficient capital position. At this point, they realized that attempting to make additional loans would only compound the problem, like tossing gasoline on a fire, and Startup’s leadership decided to at least temporarily stop making new loans.
That, in a nutshell, is why banks are not lending. Startup is an example of a very small bank but the same concepts apply to the largest financial institutions too. Simply multiply the numbers above by a few thousand and replace “residential real estate” with “derivatives” (See Sub-Prime Primer I & II).
So what were the TARP funds used for if not to allow/encourage banks to lend again? In the case of some banks lending has restarted but in others, even billions of TARP funding hasn’t returned certain banks back to an adequately capitalized position……..yes, really. Additionally, most banks have not received TARP funding for one reason or another (e.g. in Georgia only 7 banks have received TARP funds to date). That does not mean that these banks will necessarily fail. Likewise, all banks that have received TARP funding don’t necessarily have bright futures.
Until a bank’s capital position is restored to at least “adequate”, if not “well capitalized”, they are unlikely to begin lending again. And it will be a long road for banks for the foreseeable future with only the three ways mentioned above to improve their capital position, none of which seem very likely right now.