You see this all the time with all kinds of products and businesses.  You even see this specifically with banks during the best of times as areas grow and mature.  Branches close or are consolidated pretty regularly. 

 The next set of issues I’d like to deal with are a bit more complex, but truly set the stage for one of the biggest “bubbles” in the history of the world, and more specifically, Georgia.  They are:

1.  Explosive population growth and projections of continued growth

2.  Unsustainable growth in debt, and

3.  Sub-prime mortgages

 The latter two were (and continue to be) national issues.  The population growth was more specifically in Georgia, but we also saw it in places like Las Vegas, Phoenix, Florida coastal areas, and some other pockets around the country.

 Growth in population is generally a wonderful economic driver.  At one point Georgia was home to some of the fastest growing populations in the country.  For years, counties like Coweta, Henry, Cobb, and Fulton experienced unprecedented and what seemed like endless growth.  This shift was happening as the business environment got much better and more sophisticated in the Metro-Atlanta region.  Georgia is also one of the best states for entrepreneurs and most  businesses because of pro-business labor laws and a helpful tax code.  When coupled with a generally good climate, lots of relatively cheap land and homes, and some good ole’ southern charm, Georgia and specifically Metro-Atlanta looked like a wonderful new place to call home.

 All of this sounds great so far, doesn’t it?  Why on earth would population growth be a “cause” of a banking melt-down?  The answer is simple- people thought that it would continue, without interruption, forever. 

 Builders and banks especially believed this enormous myth.  The faster the populations grew, the faster banks lent money to builders who built increasingly larger numbers of homes.  They failed to realize that just like the much larger economy, population growth is generally cyclical unless you’re in a third world country. It might always be growing, but sometimes it grows faster than others, and there will almost always be some upper limit.  When the growth in number of homes that banks were financing the construction of began to rapidly exceed the number of families moving into the area, there became a huge oversupply.

 Banks were eventually forced to foreclose on a huge number of the new constructions.  These were houses that had never been lived in and in many cases weren’t even finished.  Because of the huge oversupply, banks were forced to write down values at a rapid rate.

 Everyone also knows that homes have to sit on a piece of land.  Banks were increasingly financing more and more land to be developed into subdivisions to support this huge, “infinite” population growth.  It’s the land, especially, that has and will continue to bring down the community banks.  This is where the largest write downs have been.  Land, if it sells at all, is only selling for thirty to fifty cents on-the-dollar.  That means for every dollar a bank had loaned on a piece of foreclosed land, it can only sell it if they’re willing to lose seventy cents on it. 

 What ultimately caused the housing boom and bust in Georgia, as with everywhere else, were subprime mortgages.  There’s a twist to this story for community banks in Georgia however, and it’s very important.  Most community banks don’t actually provide the funds for the mortgages that they make.   The banks that have failed so far in Georgia actually held almost no “Sub-Prime Mortgages.” 

 The problem was the home ownership and building boom that those mortgages created.  Community banks were the ones that generally financed the builder’s land purchase and construction costs.  That builder would then sell the house to whoever could get the financing, and then pay off the community bank with the proceeds from the sale.  The community bank didn’t care who bought the house, but they should have.

 A large and growing number of the sales would never have happened under more “traditional” environments.  Everyone is well aware of all the asinine practices that were going on in the mortgage market like stated income loans, Alt-A mortgages, 105% loans, etc.  Had community bankers and regulators been more aware of these buyers, they might have been able to better slow down this clearly overheated market. 

 Finally, there was an unbelievable explosion in the level of debt for average households across the nation.  Because everyone and their mother and sometimes even their dead grandmother could get a mortgage, there was a huge expansion of mortgage debt.  Also, because home values were rising at an unprecedented rate and people were spending far more than they actually made, there was also an extremely big boom in home equity lines of credit.  It is now well known that this level of debt creation could not be sustained.  When home prices plummeted, home equity lines became worthless and the huge amount of debt outstanding relative to the new values of homes created a recipe for disaster for many banks.  To summarize Warren Buffett:  Debt is like gasoline in a car.  It can make the car go 100mph in a heartbeat.  But, when the car crashes, it’s also the gasoline that blows it up.

 Through all this, a very important lesson was re-learned by many bankers: past performance does not necessarily indicate future performance.  Populations will not grow endlessly, home values will not rise endlessly, people will not be able to sustain high levels of debt endlessly. 

 In the next couple of posts, I’ll be moving on from these more general issues that contributed to the Georgia debacle and diving headfirst into more complicated, but critical problems that brought down our banks.

1.  Astronomical growth in number of new banks

 2.  Too many bank presidents, and

 3.  “Flipping” Banks

 As I’ve said before, none of the reasons for this can be stated without bringing in one or several of the others, but for the sake of simplicity, we can think of the three above as the kindling that started the fire.

As stated in the Wall Street Journal article, there was an explosion in the number of banks chartered in Georgia.  I can remember a time when the Georgia Department of Banking and Finance’s monthly newsletter contained anywhere from 10-20 banks in formation for years on end.  Money to start these banks flowed in like floodwater.  There were numerous success stories of banks starting and three years later selling for triple the initial investment.  What people failed to realize is that banks are not all that different from chain restaurants. 

What do I mean by that?

Banks all offer basically the same thing.  They all offer very similar core products.  They all claim to be service oriented.  They all want to be YOUR bank.  Chain restaurants do the same thing.  They have extremely similar food (no matter what they claim).  They all offer “great service and great times.”

Everyone knows when there gets to be too many Applebee’s, Chili’s, and O’Charley’s in one area- one of them goes out of business.  There simply aren’t enough good customers willing to provide enough profit for them all to do extremely well. 

It’s no different in banking.  The only difference is that banks can pretend to find good customers for some time before anybody realizes that there’s a huge problem.  If all of a sudden Chili’s started accepting checks where 10-15% of them got returned, they wouldn’t be able to hide the loss.  On the other side, if Chili’s suddenly starts to literally bribe people to come eat with them by offering free food, they’re probably not going to last long. 

Banks are able to do both of these.  Loans can be made to people or businesses that are extremely unlikely to pay.  Deposits can be brought in by giving away  a lot of money with high interest rates.  Neither of these shows up as problems until years later when those loans that were once deemed safe, start to turn risky.  If you couple those loans with a huge depreciation in the value of the collateral, you get a recipe for disaster.  Throw in deposits that were overpriced to begin with costing even more relatively huge amounts of money to keep, and you’ve got a bank failure. 

Moral of the story:  There were way too many banks, so the natural result in our capitalist society is that there will be an equally large number of them to go out of business.

Similarly, there were too many bank presidents.  As Robert Braswell so conveniently alluded to in the article, basically anybody with a decent background in banking could raise enough capital to start a bank.  Let me emphatically point out that banking is different from almost any other business.  It takes FAR less capital (relatively) to start a bank than it does almost any other business.  This means that if there are losses, they go out of business fairly quickly.  This is where regulators and investors fell asleep at the switch. 

Everyone can’t run a bank.  Even some great bankers eventually fall prey to things like hubris, greed, and flat out being too busy to mind the store.  When you’ve got a few great bankers trying to do business with a ton of terrible ones, you get an equally likely recipe for disaster. 

 Bad bank presidents will grow too quickly with expensive deposits and risky loans.  They won’t manage risk effectively at all.  They won’t do enough homework on their loans or ensure that processes are in place to ensure that fraud is adequately controlled.  They can definitely prosper for a long time, but eventually the music has to stop.  It did.

 With all the bad bank presidents running around and getting approval from regulators because of the flood of capital, good presidents were put into quite a pickle.  They had to compete.  If they didn’t grow as fast as everyone else, they were considered terrible.  This meant that they had to do a lot of the same things that the bad presidents were doing.  And, in the end, if it looks like a duck, walks like a duck, and quacks like a duck; it’s a duck.  Good bank presidents with real knowledge of how to do it the right way eventually became bad.  Because of the extremely competitive nature of banking, it doesn’t take many bad apples to ruin the barrel.  This one is thoroughly ruined.

 Finally, as I’ve already alluded to, banks were being built up and sold in 3-5 years with massive amounts of profit for the people who started them.  Not everyone was doing this.  A lot of people were building banks that they wanted to preserve and run well into the future.  The problem is that investors and regulators only saw the huge growth, huge number of sales at extremely high prices, and no (apparent) losses. 

These banks were being built up with expensive deposits and loans that were built on a real estate bubble that eventually had to explode.  We saw the same thing with the “dot-com” bubble in the late 1990’s.  The reason why this was so much more painful was because of the nature of banks.  I’ve already detailed this to a large extent in “Smoke and Mirrors” in an earlier post.  Basically, banks are built on relatively small amounts of real money.  If something goes wrong, it doesn’t take much to bring one down.  If a lot of things go wrong, you get the current situation.

To get back to the “flipping” analogy- everyone has seen the shows on HGTV, TLC, etc. that show a really crappy house being turned into a nicer and much more expensive one.  The banks were the same way.  They were made to look pretty on the outside, but if you looked behind the curtain, they had deteriorating wood, old electrical wires, and weren’t in all that great of areas.  But, because they looked pretty, i.e. big profit, big growth, seemingly no bad loans- they got snapped up just as fast as somebody could start a new one.  Just as the home flipping business went, so too did the banks. 

In the next part of this series, I’ll delve further into some of the more difficult to explain aspects of the implosion.  Stay tuned.

I thought this would be the perfect platform to briefly describe the most likely scenarios for a bank shutting down, what you can and can’t do following your bank failing, and where to find important information.

Here are the three most common (though not all-inclusive) scenarios.

1. Your bank fails and the FDIC takes it over without finding another bank to buy it.
2. Your bank fails and the FDIC finds a buyer of the deposits.
3. Your bank fails and the FDIC finds a buyer of the whole bank.

Scenario 1

Your bank is known to all regulators and bankers as the ugly, fat, annoying girl. Not only does it have a huge amount of problems on the surface, but it’s made up of such useless deposits and loans that nobody- not even the drunkest guy at the bar- will take her home.

If you have your deposits at this bank and they’re under the FDIC insurance limit, you’ll probably be sent a check for the balance of your account on the Monday following the Friday that the bank closes. If any part of your deposits is over the FDIC limit, you lose that amount of money (ONLY the amount that exceeds the limit). Over the weekend, the FDIC will contract with a big bank like Bank of America or SunTrust to allow transactions on the accounts to post as they normally would. You’ll have to open up another account at another bank immediately.

If you have a loan at this bank, you keep paying your loan, but might have to change where you send your payments. You will be strongly encouraged or flat out told to find another bank to take over your loan. If the loan is unsecured, you might be required to pay it immediately or find another bank to take it over. This is a bad scenario for people with loans, because the FDIC simply doesn’t have the right staff to service the accounts. It will get rid of them as fast as possible or sell them to another bank/private company. This doesn’t always turn out badly for loan customers, but it’s the worst scenario for you.

Scenario 2

To use a similar analogy, bankers and regulators think of you as a really attractive person but you have an STD. You’re hot, but they wouldn’t touch your assets even if you paid them.

If you have a deposit account with this bank, you’re perfectly fine. You won’t have to do anything but get used to a new bank’s name on your checks, debit cards, statements, etc. You’ll probably even get to work with the same staff with which you’re used to working. You’ll see the same smiling faces and hopefully get the same great service. Your accounts will also continue to be fully insured and you’ll have the peace of mind that comes with a stronger bank.

The only downside in this scenario is that the rate you’re currently paid on things with variable rates (money markets, savings accounts, checking with interest, etc) might be changed to a much lower rate. CD rates should be honored until maturity, but you will probably not be paid nearly as well when they renew.

If you have a loan with this bank, you’re in the same boat as Scenario 1 customers. The FDIC wants to get rid of you, and it doesn’t particularly care how it does it. See Scenario 1 for the breakdown.

Scenario 3

Keeping with the theme, your bank is as hot as Miss America (or Brad Pitt, for the ladies), has a great personality, and unfortunately was dumb enough to swallow a gallon e coli bacteria. With the proper penicillin, this will once again be an awesome bank.

If you have a deposit account with this bank, just like in Scenario 2, you’re perfectly fine. Go ahead and go on that weekend trip and don’t worry about your debit card working. Again, your accounts are fully FDIC insured immediately.

If you have a loan with this bank, you’re in luck. The new bank wants you and values you. They might give some customers a hard time, but they want to keep the vast majority of them. If you’re a bad loan customer (Don’t act like you don’t know you are), you’ll probably be harassed until you go away, get foreclosed on, or agree to some kind of painful workout. If you’re a good customer, just write the new bank name on your loan payments and keep rolling along merrily.

Important Information:

If your bank fails (or you think it might have failed), it is absolutely critical that you go to the following website:

www.fdic.gov

In the upper left hand corner, you will see something that says “Bank Closing Information – (Day the bank Closed)” and underneath, it will list the closed banks for that week. Click on your bank name and read EVERYTHING on each page. This will tell you exactly what you need to know regarding your accounts and what changes to expect, if any. It will also give you some interesting information detailing the transaction that took place and the loss to the FDIC fund.

The FDIC will also post information on every door and drive through window of every branch immediately upon closing the bank. This will basically detail the same information that you can find on the website.

Finally, always remember that your accounts, no matter how ugly or attractive your bank is, are fully insured up to the FDIC limit if they have a sign that says “FDIC Insured” posted in the lobby. There is absolutely no reason to worry about your money if you keep it under this limit. You will ALWAYS be paid that money…unless of course, the FDIC and US Government fall… but let’s not get into that just yet.

Him: “You know, if the government just keeps handing money over to banks that do nothing but hoarde it and lose more money, we’re never going to get out of this…”

Me: “Well, believe it or not, banks are making a ton of loans still, and the bailout was necessary because of the huge amount of money that it would have taken for the FDIC to make good on its insurance promise.”

Him: “It wouldn’t have cost nearly as much for the FDIC to just shut down all the bad ones and let the good ones survive!”

Me: “Well, let’s just pretend that this bank went out of business, ok? You have a few CD’s with us that total about $50,000… and you’re fully FDIC insured. Sound right so far?

Him: “Yep”

Me: “Alright, so we have about 6,000 customers who are in a similar position as you…and we’re a very small bank, Agreed?”

Him: “Yep”

Me: “If we went out of business today, the FDIC would lose anywhere from 50 to 100 million dollars because of just us going out of business.”

Him: “That’s a lot of money!”

Me: “Right. Now if you think about a Bank of America or Citibank, they do business with something like 100 million people just like you… and are each about 100 times as big as we are. Can you imagine what the loss would be if they went under?”

Him: “Holy hell!”

Me: “And if they went out of business, do you think people would think their money was safe ANYwhere?”

Him: “No, I’d probably pull my money out and hide it under my mattress…”

Me: “That’s exactly why they had to bailout the system. To make sure you, and 100 million other people, didn’t do that exact thing.”

Him: “Oh… well i guess that makes a lot of sense.”