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.

He told me all this in order to try and get my bank to rethink doing the financing for the new buyer and asked me flat out why on earth we would turn it down. The answer was pretty simple. I told him, “We’re out of bullets.”

Knowing that he was both a Vietnam veteran and an avid hunter, I knew that he could understand this concept more easily than talking about things like capital ratios, liquidity, shrinking the balance sheet, etc. Instead of all that, I stuck to this analogy. The deal he wanted to get done was like seeing a 10-point deer right when you get up in the stand. It was like being able to take over a town in a war that is essential to enemy supply lines, but has no real protection. We would love to shoot it down…take it over… close the deal, but we don’t have any damn bullets. Now…maybe if you had a deal that was more like a duck we could strangle… or a peasant cart we could ambush and take over without a shot… that kind of deal we could look at doing. We do still have rocks and sling-shots.

For many banks (but by no means the majority), this story rings true every day. No matter how great a deal looks, banks simply do not have enough cash or capital (bullets) to do the deal. It has nothing to do with the borrowers. It’s not meant to be an insult. We just flat out can’t do it unless somebody pulls off a Normandy-like invasion to bring us fresh ammo.