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.

Throughout the course of the global financial crisis, I have loosened most of my tightly held beliefs concerning market/capitalist economies and all ideas therein. Like many others, I was on board the Free Market train though out the majority of the decade. Letting go of this has been sobering to say the least, but it is becoming increasingly evident to me that we as a nation are dealing poorly with our enormous hangover.

In econ/philosophy we study a simple term called the “slippery slope.” In this term we come to understand that any deviation from a defined dogma or practice creates a greater propensity to continue to move farther away from the original position. This concept is troubling in terms of market economies with everything from universal health care, and more obviously now, governments taking ownership interests in private entities.

While I have acquiesced to the concepts of “systemic risk” and “too-big-to-fail,” I have struggled with each step. The article mentioned above highlights what happens when we go down the slippery slope. “Dr. Doom” asserts that a major reason for nationalization is because we have effectively done it already. This is of course partially true, but his assertion and reasoning are deeply disturbing. It is now, more than ever, that governments and the populace should most fervently resist outright socialism. If we set the precedent of nationalization, we lose credibility on every front. Investors will be even more reluctant to purchase equities and provide private capital. Just look at Venezuela’s most recent economic troubles resulting directly from socialism and lack of foreign investment. If continued and outright nationalization were to occur, the government would turn into a true Leviathon, and set the table for all manners of other socialist policies. If the media, major economists, and the Obama administration want to not only preserve the heart of our capitalist integrity, but also the “moat” around America that makes it so attractive for investment relative to other countries, they will ardently work towards market solutions- not government ones.