United States: Credit Crisis Cause And Effect – What To Expect For The Northwest In 2009

Originally Published 7^th November 2008

The current economic turmoil will continue to affect our local economy even after other parts of the country start to show signs of recovery. Expect bank loan underwriting standards, especially on commercial real estate, to remain high causing economic activity to remain below the national average for the Northwest in 2009. Although fixes are included in the Emergency Economic Stabilization Act, they may be beyond the reach of many local financial institutions without a change in implementation policy from Treasury and the federal banking regulators. So, Northwest borrowers may miss out in a material way.

Banking creates liquidity by leveraging capital. Although some liquidity is held back to cover deposit demands, the net is used to make loans and investments. Prudent banking requires banks to keep capital ratios around 8%. What this means, if you do the math, is that for every dollar of capital, banks are able to lend or invest about 80% of $12.50 of funds, with the remaining 20% held to meet foreseen deposit withdrawal demands. In good times, this leveraging works to borrowers' favor because banks have more funds to lend. Eventually, funds availability becomes so great that banks reduce underwriting standards to put excess funds to work. This all works to everyone's advantage until the risk-taking exceeds prudence.

If the economy turns, as it did two years ago, the opposite effect occurs. For every dollar lost to capital, banks lose $12.50 worth of available funds. This "deleveraging" causes banks to tighten underwriting standards because they have fewer funds to lend. From the point-of-view of borrowers, this is perceived as a credit crunch. Economic activity decreases. This is why the "subprime meltdown" lead to the "credit crisis". It's all cause and effect.

Absent a capital infusion of some sort, a credit crunch could persist, prolonging the economic down-turn. This is why Treasury's program to inject $250 billion of nonvoting preferred stock (the "Capital Purchase Program" or "CPP") into the financial system makes sense. As originally intended, the $700 billion "rescue" package was expected to be used to buy troubled assets, thereby freeing up liquidity. If originally implemented in its entirety, the economy would receive one dollar of liquidity for every dollar of troubled assets bought on a 1-to-1 basis. Infusing $250 billion as capital, when fully deployed, will create ten times (80% of 12.5) the liquidity of an asset purchase or $2.5 trillion. Banks will have more funds to lend and invest, underwriting standards can come down to (hopefully) prudent levels (which means not to the unacceptable levels that caused this crisis) and our economy can return to something approaching normalcy.

In the Northwest, however, banks have significant investments in commercial real estate. In the spring of 2008, the state of Washington, for example, ranked third in the country in concentrations of commercial real estate, expressed as percentage of capital, at about 460%. Banking regulators were well aware of these trends nationwide and issued a guidance that called for stronger risk management oversight for banks considered "concentrated" in commercial real estate. For purposes of the guidance, a bank that exceeded the 'screen" of 300% of capital would be considered concentrated for purposes of the guidance. 300% was the average level of concentrations after the last banking crisis of the late 80s and early 90s and perhaps it seemed nostalgic to get back to something closer to that level.

With the current economic turmoil, it appears that federal regulators, by enforcement action or "moral suasion" are requiring banks to reduce their concentrations in commercial real estate to levels closer to the 300% screen by increasing lending underwriting standards. In general, this move appears prudent given the higher levels in Washington relative to the rest of the nation. However, 18 years of build-up from 300% to 460% cannot be undone overnight without severe economic consequences for the region. In mathematical terms, focusing solely on banks headquartered in Washington, aggregate capital totals approximate $7.4 billion. Multiplying the excess CRE above the screen (460%-300%) by the aggregate capital level ($7.4 billion) provides the "excess" amount of CRE that would have to work its way through the system before banks achieve something closer to 300%. That's $11.84 billion or the measure of an apparent regulatory enhanced credit crunch if the regulators push too hard and too fast.

Regulatory suasion often takes the form of increased standards about what is a bankable asset and what is subject to criticism. It is not a perfect science. If regulators decide to increase the standards on commercial real estate, banks will be required to increase loan loss reserves to compensate for the higher standards. Oftentimes higher reserves are justified due to economic trends; however, higher reserves can also be a result of overaggressive and over-reactive regulation. The combination can be devastating to a bank. It appears through anecdotal evidence that regulators are in fact tightening review standards; whether this tightening is prudent or over-reactive is a subject for considerable debate. Regardless, it will have a chilling effect on commercial bank underwriting standards and the move to higher reserves will significantly impact profitability. It will also cause more deleveraging at banks and ultimately reduce new loans and refinancing, except at much higher rates if at all.

Finally, one of the unintended consequences of this tightening may be to disqualify unnecessarily deserving Washington banks from participation in Treasury's CPP program. To qualify for the program, banks must first receive approval from their responsible federal bank regulator. From the point-of-view of taxpayers, this is a prudent move. From the perspective of a Northwesterner whose bank may otherwise qualify but for overaggressive regulatory tactics, not-so-much.

Absent the ability to qualify, Northwestern banks may be unfairly excluded from CPP. This in combination with a federal bank regulatory strategy to suppress commercial real estate lending may be a material contributor to causing the Northwest economy to lag behind the national recovery.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.