DEER IN THE HEADLIGHTS; FEAR AND DENIAL IN BANKING

I've been away for a while, at least been away from this blog.

I've been concentrating on my consulting business, which focuses on assisting banks with problem loans and trying to find sustainable business lines for them that the regulators will bless. Haven't made much money, but boy has it been interesting looking at the soft underbelly of banking and regulation.

I live in western Colorado. At certain times of the year migrating deer and elk can make our highways look like lunch time on Times Square. If you could put a suit and tie on the animals, that startled, stunned look in the headlights would be a perfect approximation of bankers and regulators alike right now.

THE BAD BANKER:

Fear and denial certainly characterizes the banker with problem assets. He (or she) is scared to death that the bank will go down, resulting in a fate worse than death. So, deny the stituation. Believe that the current appraisals are right. Don't listen to the real estate broker who whispers to you over a martini that sales prices are going down 10% per month. Convince yourself that you've got your arms around your bad assets, and that you don't need any help working those assets. Then convince your board and stockholders that "All is well".

THE REGULATOR:

When a rookie becomes a bank regulator there are two standard issues of equipment: a laptop and a prayer wheel. The latter is spun constantly for the next umpteen years and each revolutions says "I gotta keep my job". These are perilous times for regulators, witness the criticism in the wake of Countrywid, Indymac Bank and WAMU. The profession has learned from these debacles:

• No Regulator ever got fired for being too tough.
• If I don't make a decision, I can't be faulted for making a bad decision.
• We let too many people in banking. If, now, we don't let any people in the club, we won't have bad people.

There's a ton of private capital out there that could, and would, relieve a lot of pressure on the hapless taxpayer, but the FDIC has made too difficult for private money to help. What the heck: do nothing, and nothing will happen, and that prayer wheel can go on spinning.

THE GOOD BANKER: He (somehow I don't see the feminine gender in the picture I'm about to paint) sits toadlike in his executive chair and his litany of ribbits translates to "Loans, we don't need to make no stinking loans. They just go bad" or, "We'll just lay low, watch some of our competition disappear, and when all of the rest of you have pulled the country out of the recession, we'll see what we can do about getting back in the lending business".

Actually, I don't blame them. But now would be the time for banks to be looking for new business lines and new ways to enhance revenue. The whole lot, good, bad, ugly and regulators, will go back to the same old format, which will assure us that we get to repeat this whole experience in a number of years.

One thing for sure: everybody's hunkered down with a blanket over their heads and pillows blocking their ears. Just try to talk to a banker today about a new idea or ways to alleviate the pressure of problem assets. Their phones are blocked, their eyes are closed, their ears are stopped, and the only emails they open are from the regulators, or maybe Amazon touting the most recent banking expose.

BANKING TERMS FOR THE 21ST CENTURY

No one on earth is more adept than bankers at euphemistically describing a difficult situation. Here are some literal translations of a few of these phrases:

SPECIAL ASSETS- Fill dirt; Chinese dry wall; bricks; lumber; open space.

SPECIAL ASSETS MANAGER- The guy with the pickup truck that hauls around some of the above stuff.

LOSS MITIGATION- Where's the phone number of that guy, Murray the Torch?

WE'RE ACTIVELY EXPLORING SOURCES OF ADDITIONAL CAPITAL- The deal with Bernie Madoff fell through.

IN THE INTERESTS OF MOVING FORWARD, WE'VE VOLUNTARILY SIGNED A CONSENT AGREEMENT WITH THE REGULATORS- "Ve have vays to make you sign. Now ve are all civilized people here, but if you do not sign zis document agreeing to Cease and Desist from your reprehensible activities, let us assure you zat ve can make it very unpleasant", the FDIC.

WE'VE HUNKERED DOWN FOR THE DURATION AND DOING QUITE NICELY ON OUR INTEREST SPREAD- What do you mean, my country club membership isn't covered? And where's the coffee machine?

YES, WE DO HAVE CERTAIN ASSET PROBLEMS, BUT WE'RE IN BETTER SHAPE THAN MOST BANKS- In Greece, maybe.

OUR INSTITUTION HAS, JUDICIOUSLY, EMPLOYED INTEREST RESERVES TO FACILITATE SERVICING CERTAIN DEVELOPER CUSTOMERS- These guys couldn't have paid us a dime if we hadn't lent them the money to do it.

ENTREPRENEURIAL PLOY OF THE MONTH:

The other day I heard about a guy who waited for the FDIC to take over his bank. Then he defaulted on his loan, so they would put it into a problem loan pool. Whereupon he purchased his own loan at a deep discount from the Feds.

Is this a great country, or what?

IN HORROR MOVIES, THEY NEVER HEAR THE MUSIC

I did a polite piece on

IN HORROR FILMS, THEY NEVER HEAR THE MUSIC

I did a polite blog on this subject a while back. This one won't be polite; diplomacy is a disposable luxury in a crisis.

For the past year and a half, since I stopped being a bank executive and became a consultant, I've been privileged (if a front row seat at the Coliseum watching lions devour Christians can be called a privilege) to witness the carnage that's characteristic of much of the face of community banking today.

In a surprisingly large number of cases, directors, management, and the banks they run are in far worse shape than anybody realizes, or wants to admit. Officers and directors are in harm's way, and directors are the most vulnerable of all. They're caught between the draconian concept of fiduciary and legal responsibility espoused by regulators, and the responsibility to support and assist the managers of the bank.

Following are some warnings and caveats to both managment and boards, stated as baldly and emphatically as I can:

• Directors, don't wait for the regulators to tell you to get a competent, sober third party review of your problem assets. You won't like the result, but you'll like it a lot less if the regulators mandate it and then question your competency as they start thinking about civil money penalties.


• When it comes to bad assets, management is ever the optimist. The loan portfolio is management's creation, the borrowers are management's customers, and often friends. Somebody has to be the pessimist and that means you, mister and ms. director. This doesn't mean that loan officers lie to directors. It does mean that they're human, and can't be fully objective when defaults are descending like a black cloud.


• Management, don't succumb to the bright idea that you can take your lenders (after all, they're not making any loans) and turn them into workout specialists. It simply won't work. A bank loan officer thinks about how to make a loan, not how not to. Once made, the loan is the cherished offspring of the loan department, to be nurtured to maturity. Getting these people to view their creations as the pieces of junk they very well may be, simply can't be done.


• Directors, if your bank is under a regulatory enforcement action, don't believe it if management tells you, "We can handle it", meaning the administration of the enforcement order, working the bad assets, and running the bank. Ladies and gentlemen of the board, simply do the math: responding to a Cease and Desist or some other enforcement fiat is virtually a full time job for management. Working the bad assets that got you into the mess in the first place, is, for sure a full time job. And then, management has to make money on top of everything else. Selective outsourcing is essential. The cost at first glance may seem daunting, but the move will pay off quickly, and it will probably mitigate regulatory pressure.


• Profitablilty has never been more vital than when assets are tanking and regulators are circling. If your bank isn't profitable, it's over. Directors should be very skeptical about any budget they're presented. Remember, your business model has most likely been pulled right out from under you by the regulators, because the problem assets are the result of that model and the examiners have deemed it broken.


• Plan for the worst and hope for the best is always good advice, but hardly anybody really gets a handle on what the worst probably is. After all, you built it and admitting that it may be a house of cards is too much like pleading guilty to being terminally dumb. Also, it's not easy to accept that maybe you really have hit that iceberg, and life jackets and lifeboats are the order of the day.


• If things get really bad, and your bank needs new capital, be very skeptical about the capital enhancement schemes you'll be looking at. It's very hard to raise new capital for an ailing bank. The present pockets, directors, officers, current stockholders, may be the only option. Know that from the outset.


• There's no more precarious financial position anywhere today than that of a bank director, especially of a community bank with problems. D&O insurance doesn't protect against regulatory suits or sanctions. Civil money penalties are levied routinely and they can be a lot more than just a traffic fine. Even when D&O coverage is a factor, the lawsuits can be long and bloody, with people having to put their lives on hold, at times for years.


• Again, unless you've been very aggressive in analyzing your loan portfolio, i.e., by having a competent, in depth third party asset review, the regulators will without fail, reclassify your loans and they won't be merciful. It's virtually constitutionally impossible for a bank's management and directors to do a tough, realistic internal classification and then say, "Hey, regulators, we're undercapitalizd". But, in the end it'll be much easier than having the supervisory agency doing it to you.

These warnings have come from seeing some very bad things happen to some pretty nice people.

Being tough minded, especially for directors, is the only way to mitigate the misery.

BAD WORDS

THE FOLLOWING BLOG CONTAINS ADULT CONTENT. PARENTS ARE ADVISED THAT IT FEATURES CERTAIN WORDS THAT MAY BE INAPPROPRIATE FOR YOUNG CHILDREN.

OK, all of the kids out of the room?

Good, because I'm going to use a phrase that's very definitely been in ill repute for the past couple of years.

Mortgage banking. There, I've said it. That's right, the activity that allegedly brought the whole world financial system crashing down. That dirty business of making loans to homeowners and selling the paper on the secondary market.

Now, it's profitable for banks (and it always was, until the bad loans came flapping back to roost), and it's a safe business. That's because of the changes that have taken place in programs, underwriting, property types and required down payments. As far as all of these criteria are concerned, we're probably about where we were in, say, 1980. You might say that we've gone back to the future in the instance of residential lending guidelines.

Because borrowers now have to show that they make enough money to make the mortgage payments (what a novel idea!), that they have good credit, and have to put some money down, it's pretty hard to make an egregiously bad loan. Makes you wonder why we didn't think of that before.

And it's profitable too. Rates are low, and there are a lot of borrowers out there who want to lower their current interest rate, or take advantage of dropping housing prices, and may of them do, indeed, qualify.

The other day I spoke to a mortgage broker with some 25 years in the business, who said that last summer was one of her best ever. Despite everything, including falling home values, stringent underwriting requirements, tougher down payment rules, and increased documentation.

Some banks are realizing this, and taking advantage of it. Others haven't and aren't. Unfortunately, the latter group includes a lot of small and medium sized institutions that are under regulatory enforcement actions, and consequently have had their business model pulled out from under their feet. While some institutions are dithering as they see red ink mount, and the regulatory glare become more intense, they're missing an opportunity for which the stars are uniquely aligned.

Rates are low, the first time homebuyer tax credit has been extended, and home prices are down. Also, the competitive environment couldn't be better. The disappearance of much of the secondary market, along with old fashioned underwriting and new, draconian, government regulation have combined to drive a majority of mortgage brokers out of the business.

In the new, severely restricted banking business there aren't many roads to profitability. Mortgage banking is one.

SINK, DON'T SWIM

We've spoken in general terms about the difficulties a bank's directors and management face when hit with regulatory enforcement. The orders are complex, compliance challenging, and often contradictory.

The devil is definitely in the details, and the details are vital, with very unpleasant consequences for non-compliance.

But there's one thing that's absolutely essential to the suvival of the bank:

Be profitable.

Management and directorates get so focused on getting a hall pass from the regulators just to use the restroom that making money may not get the attention it needs.

Bad assets engender operational losses, and these are the two primary factors that trigger a supervisory love letter from Uncle Sam. The beleaguered bank can't make the bad assets go awy; only time (and deep pockets) will heal that wound. Unfortunately, the one thing that management does have a modicum of control over, operational profit, will be very difficult to accomplish.

And, if you're not profitable, you're dead. Next to liquidity (the ability to pay out withdrawals) there's no element of banking that the reulators monitor more closely. If a bank is under an enforcement actgion, core profit, that is, profit from traditional banking activities, must be demonstrated.

If it isn't, it won't matter how meticulously management meets the order's reporting deadlines, or how well structured the new policies and procedures are. even capital injections lose their impact if the capital account is constantly be drained by red ink on the operational side.

There myriad reasons why achieving profitability can be almost impossible if a bank is under an enforcement action. Actually, it's a corporate work release program. You get to go to work in the morning, but often little else.

For one thing, the bank's main business line may have been taken from it. For example, if a major activity was construction lending, then,inevitably,the bank's asset problems will involve construction loans. It can be counted on that the Cease and Desist order from the regulators will mandate no further construction lending. Period.

It won't say, "Make good construction loans", or "Make them carefully". Rather, it'll be, "What is it that you don't understand about DON'T?".

So, it's likely your previous business model has been suddenly terminated. The bank has to find a new revenue producing business line,fast. And it has to pass regulatory muster, which isn't easy considering that the short list of acceptable activities is pretty short.

Some points to carefully consider:

• How will yoou make money out a new activity? Obviously, the bank hasn't made big money doing it previously.
• Who's going to do it? The bank's current specialists aren't going to turn into new experts overnight, and you don't have much time to make the transition..
• The bank's current management and staff may simply not have the time to realign the business model. They're working on problem asset mitigation and enforcement compliance, which is pretty much a full time job.
• You don't have a lot of rope. Positive results must be quickly apparent.

For a bank, being under a regulatory enforcement action is kind of like being dumped from a boat a couple of miles from land without a life jacket. You're making good progress swimming for shore when the Coast Guard comes along and says, "Stop swimming, tread water".

"But if I do that, I'll eventually drown".

"Hmmm"

Under the circumstances, calling on competent outside help may be essential to survival.

QUOTE OF THE WEEK:

No mercy

"I did not run for office to help out a bunch of fat cat bankers on Wall Street".

President Barack Obama

THE GAME NEEDS NEW BLOOD!

Well, we're a couple of years into the recession, and I hope we're all enjoying ourselves. Contrary to informed predictions, the sun has come up every morning, it still rises in the east, and the home team continues to break your heart.

So, where to we go from here?

Civilization as we know it did not end, but things on the financial front will be different for some time. The lessons learned will control banking and the movement of money for, probably, at least a decade (or until we forget how much the recession hurt, whichever comes first)

For sure, we've learned that Americans can't be allowed to play Monopoly without close supervision, and the playground supervisors aren't any smarter than the kids on the merry-go-round. (See Madoff, Bernie)

There's a universal realization that we don't play well with real money, and it's hampering the recovery. Everybody's afraid to make a move; the consequences are simply too dire. Many banks can't lend because of problem assets and regulatory fiat that virtually shut off the discretionary lending that's vital to a vibrant economy. Those that can lend are afraid to; if they have few problems, the want to keep it that way, so robust or even conservative lending is being put on the back burner for the duration. And nobody knows what the duration might be.

In the second quarter, outstanding bank loans took the sharpest drop since the statistic was instituted in 1984. The Fed is pumping stimuli into the economy, and bank regulators are chomping like beavers to dam it up before banks, who've proven themselves irresponsible, get crazy all over again and lend it out.

Want to see a creature roll up into a ball like an armadillo? Just threaten a regulator's job and pension. No regulator ever got fired for saying "no". Many have been fired for saying "yes".

I would be great if somebody besides Uncle Sam would get in the banking business. Better for the taxpayers, for sure. Private capital is starting to wake up from hibernation and is sniffing around for investments. There are some banks out there for sale that have relatively few problems, and could do some exciting things for their investors,customersandthe economy. But the federal regulatory agencies are making it almost impossible for private purchasers to cut a deal, for fear, apparently, that entrepreneurs can't be trusted.

I've spoken to some of these groups. They're levelheaded business people with conservative business plans. But the supervisory agencies, smarting from media and congressional criticism for being lax, simply aren't letting private capital in the door.

The business of banking involves making a profit on the movement of money. If it doesn't move, the recession will last a lot longer than anybody wants to imagine.

The world economy needs new players and fresh capital. The feds need to let them suit up and get into the game.

OBSERVATION OF THE WEEK:

Boards of troubled banks often don't know the trouble their in, or how to navigate their institution through the maze of regulatory sanctions. More on that in the next posting.