By Bill Pilkington
“Bill, what are we going to do?” On the phone was my friend, mentor and icon in the industry Donald Mann. With over 50 years in the industry, he has seen it all from Director of Banking in Michigan to frequently sought after consultant. After 40 years of his direction, I instantly knew his reference. The collective “we” refers to all of us…bankers, regulators, accountants, attorneys, consultants, appraisers and all others who will be critical in the resolution of the next recession.
Whatís Past is Prologue
After the last recession, Mr. Mann and I frequently discussed the many contributing factors that resulted in an inordinate number of bank failures. In a four year period, the United States experienced 440 failures, nearly 80% of all failures going back to 2000. By any measure, these results do not reflect a successful outcome. A quick review of causal factors revealed why.
By 2008, regulators and banks were all speaking the risk language. As 2008 progressed, it was clear we were headed for trouble. In anticipation of trouble to come, banks were intent on not increasing risk until the recession passed. Historically, recessions last less than a year with all repercussions limited to a finite period afterwards. Initially, there was some pushback about the potential for so called “zombie” banks. This is a concept I categorically rejected. A short term cessation of lending in a period of upheaval while still operating in the community, employing people, maintaining accounts, and servicing existing loans is far better than driving by an empty storefront. At the time I was working for the Federal Reserve Bank of Chicago, I was advised that closing banks was far more efficient and consolidation of the industry allowed for more efficient regulation. Having reached a significant philosophical impasse, I quit.
On Monday of the following week, I went to work for a bank with the highest percentage of land, construction and development (LCD) loans in the country. While on the face of it a high risk decision, I was very familiar with the bank and very familiar with the market. The bank had written down loans and I confirmed the availability of $30 million of potential capital. Absent unusual events, it was time to roll up the sleeves and shore up the portfolio.
A week after my arrival the regulators visited, including some members of my old team. Assets, including loans, were appropriately valued. Simultaneously with the examination, Treasury Secretary Henry Paulson was filmed sashaying down stairs with TARP approval in hand, announcing the preservation of our capitalist system.
As originally approved, TARP appeared to be a panacea for community banks that did nothing to create circumstances that became an existential threat to community banks. Irrational government lending programs that funded mortgages for previously unqualified mortgagors drove losses on the loans as well as the government investments that were securitized with the now worthless mortgages. As drafted, TARP would save most community banks. As enacted, it would save none.
In the brief aftermath of Secretary Paulson’s initial announcement, I did the math. Having written down the LCD portfolio to 65% loan-to-value, the bank stood to have significant recovery potential. Then Paulson, allegedly acting under his authority, decided that it was potentially too good for community banks. He created a means test that effectively made community banks ineligible to receive TARP. Shortly thereafter it was announced that the government would be defaulting on its “indirect” guarantee of FNMA preferred stock, after enticing banks to acquire the stock by increasing the after tax yield.
Then it was time for the bank regulators to wreak havoc. What they lacked in support, they made up in authority. By the power vested in them, in short order, they ruled that tax loss carryforwards be limited to that which can be proven to be used in the current calendar year; that land, construction and development loans be written down to that which can be received in a year; that examiners would determine the “true” value of properties regardless of current appraisals. For my bank, it meant paper losses of $50 million. At an emergency meeting of the Board, I informed them of the regulator’s decisions. The Board collectively expressed their desire to continue by finding an additional $20 million in capital even if it meant giving up control. I expressed my disappointment in the outcome and my frustration at “fighting ghosts” that did not rely on logic, GAAP, or precedent. Yes we could raise capital but there would likely be more ghosts to appear. I proposed accepting the inevitable shutdown of the bank and the Board reluctantly agreed.
This scene repeated throughout Michigan and the rest of the country. In predictable irony, the market values of property pre-recession returned as expected. Before values returned, the FDIC liquidated portfolios and congratulated themselves for their accuracy in determining values during bank resolutions.
We all died a little bit in that damn war. The purpose of revisiting the past is so we do not repeat it. Collectively, there is a tremendous amount of intelligent, experienced talent throughout banking and regulation. We have to do better than losing another 400 banks. Yet recent experience suggests that we are still at the mercy of political decision makers who will play a key role in determining our future. The corruption involved in the recent bank failures of venture capital based banks provides little comfort that we will have a level playing field in the challenges ahead.
The Challenges of Now
I was fortunate to have an appointment with Dan Fischer, CEO of Citizens State Bank, Royal Oak, Michigan. Having successfully resolved a problem bank in Ohio, Mr. Fischer joined Citizens State Bank when new investors acquired the franchise and moved it from the Upper Peninsula to a suburb north of Detroit. The bank is currently $300 million with superior performance metrics.
The Great Recession, 2008-2010, with residual issues to 2012, devastated the banking industry in Michigan, particularly in the Detroit area. I asked Mr. Fischer what he expected in the pending recession. “It feels like we may be in a recession right now. Real estate is not moving but values appear to be holding. Household income has been maintained but the buying power has been reduced. All recessions have been different, but this one has potential to be significant. All we need is an increase in taxes to push us over the edge.”
“So what is Citizens State Bank doing in anticipation of a recession?” I asked. Mr. Fischer replied, “We are being a traditional community bank. We underwrite people and their projects first. We do not lend on projects that rely on leases to third parties. I see that as a very soft market and most likely to be ground zero for the anticipated recession. We expect to be a source of strength for the industry. Other community banks may struggle and need support. I know very well the challenges of being a problem bank. Rather than experience the chaos that comes with an adverse regulatory process, we would like to discuss options. Options that would keep branches open and people employed.”
In the previous recession, the lack of acquisitions was noticeable. Whether it was self-preservation or justifiable fear of ghosts, most banks hunkered down. While some banks, like Citizens State Bank, have the financial strength and interest in exploring merger options, most are likely to duck and cover in the hopes of surviving the next recession.
As I evaluated the industry, I sought counsel with life-long banker and friend Jeff Kopelman. Now a Board member at Community Unity Bank, Mr. Kopelman provided interesting insights into the market. “The pending recession will be unique, as they all are. What I am most concerned about is leased commercial real estate. My concern is founded in all the traditional issues but also the social development impacts. More and more we see employees working out of home. This reduces the demand for office space which is already soft. Businesses supplying services to the office population also are suffering. We can expect the recession to begin in office space, especially non-owner occupied, and expand from there.”
Solutions, Not Blame
I used to remind my staff that we are in the solutions business, not the blame game. While I previously described the experience in the last recession, I did so to illustrate the challenges of the next recession. I reached out to an old regulatory contact who wished to remain anonymous. “What are you seeing regarding preparations for the next recession,” I asked. He replied, “We are seeing a wide range of actions. The larger banks are overtly addressing the expected recession in summaries to the Board. They are also including recession comments in individual relationship write-ups.”
Often the experiences in large banks are filtered down to community banks as “best practices”. Like any pertinent risks, the findings should be included in Board reports. I recommend a top ten (or so) list of commercial relationships most at risk to recessionary pressures. Accuracy in ranking is not essential, you may not want to include a numerical assessment. The point is these are your canaries.
No one knows the relationship better than the loan officer. Whether it is a periodic review, an update or an approval request, going forward every loan write-up should address potential impact of a recession. I recommend a separate item within loan write-ups.
Of course the regulators will play a significant role in any recession, beginning with the bank examiners. Engage the discussion and take copious notes.
Is there anything you would recommend we do to prepare for a possible recession?
Did you find our assessments accurate? Valuable?
Is there anything in our risk assessments that you found lacking?
Is there anything you recommend to improve our risk management process?
Do it now as there is no value in discussing fire prevention when the flames are consuming your backside.
One of the principles of proper risk management is to identify and evaluate risks before they reach critical mass. Last recession was made highly difficult as items were sprung on us without reasonable warning. As a result, consider the previous experience to be reasonable warning for the next experience.
About the Author
Bill Pilkington is a 25 year regulator and 10 year banker. He can be reached at 734-558-7427 and PilkingtonLLC@outlook.com.