I was talking with a client about the state of the construction industry. He is involved in the owner end of the business. They develop numerous properties around the world. It is capital intensive and they rely upon borrowing for their capital construction program. They are a well know, very reputable firm and have great credit. They want to build because construction pricing is inexpensive (read that very cheap) right now. But they cannot! They are frozen out of the commercial credit market because the lenders are not loaning money.
Bankers make their money by loaning money. In a simple explanation, bank deposits are the basis to issue more loans. I keep reading how savings rates are increasing. I keep reading how banks are issuing fewer loans. Since banks grow by lending money (duh!) why would they reduce lending to creditworthy clients? This didn’t make sense until I talked with a banker a few days ago.
He confirmed savings rates are increasing. He confirmed lending is going down. He went on to explain how this is occurring. My understanding follows.
It seems there is a group out there. I will call them The Regulators. They have a substantial and immediate impact on how federally chartered banks operate. They have the power direct bank operations and to shutdown and sell the banks. No matter who may have an objection!
The Regulators are now focusing on two categories that determine how much the banks can loan.
- The first is the capitalization of the bank. The cap rate is set by law and is usually expressed as a percentage of the assets. This is the money the bank has to have as assets from the owners. The Regulators are enforcing this vigorously. The owners are putting money into their banks to meet this cap rate. The larger the assets in the bank, the more cash must be infused by the owners to meet this percentage.
- The second is the review of the loans that have been made by the banks. This involves rating the loans. This can be on a rating of 1 to 10 in terms of quality. A 1 rated loan would be the best with a 10 rated loan being worst. Loans with little to no chance of default would be in the 1 to 3 levels of quality. The 4 to 10 rated loans go from slight to a high chance of default.
The Regulators are vigorously and intensively reviewing the loans made by the bankers. Some may even say they are going overboard in these reviews. The Regulators are down rating loan packages already being carried by the banks. They are having the bankers take loans rated from 1 to 3 and down rating them one or two levels. They are taking the 4 to 6 rated and the 7 to 10 ranked loans; and down rating these in the same manner or more. This down rating process also involves The Regulators directing the banks to increase their loan loss reserves. These reserves are generally a percentage of the total loan portfolios. The Regulators downgrade of the loans, along with the direction to increase loan loss reserves, is immense in scope. Loss reserves have to be increased to the levels specified by The Regulators. This has to be done in a time period they specify. There is no recourse by the federally chartered institutions if they want to stay in business. They have to comply. This dries up loan capital and reduces the incentive to make loans.
They only way banks have to increase loan loss reserves is to add capital, cut expenses and/or suspend loans so income can be put into the loan loss reserves. The banks are cutting expenses. Bank owners are adding capital. And, wasn’t the TARP program developed to add capital to the banks (yeah right)?
The remaining avenue to increase the loan loss reserves is limited. This leaves suspending loans so income can be put into the loan loss reserves account against the outstanding loans. It also tends to make the bankers ultra cautious because The Regulators carry a big stick with threats to put them out of business. This might just be where all the money has gone. It might be a long time lasting.
Oh, by the way… who controls The Regulators? It just might be the 535 people working in Washington DC on your health care overhaul.
