Thursday, August 27, 2009

Real estate exposure - revisited

We received a thoughtful comment from EPEON (on Seeking Alpha) on the recent post called Small bank, big bank - the difference is real estate exposure
I have reviewed a lot of small banks and I have to say that your analysis is true but entirely misleading. Small banks (and credit unions) do, indeed, have a higher exposure to real estate loans. However, the exposure is usually to their own depositers and or members. The banks and credit unions have relationships with these people and they know, quite well, the credit worthiness of these people.

Their default rate is usually far lower then it was on the subprime crap. So, the problem is not real estate. Rather, the problem is loaning money to people that are not credit worthy.

This is an excellent point, and is indeed part of the problem. Smaller and regional banks lend within their community, often to clients they know well. However just as their clients were stretching on their real estate purchases, so did the banks on their lending practices. Part of the issue is that regional banks have been poorly diversified, with tremendous exposure to real estate in their communities. And as the communities came under pressure in the recession, so did the banks.

Here is a map showing housing price to income ratio. No surprises here - the overheated markets are all showing up in yellow and orange.


And here is a map of bank closings. Again, it shouldn't be a surprise given banks' exposure to real estate in their communities. The overheated real estate areas tend to get hit with more bank closings. There are obviously idiosyncratic local factors affecting bank closings, but the pattern is clearly there.

Regional banks' real estate exposure will continue to pressure their balance sheets, making it harder to lend, compressing their earnings, and forcing some to close. And at this stage it's not the sub-prime that is causing the problem, it's the prime lending into what was an overheated real estate market as well as commercial property and construction loans.

Increasing FDIC fees (which the FDIC will eventually have to do) on secured deposits will make the situation even worse.

The market definitely recognizes this. The chart below compares year-to-date performance of KRE - the regional banks ETF (down 24.7%), and VFH - the Vanguard financials ETF (up 18.8%). Regional banks are clearly struggling.

The small and regional banks excessive real estate exposure and lack of diversification has been a major factor in bank closings and is likely to continue pressuring these institutions going forward. From Bloomberg:

The U.S. added 111 lenders to its list of “problem banks” in the second quarter, a 36 percent increase that pushed the group to a 15-year high.

A total of 416 banks with combined assets of $299.8 billion failed the Federal Deposit Insurance Corp.’s grading system for asset quality, liquidity and earnings, the most since June 1994, the Washington-based FDIC said in a report today.

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