Let’s Twist Again

Banks struggle with large debt and minimal borrowers

Back Longreads Feb 1, 2012 By Allen Young

The Federal Reserve calls it Operation Twist, named after the 1961 Chubby Checker hit that sparked gyrating hips in dance halls across America. That was also the first year the Fed embarked on a mission to purchase long-term Treasury notes in an effort to drive down interest rates on long-term loans.

Checker set off a dance craze, but the Fed’s version of twist was not nearly as influential: Interest rates on 30-year Treasury notes dropped by just 0.13 percent, or 13 basis points.

Now, the Fed is at it again with a new twist announced in September. Observers note that it marks the next step in a series of efforts by the U.S. central bank to stimulate economic growth by lowering interest rates on short- and long-term consumer loans. Since banks park a portion of their depositor’s money at the Fed, lowering rates of return is, in part, a way to push banks to deploy that capital into the private sector.

If only it were that easy. Banks across the country — and in the Capital Region — are sitting on a mountain of defaulted or modified loans otherwise known as nonperforming assets. In a recent study, 16 Sacramento region banks had more than $200 million wrapped up in these bad loans. The total number of nonperforming assets in the greater Sacramento has dropped by about a fifth since 2009, but bankers remain hesitant to lend to anyone but the most credit-worthy borrowers.

“We are not here to say no. Nothing would help our balance sheet more than to say yes,” says Rick Smith, president and CEO of TriCo Bancshares, parent company of Tri Counties Bank. “It’s very difficult to find qualified borrowers and find enough of the volume of loans to put on our balance sheet.”

Lending volume was high in the middle years of the last decade, until the Wall Street crash revealed obscene cases of high-stakes bluffing on behalf of every kind of borrower, from mortgage owners to the megabanks. Since then, the banking world’s response has been a return to austere underwriting standards.

“Have underwriting criteria standards gotten much more rigorous? Probably, but only to the extent that it’s standard, acceptable underwriting criteria. There’s no room to be sloppy,” says Rodney Brown, president and CEO of the California Bankers Association, a trade group representing more than 200 lenders.

For the average borrower, that change means “more control, more frequent financial reporting requirements,” says Greg Patton, president and CEO of Sierra Vista Bank. “That’s the difference that they are going to feel today. The ongoing oversight of their credit is going to feel tighter.”

Another impact of the recession has been banks’ reluctance to take on new depositors. Banks desire new customers, but concerns exist that deposits in many cases are outpacing the rate of lending.

“The best and worst thing that could happen is (if) a bunch of money flowed in here today. What would I do with it? That’s the immediate challenge,” says Patton. “We’re all sort of in the same place right now: We’re happy to service our existing clients, we want a little bit of growth, but I don’t see anybody in the greater Sacramento area trying to promote a rapid expansion of their banking platform.”

The reckoning of Wall Street’s overaggressive lending practices hit Sacramento’s banks in 2009. That year, 18 community banks headquartered in the Capital Region saw their nonperforming junk assets jump from a few million dollars in 2006 to more than $300 million, according to data from the Federal Deposit Insurance Corp. Some banks already were over-leveraged, and then borrowers started defaulting and restructuring their loan terms.

“By the end of 2009, bank capital levels had dropped precipitously. Most banks weren’t in a position to lend because you have to have a certain amount of capital to lend money,” says Jonathan Lederer, president of Lederer Private Wealth Management LLC, an investment advisory firm.

At the time, the lending slowdown was dramatized by the fact that loan demand also fell, says Lederer, who co-authors the banking section of the “Sacramento Business Review,” a semiannual banking forecast published by Sacramento State. Borrowers were focused on paying off current debt and not looking to expand. The result was a stoppage in the flow of credit.
 

“It’s not as if we need Ben Bernanke to incentivize us to take our money out to make interest rates 5 percent.”  —Kirk Dowdell, CEO, Golden Pacific Bancorp

Now as the region slowly recovers, there is a wide variance in the reserve levels of each of Sacramento’s 18 community banks. A bank with larger reserves is typically run more conservatively and has a greater ability to lend. As of September 2012, Bank of Sacramento led the pack with $8.84 set aside to cover every dollar in a nonperforming loan, according to FDIC data provided by Lederer. River Valley Community Bank in Yuba City had $7.88 to cover every nonperforming loan dollar, and River City Bank in Sacramento had set aside $6.79.

On the other end of the spectrum, Community 1st Bank in Auburn had just 22 cents for every dollar wrapped up in a nonperforming loan. American River Bank in Sacramento had 38 cents per dollar, and Redding Bank of Commerce had set aside 54 cents per dollar.

With banks struggling and loan demand sluggish, the Fed feels pressured to reverse the effects of the recession by getting people to borrow again and grow their businesses. For the past three years, the central bank’s answer has been quantitative easing, a practice of pushing short-term interest rates down to near zero by creating more than a trillion dollars to pump into government debt, consumer debt and mortgage-backed securities.

The Fed lowers consumer interest rates by increasing demand for government bonds, which drives up prices for those bonds. That lowers the yield, or the amount bond holders receive for their investments. The yield determines the rate of interest on loans. Since interest rates stay competitive in the public and private sector and banks have to deploy their money somewhere, lowering U.S. government interest rates subsequently lowers interest rates on business loans, car loans, mortgage rates and other securities.

“By making Treasury bonds less attractive, you’re making private-sector loans more attractive to banks and trying to get the credit flowing,” says Eric Swanson, senior research advisor in the Economic Research Department of the Federal Reserve Bank of San Francisco.

But some bankers are skeptical that lowering federal interest rates will induce risk taking. “It’s not as if we need Ben Bernanke to incentivize us to take our money out to make (interest rates) 5 percent,” says Kirk Dowdell, CEO of Golden Pacific Bancorp in Sacramento.

Others surmise that the Fed’s power over the economy is relatively weak and further impaired by a Congress more focused on political brinksmanship than working with the central bank for solutions.
“What (the Fed) is realizing, unfortunately, is that they are pushing against a piece of string. There are limits to the impact that monetary policy can have in isolation, and I think that’s some of the frustration that you see coming out of the Fed,” says Steve Fleming, president and CEO of River City Bank in Sacramento.

Following three years of quantitative easing, the Fed can’t lower interest rates of two-year bonds any further — they are now just a spec above zero and are expected to stay there through 2013. So the central banks’ new solution is to swap out $400 billion in short-term bonds with long-term Treasury notes, driving down the cost of long-term loans.

As with the previous execution of Operation Twist, the Fed is not seeking a dramatic improvement, but there is hope for another minor reduction in mortgage rates and a slight stimulus to major industries, including housing and automotive sales.

“I think everybody expects those effects to be pretty modest,” says the Fed’s Swanson.

There are some negative effects associated with Operation Twist. First, it affects a banks’ ability to make a spread, the interest earned from lending minus the interest spent on deposits. Secondly, the twist lowers interest rates for depositors, which largely hurts retirees living off of their savings.

“The people that deposit with us and save money will be less happy. For every borrower there is a saver. It’s a zero-sum game,” Fleming says.

Banks across the Capital Region are simply waiting for economic conditions to improve so more credit-worthy individuals will begin asking for loans. It may be several years away.

“What I suspect that you will see from our industry is not a lot of change in the short run,” says Patton. “You won’t see a lot of new, innovative kinds of products. You will not see a lot of new, innovative kinds of delivery systems.

“You will see pretty much status quo for a while as everybody kind of waits to see what happens next and to see whether they want to expand.”

As businesses and individuals begin borrowing again, banks will be enabled to pay off nonperforming loans and take on greater lending risk. As Smith from TriCo Bancshares points out, an increase in lending will signal that financial health is returning to our region.

“A bank is really the blood supply. We aren’t any more important than anybody else, but we move things from place to place just like the blood system does,” Smith says. “Any time the bank is lending and making more loans is a sign that the economy is improving. And if the economy is improving, that means people are getting employed and people are getting pay raises. That is the road to recovery.”

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