Southeastern Banks: In the Eye of the Storm
In some previous economic downturns, U.S. banks remained relatively unscathed by troubles in the overall economy. But in the current economic recession and financial turmoil that began in 2007, banks, especially those in the Southeast, have been close to the eye of the storm—the real estate downturn.
Banks nationwide are experiencing one of the most challenging operating environments in recent history, marked by deteriorating performance and rising numbers of bank failures. Banks in the Southeast have not been immune to the stiff headwinds created by the recent liquidity crisis, the retrenchment in housing and the economic recession. Indeed, a confluence of factors has made conditions particularly acute for Southeastern banks.
U.S. government agencies and the Federal Reserve have taken a proactive role, working with banks to help them weather the storm. Early indicators suggest that these efforts are showing some signs of success in restoring liquidity and confidence to financial markets. While challenges certainly remain, the gradual return of economic growth will boost Southeastern banks' performance.
The gathering storm
These factors, in combination with low interest rates and easy access to credit, fueled demand for financial services and financing, especially for residential and commercial real estate development. To support the needs of the growing economy, new banks formed throughout the region. Between 2001 and 2007, three of the top states for new bank and thrift formation were located in the Southeast; Florida ranked second, Georgia, third, and Tennessee, fifth.
The Atlanta area's experience illustrates why the environment for bank expansion became so fertile. Joe Brannen, president and chief executive officer of the Georgia Bankers Association, said the city's rapid growth from 2000 to 2006—when the Atlanta metropolitan statistical area was the nation's fastest growing—fostered increased demand for financial products and services that competed for newly arrived businesses and consumers. The Atlanta area's pace of growth created an environment conducive to investing in existing banks and creating new ones. "That population growth, plus our state's long history of supporting diverse types of banks serving our needs, helped foster the growth of community banks," he said.
Bolstered by the growing economy, bank performance in the Southeast compared favorably with bank performance nationwide. Median return on assets (ROA), a standard bank performance metric that measures annualized net income as a percentage of total assets, trended upward after the 2001 recession, and by 2006 Southeastern banks' ROA began to eclipse ROA in the rest of the nation (see chart 1).
After 2005, however, evidence began to mount that housing markets were peaking, and delinquencies on home loans made to borrowers with spotty credit histories were beginning to rise. The effects of the weakening real estate market, initially confined to housing-related industries, started to spill over into other areas of the economy. Financial markets began to suffer because subprime loans, which had been securitized and sold to investors, were no longer performing. From there, uncertainty about the true risk exposures of large financial institutions led to increasing levels of illiquidity in many credit markets. By 2008, recessionary economic conditions, exacerbated by spiraling energy prices, were forcing many businesses to cut jobs. As economic conditions worsened, the retrenchment in housing spread inland from coastal markets and began to affect even prime borrowers' credit quality.
Southeastern banks were especially hard hit. Return on assets for banks in the Southeast and nationwide declined as loan delinquencies, which had been at historic lows, began to rise. As the recession progressed, Southeastern banks' performance weakened further, especially in Florida, where more than half of banks were unprofitable by the end of 2008. Across the Southeast, nearly one in two banks was losing money, and more than 6 percent of all loans were delinquent by the end of 2008.
In response to the weakening economy and in the face a lack of loan demand, uncertain collateral values, and tighter credit standards, banks began to tighten lending conditions.
The severity of the current financial crisis also led to a steep rise in the number of bank and thrift failures, although to levels well below those seen during the savings and loan crisis of the late 1980s. Between 1998 and 2004, just 40 financial institutions failed nationwide, and no banks were shut down in 2005 or 2006. In contrast, since the beginning of 2007 through April 2009, almost 60 institutions failed. During this period Georgia led the nation with 11 failures, while Florida saw four institutions close.
Real estate lending at the center of the tempest
Joseph R. Mason, a banking professor at Louisiana State University (LSU), said that high levels of exposure to real estate lending contributed to banks' failures, adding that Florida banks with limited branches were especially vulnerable to a downturn. "Many smaller, less diversified institutions therefore had debilitating local real estate exposures from the real estate bubble," he said.
After new home sales peaked in late 2005, homebuilding was one of the first segments of the economy to feel the effects of the housing downturn. Construction and development (C&D) loan delinquency rates in the Southeast, which had averaged below 1 percent, began to rise. From late 2006 through late 2007, the delinquency rate rose steeply to 5.3 percent. By the end of 2008, the rate had increased to over 13 percent, and banks had charged off more than 6 percent of C&D loans. Rapid deterioration in asset quality posed a significant risk for the region's banks, where the share of C&D loans, at 17 percent, was more than twice the share as elsewhere in the nation. Of the failed institutions in the Southeast since 2007, all but one had C&D loans well in excess of the average share.
According to Rudy Schupp, president and chief executive officer of 1st United Bank in West Palm Beach, Fla., and a member of the Atlanta Fed board of directors, "The construction and development lending issue is not over. We have not reached resolution with many loans, and there still remains a lot of hurt and haircuts before the end of the C&D situation is written."
Income-producing real estate lending is worrisome, Schupp said. With higher vacancy rates and few reductions in common area maintenance costs, landlords can do little to lower basic operating expenses. These factors are causing a softening of net operating income properties. Schupp also reported that existing tenants are now aggressively negotiating better deals even if they have no intention of moving.
Finally, Schupp said capital markets are, for the most part, unavailable to community banks right now. These banks especially are priced out of capital markets, and some of these markets are closed.
The forecast: Continued stormy conditions with eventual clearing
"While most banks have capital to lend, they will do so more carefully than in the past," said LSU's Mason. "While rates may seem favorable, only high-quality borrowers will qualify for loans, and even those may need to shop around for a lender with both resources and the willingness to lend."
Moreover, banks have other potential risks to consider. In commercial real estate, deteriorating supply/demand fundamentals and increasingly limited options for refinancing are taking a toll on property values (see the sidebar). In residential real estate, a recovery may take some time as the threat of option adjustable rate mortgage resets on properties where values have fallen could make it difficult for many homeowners to refinance. High levels of repossessed real estate in banks' portfolios will further challenge their recovery.
But there is room for optimism. Some indicators suggest that liquidity pressures in financial markets may be easing. As a result of the policy initiatives of the government and regulatory agencies, interest rates remain low while credit spreads have generally retreated from their peaks in October 2008. Despite perceptions to the contrary, banks are continuing to lend money, and historically low interest rates make the current environment a good time to borrow for those who qualify. In early 2009, purchases of mortgage-backed securities by the Federal Reserve allowed mortgage rates to drop to record lows, prompting a boom in mortgage refinancing that aided borrowers and helped boost fee income for banks. Subsequently, however, mortgage rates have risen.
Schupp said he is seeing an uptick in consumer sentiment, a sense of optimism, but at the same time a lot of false starts. From his perspective, some consumers are overreacting to the concept of "let's get in early," but Schupp said banks don't share this sentiment because of the overhang of real estate on their books.
Yet as consumers place greater emphasis on saving and seek the safe haven of insured deposits, Southeastern banks have seen a rise in deposits, which can be loaned out to help support an economic recovery.
Macke Mauldin, president of Bank Independent, a Sheffield, Ala.-based community bank, said his customers are saving more, possibly out of a desire to have easy access to their money. "I don't know if the increased savings means people want to be portable or just see what the interest rate environment does," he said. He added that the increased savings rate will allow his bank to make more loans at better rates to individuals and small businesses. "We've yet to determine if this trend will hold up, but some of my banking peers who have been in this industry longer than I have told me they've never seen the consumer this liquid."
When the economy recovers and consumers and businesses become more confident, the health of banks in the Southeast will improve. However, even post-recovery, lessons learned from this decade will shape the future financial landscape in fundamental ways. The loose underwriting practices that occurred likely will not return and could limit some banks' pool of potential borrowers. The structure of financial regulation also may change as policymakers attempt to close supervisory gaps that may have contributed to the current set of problems in the financial sector.
This article was written by Scott Hughes, a senior financial analyst in the Atlanta Fed’s Supervision and Regulation Department.