Sunday, January 18, 2009

Minnesota Community Banks

Here's an article from one of the best reporters in the (soon to be no more) Star Tribune, Chris Serres. It's about the "community banks" here in Minnesota which presumably were above the fray when it came to the housing debacle. As Chris and analysts point out, it couldn't be further from the truth. Matter of fact, I contend it was the community banks that sent the market into "hyper-over supply" in my book, which of course you should no doubt buy and read.

In any case, here is an excerpt from my book written nearly a year ago;


Though banks were also doing their fair share of “enabling” unworthy borrowers to buy homes, their primary contribution to the housing crash was from a different angle. For while mortgage lenders and mortgage brokers were artificially inflating demand, the traditional commercial banks were artificially inflating supply.

This is not by coincidence in that the nature of real estate lends itself well to being oversupplied. The reason is the numbers. Since bankers get paid on commission, usually a percentage of the total deal amount, the larger the deal, then the larger the commission. This makes real estate deals particularly appetizing in that unlike the commission on a $25,000 operating line of credit, the commission on a $25 million condoplex deal is infinitely more appealing and for roughly the same amount of work. Because of this anybody who stands to earn a percentage commission on the deal (bankers, management, investment brokers, etc), lobbied heavily for such deals to get approved, even if they are doomed to fail.

However, this resulted in a lopsided business. Since the majority of the deals were in real estate, the majority of the bank’s portfolio ended up in real estate. This was bad position to be in as, just like any other portfolio, you want to diversify your holdings to lower your risk. But despite the risks of having an overexposure to real estate, and especially in light of a potential housing crash, the commissions on real estate deals were so lucrative, the incentive to do them would more often than not triumph over those risks. This effectively eliminated any stops or regulators which would normally curb the amount of housing entering on the market and resulted in a flood of deals that were doomed to failure.

But while the sheer size of real estate deals helped bring about an oversupply of housing in a self-fulfilling sort of way, there was another odd incentive at play that would result in even more housing. A pecking order.

Because of their size and reputation, large, established commercial banks in a sense “get the pick of the litter” when it comes to loans. They have billions of dollars in capital, they can offer the best rates and they have the labor resources to originate, service and administer your loan. They can outdo their smaller competition because of economies to scale and therefore cherry pick the most profitable loans.

And not that there aren’t any good loans left to do, but as you go down the pecking order from large, established banks to medium sized regional banks to smaller community banks the quality and caliber of the loans erode. So by the time the loan gets to the smaller community banks it has already been passed on by several banks above.

In this sense the smaller community banks eat the crumbs that fall off the table of the larger banks. But despite their smaller size and despite being at the bottom of the pecking order these banks punched above their own weight when it came to oversupplying the market with housing. The reason was multi-fold.

One, the real estate deals these smaller banks were getting were doomed to fail. The market was already oversupplied and other banks had already passed up on these deals. If a bank had already turned down the loan, this spoke volumes as other analysts had looked at it and believed it would not be paid back. However…

Two, despite the impossibility of the deal, bankers were paid on commission. So even if the deal was unlikely to be paid back, they would still lobby for it, and more often than not, get it approved.

Three, these smaller community banks would salivate over multi-million dollar deals simply because they were multi-million dollar deals. To a large national bank a $4 million deal is nothing grandiose. But to a small town community bank $4 million is a large and coveted piece of business. Not because it’s a good loan, but because it’s a big loan.

The results were predictable. Despite the loan being a bad loan, despite it being passed on once, twice or thrice before, these small banks could only see the loan for its largess and potential commission check. And even though it was practically guaranteed to fail, these banks would approve these loans anyway.

But in doing these loans the damage these banks caused was disproportionately large for their size as all they managed to do was “hyper”-supply an already gluttonously-supplied level of housing. Furthermore, the amount of housing they would bring to the market was not insignificant for what they lacked in size they made up for in numbers. If it was just one small time community bank approving a couple of bad loans then there would be no consequence. But if 50 small time banks start approving hand-me-down loans, it was the equivalent of a large commercial bank approving hand-me-down loans. With so much “extra-excessive” supply hitting the market, housing prices were disproportionately affected downward as the number of houses a buyer had to choose from went from five to ten.

But be it large commercial banks flooding the market with condos or small community banks sending the market into hyper-supply, the crux of the problem was an incentive situation similar to the mortgage brokers. You were paid on volume, not risk. Bankers would get paid on deals completed, not paid back. Management would get bonuses based on sales, not loans paid back. And so the results were similar. Being obsessed with commission and completely disregarding risk, banks financed the construction of millions of homes that would never sell. Housing inventories skyrocketed, driving down prices and the banks did their job in helping contribute to the housing crisis.


Anonymous said...

Do you have a good idea on how a loan officer should be paid? Since they get paid when the loan is originated, and not when the loan is repaid, their incentives are not well aligned with the bank's shareholders and depositors.

Captain Capitalism said...

They are paid a salary and then a commission ONLY when the loan is paid back in full.