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If you are a regular reader of StreetWise, you know that in New York City the community and regional banks have been the main driver of financing activity which has kept the sales market out of the morgue, especially for small to mid-sized assets. Ironically, these are the very types of banks which are suffering the most around the country, threatening our economic recovery. Banks are failing at an alarming rate and, as real estate professionals, it is important to be familiar with the status of this critical industry.Last Friday, Bradford Bank in Maryland and Mainstreet Bank in Minnesota were closed by regulators marking the 82nd and 83rd US bank failures in 2009. This figure is greater than that seen in any year since 1992 and, what is most troubling, almost half of these have occured since July 1st. In 2008, 25 banks failed bringing the total during this recession to 108. It is expected that this number will grow to as many as 1,000 over the next 18 months before the smoke clears. The FDIC seizes banks on Friday afternoons and the banks are reconstituted over the weekend to open as part of the acquiring bank on monday morning. During the Savings and Loan Crisis, 853 banks failed and today’s conditions are widely considered to be far worse than the conditions we saw in the early 1990s.  The problems this time around will result in hundreds of failures with some of the stronger banks growing stronger as they emerge from this cycle.The FDIC insures deposits at 8,246 banks and keeps a “watchlist” of banks which are candidates for insolvency. This figure comes out periodically and at the end of March it was 305. Last Thursday, the FDIC said the number had grown to 416 which is the highest number since 1994. In 1988 this number was a record 2,165. Given the relative comparision, the watchlist level is expected to soar during the next year or two.Stronger and larger banks, in addition to receiveing TARP funds, have been able to raise $48.3 billion recently through a combination of strong earnings, dividend cuts, asset sales and equity raising. Unfortunately, it is estimated that $275 billion is needed to stabilize the industry. How did the industry get into this position? It did because far too many banks tripled-down on real estate investments. Here is the triple-down scenario:First, and most obviously, banks made loans on residential real estate, commercial real estate and development projects. Unfortunately, the present speed of deterioration in loan performance is unprecedented – even relative to the early 1990s. Particularly, some banks deployed over 100% of their risk-based capital into development projects. Many of those banks no longer exist.Second, we must look at how some banks handled their investment portfolios. Thousands of banks and thrifts purchased securities tied to the housing market. Banks bought $2.21 trillion of these securities which represents 16% of the industry’s total assets of about $13.5 trillion. 1,400 banks purchased “private label” securities which are those not issued by Fannie Mae or Freddie Mac. It has been estimated that small and regional banks presently own $37.2 billion of these private issuer securities.Third, the industry has been battered by $50 billion of “Trust Preferred Securities”. These are financial instruments issued by banks which are a hybrid between debt and equity. Between 2003 and 2008, 1,500 banks issued these products. Wall Street purchased these securities, created CDOs, and sold the resultant securities back to the same pool of banks! As market conditions weakened, the performance of these banks and of these securities weakened. In the first half of 2009, 119 of these banks deferred dividend payments on these securities and 26 banks defaulted altogether. The consequences of these stresses are cascading down to the buyers of the securities (the banks).This tripling-down effect has created the difficulties in the banking sector. As the sector weakens and more banks fail, tremendous stresses are being exerted on the FDIC and its insurance fund which takes a hit each time a bank is seized. As the FDIC seizes banks, it prefers to have a buyer in hand prior to the seizure so that a conversion can be implemented over the weekend. Unfortunatley, buyers, particularly for larger institutions, have not been plentiful in supply.Two weeks ago, Colonial Bank, with $25 billion in assets, was seized and sold but there were surprisingly few bidders engaged in the process. When Guaranty Bank in Texas was sold, the FDIC, for the first time in history, sold the assets to a foreign bank. Banco Bilbao Vizcaya Argentaria, a Spanish bank, was the buyer.The FDIC’s most important consideration is to limit the cost to its insurance fund, which covers losses from a failed bank’s troubled loans. In order to achieve this objective, having as many bidders as possible is in their best interest. Expanding the arena of foreign banks is part of this strategy and several have expressed interest including TD Bank (Toronto-Dominion Bank), Bank of the West (BNP Paribas), UnionBanCal (Bank of Tokyo-Mitsubishi UFJ) and Rabobank (Rabobank Group).This past week, the FDIC also made it a bit easier for private-equity firms to purchase failed banks. Existing bank holding companies need a Tier 1 capital ratio of 5% to be a qualified purchaser while new banks require 8%. Private-equity firms were required to have a Tier 1 capital ratio of 15%. This has been reduced to 10%. By attracting private capital to buy these failed banks, the FDIC can reduce the number of liquidations and thus reduce the potential losses to taxpayers. The impulse to demand a higher capital cushion as proof of ownership commitment and staying power is exactly correct. The same goes for the requirement for non-bank holding companies to hold onto the bank for at least 3 years before it can be resold and the requirement that the buyer act as a financial backstop. The weak US banking system doesn’t need investors looking mainly for a quick spinoff that could leave a bank in poorer hands within a year or two.Sheila Bair, the Chairman of the FDIC, has been one of the most on-point players in our financial markets during this cycle. She had the foresight to ask congress to provide access to a $500 billion Treasury line of credit several months ago. While she is reluctant to tap the line (for obvious reasons) it is good that the facility is in place.We keep hearing from the Treasury and Congress that the US needs more and tougher bank regulation, even though regulators failed miserably to detect problems within the system. Yet the FDIC is being roughed up, by these same proponents of more regulation, for demanding capital and other standards from nonbank investors who won’t have to meet current bank holding company rules. This position is not the way to restore confidence in the banking system.We need a healthy banking system to provide financing to our industry. There is a recycling process that it will have to go through but we remain hopeful that a stronger system will emerge from the rubble.

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