KABUL—A top shareholder in Afghanistan’s largest bank called on the U.S. to shore up the lender after depositors withdrew about a third of its cash reserves in two days, while the country sought to avert a destabilizing crisis at a crucial moment in the fight against the Taliban.

Mahmood Karzai, brother of Afghanistan’s president and the third-largest shareholder in Kabul Bank, urged the U.S. to calm the situation, saying the lender could keep up with the pace of withdrawals for only a few more days.

“America could support Kabul Bank to the last penny, of course that would help,” he said in an interview at his Kabul home. “The full faith and credit of the U.S. government behind Kabul Bank—what more do you want?”

If the withdrawals continue apace, Mr. Karzai said, the bank would be effectively insolvent by early next week. The bank has $1.3 billion in deposits, and its total assets are almost equal to its liabilities. But the lender only had $500 million in cash on hand at the start of the crisis, he said. Its other assets—including Dubai real estate investments of uncertain value—aren’t easily convertible into cash.

Kabul Bank’s woes became public late Tuesday when word emerged that Afghanistan’s central bank had quietly forced out the bank’s two top executives, and its biggest shareholders, amid allegations that they made hundreds of millions of dollars in often-clandestine loans to themselves and Afghan government insiders.

Some U.S. officials expressed doubt that the Afghan government could bear the strain of propping up Kabul Bank without outside help.

Mr. Karzai’s request for the “full faith and credit” backing of Kabul Bank by the US Government was reportedly declined by the U.S.  With U.S. taxpayers still extremely irate over the cost of bailing out the U.S. banking system, it would have been political suicide for Congress to even consider such a request.

With 118 banking failures to date and 829 banks on the Problem Bank List, the United States is financially stressed trying to resolve its own banking crisis.   The shareholders of Kabul Bank will rightfully have to solve their own banking problems.

It has been generally recognized that high cost, inappropriate mortgage products marketed on a mass scale contributed, in part, to the mortgage crisis.  Lenders promoting highly leveraged, high rate mortgage loans to borrowers with poor credit and no capacity to repay would be hard pressed to explain how such loans could possibly promote sound homeownership.   Due to the role of nontraditional lending in causing the housing crash and recession, the industry has effectively been legislated out of business.

Should Subprime Lending Be Allowed?

Some policy makers are now considering whether the prohibition of certain mortgage products has caused a significant reduction in credit availability to customers able to repay and understand high-risk mortgage products.  Removal of restrictions on nontraditional mortgage products, coupled with counseling and financial education, might allow borrowers to make informed financial decisions while evaluating the risks, costs and benefits of a nontraditional loan.  These issues were recently examined by Charles Evans, President of the Federal Reserve Bank of Chicago, in a speech before the Indianapolis Neighborhood Housing Partnership.

Commenting on the risks of highly leveraged or unaffordable home purchases, Mr. Evans stated:

Thus it was very destructive when, in the early part of this decade, dubious underwriting practices and mortgage products inappropriate for mass consumption became more common. It is difficult to understand how loose underwriting, high degrees of leverage and the broad marketing of exotic and often very high-cost mortgage products can promote homeownership.  Moreover, partly as a result of these practices, we’ve seen an unprecedented housing market collapse that contributed to a very deep recession marked by many lost jobs. And now homeownership has declined for six straight years.

Mr. Evans noted that “While economists usually give great respect to individual choice, in this case it seems that many borrowers made poor choices” and were abetted by lenders into choosing exotic mortgages without regard to their income or ability to repay.  While recognizing that “the mortgage crisis was caused in part by the use of inappropriate mortgage products”, Mr. Evans discussed two possible future policy options regarding nonstandard mortgages.

One possibility would be to impose very stringent regulatory oversight that eliminates such products all together. Such a policy would certainly prevent unqualified borrowers from obtaining high-risk mortgage products. However, such specialized products may actually be appropriate for certain people, so such a policy would have some real costs.

An alternative approach would be to place few restrictions on the choices available to borrowers and rely instead on better educating them about homeownership and mortgages.  Such an approach might keep those who shouldn’t be in exotic mortgages from getting them while leaving such mortgages available to the small group of people for whom they are appropriate. A big question, however, is whether financial education can work.

Unfortunately, studies done by the Chicago Fed on the effects of financial education offer mixed results.  In addition, implementing educational programs on a wide scale would likely be cost prohibitive.  Mr. Evans noted that the results of the Fed study correlate highly with “behavioral economics” which “recognizes that people frequently make substantial mistakes in their economic decisions”.

It is highly unlikely that we will see a return of high-risk, nontraditional mortgage lending anytime soon.  Although nontraditional lending may have genuine benefits for a small number of qualified borrowers, most of these products have ultimately caused substantial economic hardship for both borrowers and lenders.

The number of banking failures this year now totals 118 and is on track to double the 140 banking failures of 2009.   According to FDIC Chairman Sheila Bair, “Without question, the industry still faces challenges. Earnings remain low by historical standards, and the numbers of unprofitable institutions, problem banks and failures remain high”.

Despite the challenges, Ms. Bair noted that “This is the best quarterly profit for the banking sector in almost three years.  Nearly two of every three banks are reporting better year-over-year earnings”.  Earnings, however, remain well below historical norms and 20% of all banks reported a loss for the quarter, compared to 29% in the previous year.

The banking industry may be showing signs of improvement but with over 10% of all banks on the Problem Bank List, the banking industry is far from a full recovery, especially if the economy continues to weaken.  Banks classified as “problem banks” generally have a weak capital position and a high likelihood of failure, especially if economic conditions worsen.

Problem Bank Assets Decrease

Problem Bank assets decreased by $28 billion to $403 billion from $431 billion in the previous quarter.  Although larger banks have been reporting profit increases and have increased their capital positions, smaller and midsized banking institutions remain under duress as indicated by the increase in problem banks.  The average assets of the 829 problem banks is $486 million, suggesting that the problem bank list contains very few large institutions.

Banking Income Shows Tentative Rebound

The latest quarterly banking industry profits totaled $21.6 billion, a slight increase from the previous quarter.  The increased earnings, however, were the result of a reduction in loss provisions.   According to the FDIC, “The primary factor contributing to the year-over-year improvement in quarterly earnings was a reduction in provisions for loan losses. While quarterly provisions remained high, at $40.3 billion, they were $27.1 billion (40.2 percent) lower than a year earlier”.  In addition, the coverage ratio for noncurrent loans is still dramatically below historical norms.

The banking industry’s total reserves declined by $11.8 billion as larger banks reduced their loss provisions.  The ratio of reserves to total loans fell to 3.4% from 3.5% during the quarter but is still the second highest ratio in 63 years.

Noncurrent Loans Decrease

Asset quality trends showed improvement with the amount of noncurrent loans and leases  (past due 90 days or more) decreasing for the first time since the first quarter of 2006.  During the quarter banks charged off $49 billion in uncollectible loans, a slight decrease of $214 million from a year ago.

FDIC Deposit Insurance Fund (DIF) At Negative $15.2 Billion

The FDIC DIF improved slightly in the quarter to negative $15.2 billion from $20.7 billion due to increased assessments on insured banking deposits and a reduction in the contingent loss reserve to $27.5 billion from $40.7 billion.  The contingent loss reserve covers the cost of expected failures, indicating that the FDIC expects failed banking losses to decrease.

The DIF fund had been strengthened by a special FDIC assessment of $46 billion on the banking industry at the end of 2009.   The FDIC presently has liquid  resources of $44 billion, a decline from $63 billion at the end of the first quarter.  Liquid resources of the FDIC Insurance Fund represent a small fraction of total FDIC insured deposits of $5.5 trillion.

To “enhance public understanding of Fannie Mae’s and Freddie Mac’s financial performance and condition leading up to and during conservatorship”, the FHFA released its first Conservator’s Report on the Enterprises’ Financial Condition.  Going forward, the report will be released on a quarterly basis.

The FHFA report highlights the extraordinary growth of non traditional mortgage products from 2003 to the peak in 2006.  The volume of risky subprime and Alt-A mortgages during 2005 and 2006 accounted for nearly one third of all mortgages originated.  Many of these non conforming mortgages required little or no income verification and were done at high loan to values, making them particular susceptible to default after housing prices crashed.

The FHFA report notes that as the volume of higher-risk mortgages increased, Fannie and Freddie “guaranteed and purchased an increased amount of nontraditional and higher-risk mortgages”. These higher-risk products were acquired at the peak of the market and, not surprisingly, lead to a disproportionate share of credit losses. The FHFA report shows that higher-risk Alt-A and interest only mortgage products had virtually disappeared from the market by 2009.   Since 2008, the average loan to value and credit scores for new Fannie and Freddie mortgage acquisitions have improved dramatically as rigorous mortgage underwriting guidelines have been re-established.

The FHFA report notes that post-conservatorship, Fannie and Freddie have seen markedly lower default rate for 2009 mortgages due to higher credit scores required for borrowers.  An explanation for Fannie’s and Freddie’s aggressive acquisition of higher-risk mortgages in 2006 and 2007 was not provided.

Acquiring high-risk mortgage products, especially in states that had some of the largest increases in housing values (California, Arizona, Nevada and Florida) lead to a disproportionate share of credit losses.  Although not mentioned in the report, it could be argued that Fannie and Freddie fueled the housing mania and subsequent collapse by providing easy credit to unqualified buyers at unsustainable price levels.

Fannie and Freddie are not likely to disappear anytime soon.  The combined mortgage giants, now 80% owned by the government, continue to provide approximately 75% of funding to the mortgage market.  In addition, Fannie and Freddie insure or own $5.7 trillion of the outstanding total of $11 trillion in mortgages.  The government has agreed to provide unlimited funding while policy makers debate how to reform the mortgage system to prevent Fannie and Freddie from again becoming a systemic risk to the financial system.

At this point, most analysts are forecasting that the recovery in housing values and the ultimate restructuring of Fannie and Freddie is likely to take many years and many additional taxpayer dollars.

Loans at least one payment past due or in foreclosure totaled 13.97%, down slightly from 14.01% in the last quarter but up 1.14% from last year.

The number of homes in foreclosure decreased for the first time since 2006 and loans seriously delinquent at 90 days past due also decreased.  The delinquency rates, although slightly improved, remain at historically high levels as consumers struggle to stay current with enormous amounts of debt, shrinking income and high unemployment.

The pertinent question is whether the slight improvement in delinquency rates is a mere statistical blip.  MBA data on the increase in 30 day delinquencies suggest that high unemployment rates and first time claims for unemployment insurance could ultimately lead to increased foreclosure rates.

The disappointing news is that, after declining since the beginning of 2009, the rate of short-term delinquencies is going up and the increase in these short-term delinquencies may ultimately drive the foreclosure measures back up. The percent of loans one payment behind had peaked in the first quarter of 2009 at 3.77 percent and fell to 3.31 percent by the end of 2009.   Unfortunately that rate has now risen to 3.51 percent.  The causes are likely two-fold.  First, 30-day delinquencies are very closely tied to first-time claims for unemployment insurance.  The number of first-time claims fell through most of 2009 but leveled off in 2010 and have started to rise again.  This increase in unemployment directly impacts mortgage delinquencies.  Second, some percentage of the loans modified over the last several years have become delinquent again because those borrowers, by definition, have weak credit.

Ultimately the housing story, whether it is delinquencies, homes sales or housing starts, is an employment story.  Only when we see a consistent increase in employment will we see an increase in sales and starts, and a sustained improvement in the delinquency numbers.  Until we see the increase in the number of households that comes with an increase in the number of paychecks, all measures of the health of the housing industry will continue to be weak.

The delinquency rate by loan type was 7.8% for VA loans, 13.75% for prime ARM loans, 5.98% for prime fixed loans, 25.2% for subprime fixed loans, 29.5% for subprime ARM loans and 13.3% for FHA loans.

Where we go from here is fiercely debated, with some seeing a gradual recovery, while other forecast a Japanese style deflationary quagmire or a total economic meltdown as the banking system becomes overwhelmed by defaulting loans.  Recent comments from prominent analysts indicate the divergent opinions on the future of America’s economy.

The most optimistic (although guarded) outlook for the US banking industry came from Standard & Poor’s Rating Services.

Wall Street Journal - Standard & Poor’s Ratings Services said the worst appears to be over for the U.S. banking industry, though a sluggish economy and continuing real-estate issues—combined with regulatory uncertainty—mean the sector isn’t likely to see a quick rebound.

Banks have posted generally improved results this year, rebounding from dismal results in early 2009, but fears have mounted lately that economic recovery in the U.S. may be slowing.

Loan performance appears to be stabilizing in some categories, such as credit cards and commercial loans, but the rate of nonperforming loans remains high while the sluggish housing and commercial real estate markets remain a concern.”

In a more somber assessment, Robert Schiller, economics professor at Yale, predicted an imminent recession, deflation and the possibility that housing prices may decline for another five years.  Mr. Schiller is famous for his accurate prediction of the collapse in the US housing market.  The prospect of an extended decline in US housing prices is alarming due to the correlation of mortgage defaults with negative equity.

A Federal Reserve study released in June revealed that when mortgage debt exceeds 150% of a property’s value, “half of the defaults by driven purely by negative equity”.  With 25% of borrowers already owing more in debt than the underlying value of the property, the prospect of a continued erosion in home values has the significant potential of causing another large wave of mortgage defaults.   Mr. Schiller spelled out his concerns in an interview with the Wall Street Journal:

Mr. Shiller also said he thinks the U.S. economy is “teetering on the brink of deflation.” Deflation occurs when the general level of consumer prices falls, as was the case in the Great Depression. He said the U.S. is ill-prepared for such an event because of the lack of “indexing” in contracts.

In addition, the co-creator of the Case-Shiller Home Price Index said he is worried that housing prices could decline for another five years. He noted that Japan saw land prices decline for 15 consecutive years up to 2006. Data released earlier this week show the housing sector is performing at the worst level in decades.

When asked about how to stimulate the private sector to create jobs, he noted that there was such uncertainty in the economy currently that businesses were backing off from making hiring decisions.

Mohamed A. El-Erian, chief executive of Pimco, explains why the alarming deterioration in economic conditions is structural and offers the somber assessment that policy responses by governments will most likely be inadequate.

Washington Post - Throughout the summer, data signals have become more alarming. Despite all the rhetoric about job creation, unemployment remains stubbornly high and the problem is becoming structural in nature (and, therefore, harder to solve). Consumer credit continues to contract while small companies find it difficult to access new bank lines of credit. Housing activity is falling, and home values are poised for further declines as foreclosures increase. The trade balance has taken an ominous turn, with exports stagnating and imports surging. More Americans are falling through the large holes in the country’s safety net.

In sum, the current policy approaches here and abroad are unlikely to deliver a durable and robust U.S. recovery and, critically, create sufficient growth in jobs. Yet the main debate in Washington is whether to do more of the same — namely, another fiscal stimulus and another round of quantitative easing by the Federal Reserve. This clearly conflicts with evidence that a broader and more holistic response is needed.

An already polarized political environment is becoming even more fractured by real and far less substantive issues. There is virtually no political center that can anchor consensus and enable sustained implementation of policy.

I hope that sober policy responses will accompany the coming cooler temperatures. Given the proximity of the November elections, however, I worry they may not.

Peter Schiff, President and Chief Global Strategist for Euro Pacific Capital, believes that the US is already in a depression with the next down wave likely to be far worse than the last resulting in the destruction of wealth on a massive scale.

Peter Schiff - Rather than a recovery, the jobs data seems to indicate that we are still mired in the first economic depression since the 1930s. Increased spending, financed by unprecedented borrowing, will prove to be just as temporary as a job opening at the US Census. When the bills come due, the next leg down will be even more severe than the last. The swelling ranks of the government payroll, and the shrinking number of private taxpayers footing the bill, will guarantee larger deficits and a weaker economy for years to come.

The oracles who have described the nature of this imminent recovery do so based on their conviction that consumer spending is slowly returning to levels that existed prior to the recession.  However, missing from their analysis is any plausible explanation as to why consumers will be able to sustain such spending given the plunge in income and credit, and the lack of available savings. But most consumers are tapped out, millions are unemployed, and home equity has been wiped out. The only reasonable thing for them to do is to pay down debt and sock away as much money as possible to rebuild their savings.

In a world without apparent solutions to our economic malaise, the consensus now seems to be that monetary actions by the Federal Reserve will save the day.  Speaking at Jackson Hole, Chairman Bernanke today stated that economic “policy options are available to provide additional stimulus”.  Policy actions taken thus far by the Federal Reserve, including driving interest rates to zero, have not produced an economic recovery.  The last desperate option available to the central bank now seem to rest on a risky implementation of quantitative easing to increase asset values and credit demand.  As noted in comments by Comstock Partners, this approach has already been tried without success:

Now, five years later another Jackson Hole symposium will attempt to find solutions to the economic mess that partially resulted from the Fed’s reckless actions.  The problem is that an already sub-par recovery (if we can even call it that) is giving signs of petering out even after all the massive stimulus programs provided by the Fed, the Administration and Congress.

With the recognition that economic growth is showing signs of coming to a halt, the talk has turned to the possibility of more quantitative easing or QE2.  The problem, though, is that after TARP, the stimulus plan, Fed purchases of $1.7 trillion of government securities and near-zero interest rates, there is little more the Fed can do that they haven’t already done.  At this point the Fed cannot use monetary policy to force companies, banks and consumers to take credit that they do not want to use.  In economic literature, this situation is known as a “liquidity trap”, a phrase you will probably hear a lot in coming months.

The Federal Reserve cannot bestow upon us what we need most - job creation and real income growth necessary to service debt and improve our standard of living.  Real income growth has been stagnant for decades as debt burdens have expanded exponentially - neither money printing nor easier credit will cure this fundamental economic problem.

Income Growth

TOTAL US DEBT TO GDP

A cease and desist order is issued when the FDIC has “determined that it had reason to believe that the Bank engaged in unsafe or unsound banking practices and violations of law and/or regulations.”

It is highly likely that banks  issued cease and desist orders or prompt corrective actions are on the Problem Bank List.  The Problem Bank List contains the names of institutions that have weak capital positions caused by large loan losses or operational deficiencies that usually lead to failure. The FDIC does not publicize the list for fear of causing depositor withdrawals and bad publicity which would only serve to hasten the bank’s closing.

As of the latest report released by the FDIC there were 775 problem banks at March 31, 2010 up from 702 at the end of  2009.  Total assets held by the troubled institutions is $431.2  billion, up from $402.8 billion at the end of 2009.

Given the serious financial issues cited by the FDIC for the banks listed below, expect many of these institutions to wind up on the Failed Bank List. Banking depositors with balances in excess of the FDIC deposit insurance limit should consider this list as “fair warning” from the FDIC and take appropriate action to avoid potential losses.

FINAL ORDERS ISSUED PURSUANT TO SECTION 8(b), 12 U.S.C. §1818(b)
(Cease-and-Desist)

CB&S Bank, Inc., Russellville, AL; FDIC-10-176b; Issued 7/8/10 - PDF

Summit Bank, Prescott, AZ; FDIC-10-384b; Issued 7/28/10 - PDF

Metro United Bank, San Diego, CA; FDIC-10-379b; Issued 7/22/10 - PDF

Oceanic Bank, San Francisco, CA; FDIC-10-362b; Issued 7/15/10 - PDF

The Wilton Bank, Wilton, CT; FDIC-10-375b; Issued 7/22/10 - PDF

Bank of Jackson County, Graceville, FL; FDIC-10-364b; Issued 7/27/10 - PDF

Great Eastern Bank of Florida, Miami, FL; FDIC-10-365b; Issued 7/27/10 - PDF

TIB Bank, Naples, FL; FDIC-10-358b; Issued 7/2/10 - PDF

Pinnacle Bank, Orange City, FL; FDIC-10-184b; Issued 7/7/10 - PDF

First Chatham Bank, Savannah, GA; FDIC-10-177b; Issued 7/13/10 - PDF

AztecAmerica Bank, Berwyn, IL; FDIC-10-441b; Issued 7/30/10 - PDF

Millennium Bank, Des Plaines, IL; FDIC-10-200b; Issued 7/20/10 - PDF

First Choice Bank, Geneva, IL; FDIC-10-311b; Issued 7/29/10 - PDF

Security Bank, S.B., Springfield, IL; FDIC-10-317b; Issued 7/20/10 - PDF

Midwest Community Bank, Plainville, KS; FDIC-08-373b; Issued 7/12/10 - PDF

First Bank and Trust, New Orleans, LA; FDIC-10-329b; Issued 7/9/10 - PDF

HarVest Bank of Maryland, Rockville, MD; FDIC-10-349b; Consent Order; Issued 7/2/10 - PDF

Monroe Bank & Trust, Monroe, MI; FDIC-10-163b; Issued 7/12/10 - PDF

Sherburne State Bank, Becker, MN; FDIC-10-296b; Issued 7/12/10 - PDF

Riverland Bank, Jordan, MN; FDIC-10-208b; Issued 7/1/10 - PDF

Progrowth Bank, Nicollet, MN; Issued 7/1/10 - PDF

1st Commerce Bank, North Las Vegas, NV; FDIC-09-703b; Issued 7/13/10 - PDF

Hanover Community Bank, Garden City Park, NY; FDIC-10-292b; Issued 7/27/10 - PDF

Parkway Bank, Lenoir, NC; FDIC-10-402b; Issued 7/15/10 - PDF

Security Savings Bank, SSB, Southport, NC; FDIC-10-330b; Issued 7/28/10 - PDF

Benchmark Bank, Gahanna, OH; FDIC-10-355b; Issued 7/30/10 - PDF

Sevier County Bank, Sevierville, TN; FDIC-10-150b; Issued 7/27/10 - PDF

Main Street Bank, Kingwood, TX; FDIC-10-321b; Issued 7/28/10 - PDF

Cascade Bank, Everett, WA; FDIC-10-322b; Issued 7/15/10 - PDF

Citizens Bank of Mukwonago, Mukwonago, WI; FDIC-10-357b; Issued 7/30/10 - PDF

According to the FDIC:

Acquirers of failed institutions view the LSA structure as attractive because the FDIC’s loss coverage provides substantial downside protection against losses on covered assets.  When the FDIC calculates the estimated cost of a failure, it takes into account all expected losses on the assets covered in loss share agreements (LSAs). These current market assumptions are built into the cost of failure at resolution. Thus, the cost of all expected future payments are recognized at the time of bank failure and no losses are deferred.  Loss sharing also reduces the FDIC’s immediate cash needs.

As the number of banking failures has increased dramatically over the past two years, the FDIC’s immediate cash needs have become an increasingly important issue.  At the end of 2009, in order to bolster the Deposit Insurance Fund (DIF), the FDIC required insured institutions to prepay 3 years of FDIC insurance premiums which raised about $46 billion.   Despite this additional assessment, as of the latest reporting period at March 31 2010, the Deposit Insurance Fund (DIF) reserve ratio was -.38 percent (negative $20.7 billion), the lowest ratio in the history of the FDIC.

Despite no announced changes by the FDIC in the method of computing losses for a failed institution, three of last week’s bank closings had unusually low loss estimates.

If the estimated future losses on the sale of a failed bank’s assets are lowered, the loss to the DIF fund will decrease.  Protecting the Deposit Insurance Fund (DIF) from further losses is an important issue to the FDIC.

The FDIC believes that it is important that the fund not decline to a level that could undermine public confidence in federal deposit insurance. A fund balance and reserve ratio that are near zero or negative could create public confusion about the FDIC’s ability to move quickly to resolve problem institutions and protect insured depositors.

Is the FDIC using overly optimistic estimates of losses on failed banks?  Three of last week’s banking failures were highly unusual since the estimated losses to the DIF were exceptionally low.  During 2009, the average loss to the FDIC for bank failures amounted to 22% of total assets of the failed banks.  For 2010 to date, the ratio of total estimated losses to total failed bank assets was approximately 23%.  The three failed banks on August 20 with very low loss ratios are listed below:

Using Sonoma Valley Bank as an example, a review of the company’s financial position portrays a very troubled bank with a large amount of nonperforming loans.  In addition, Sonoma’s loan portfolio was overly concentrated in commercial real estate (42.9%) and development loans (13.2%) as discussed by management in the Sonoma 10-Q.

Like many community banks, the Bank does have a significant concentration in commercial real estate loans. At the present time, due to severe economic recession, significant decrease in real estate values, and the lack of available financing options, local commercial real estate values have declined considerably. This severely impacts the Bank’s commercial real estate portfolio causing additional provisions for loan losses.

Although the economy has shown some signs of stabilization, conditions in the commercial real estate market are anticipated to worsen further which may result in additional provisions for loan loss throughout 2010. The non-performing assets to total loans ratio was 16.27% as of June 30, 2010 compared to 4.09% as of June 30, 2009.

As of June 30, 2010, commercial real estate properties were identified as a concentration of credit as it represented 42.9% ($108.5 million) of the loan portfolio.

Management believes that the adverse impact on the collectability of certain of these loans will continue in 2010, as the combined effects of declining commercial real estate values and deteriorating economic conditions will place continued stress on the Bank’s small business and commercial real estate investor borrowers.

The severe decline in commercial real estate markets suggests that banks with a heavy concentration of commercial real estate loans not yet marked down to market values may face further significant losses.  Moody’s Commercial Property Price Index shows a stunning decline in value of 41% from the peak of October 2007.  Banks with commercial loans on their books backed by inflated asset values will avoid further large writedowns only if property values recover.

The troubled asset ratio of Sonoma Valley Bank was 138% compared to a national median of 15%.

Considering the comments by Sonoma Bank’s management and the amount of losses historically taken on failed banks, the FDIC’s estimated losses on Sonoma Bank, Los Padres Bank and Butte Community Bank seem unusually low. The FDIC did not respond to emails and phone calls requesting comment.

Based on current credit score requirements for a mortgage approval, any applicant with a score below 600 is almost certain to be turned down by a banking institution.  Borrowers in the 600-649 range are also considered “weak” candidates with a high turn down rate, especially if the credit score is below 620.

Based on the total number of Americans with a credit score of 649 or lower, up to 35% of all Americans are effectively locked out of the refinance or purchase mortgage market for the foreseeable future.  With foreclosures and default rates constantly increasing, it is conceivable that credit standards could be tightened even further by banks.

CREDIT SCORE DISTRIBUTION

To gain insights into how the current mortgage market differs from  previous recessions and the implications for banks and borrowers, I interviewed Don Luth, Executive Loan Consultant with over 30 years of experience, at HamiltonLadd Home Loans, Ridgefield, CT.

PBL - Don, what’s your take on the increasing number of borrowers with low credit scores?

Luth:  I do not have access to the same statistical data you mentioned but from my 30 plus years in the mortgage business…

Recessions equal a higher unemployment rate.
Higher unemployment rates lead to higher mortgage and/or consumer credit delinquency rates.
Higher delinquency rates negatively impact credit scores on a larger percentage of the total consumer population.

So there is no doubt in my mind - we now have a larger segment of consumers that have a lower credit score than before this recession began.

PBL - What actions have banks taken to compensate for lower credit scores and how does this housing recession differ from previous ones?

Luth:  As a result of the decline in real estate values and higher unemployment rates, the banks had no choice but to tighten credit standards across the board.

In the most recent two recessions (excluding the one we are in today) a sub 600 credit score consumer with a job and verifiable income had the option of either selling their home to eliminate debt or they could possibly qualify for a sub prime mortgage refinance.

Sub prime lenders actually experienced an increase in market share during the prior recessions. Companies like Beneficial Finance, Household Finance, Nations Credit, Avco Finance, and Security Pacific Finance to name just a few.

Those companies were portfolio lenders who stepped in to bridge the financing gap when banks tightened their lending standards and effectively excluded most sub 600 score borrowers from the mortgage market.

But for all intent and purpose– sub prime lending has now been legislated out of business. So the sub prime financing options that were available to the sub 600 score consumer during prior recessionary periods are no longer available today.

Their exit from the landscape is one of the primary reasons why FHA’s market share has risen so significantly in the past two years.

PBL - The FHA has also seen a large number of defaults and have imposed tougher underwriting guidelines.  How difficult is it to get an FHA approval today and what are the options for borrowers with who cannot qualify for conventional or FHA financing?

Luth:  One of the more liberal mortgage programs from a qualification standpoint in today’s market is the still the FHA 203B mortgage program. But even FHA lenders have tightened their lending standards a great deal in the past two years. Credit scores today generally need to be 620 or greater and consumers with a credit score below 660 will pay a higher interest rate.

In addition, every new FHA applicant “regardless of their score” must now pay a significantly higher cost for FHA’s mortgage insurance premiums.

Frankly the only (low rate) mortgage product that readily comes to mind for a consumer with a sub 600 score is a Reverse Mortgage.

The reverse mortgage product “does not” have a minimum credit score qualification requirement. But a qualified applicant needs to be 62 years or greater.

The maximum loan limits for a reverse mortgage have declined due to adverse market conditions but the overall qualifications needed to obtain a reverse mortgage, such as no credit score requirement - have not been changed over the past 24 months.

PBL -At this point, very few analysts are forecasting a quick turnaround in the real estate or mortgage market.  What’s your take on this and what needs to be done to ensure a sound banking system going forward?

Luth:  I’m afraid this recession will take a much deeper toll on consumer credit scores and credit availability than any recession we’ve experienced in the past 30 years.

The majority of banks (including all of the GSE’s) allowed way to much leverage to occur on behalf of the consumer.

The foundation for bank lending standards which included an analysis of the borrowers ability, stability and willingness to repay a mortgage loan - all took a backseat - to what I can only describe as sheer greed for short term profits.

Needless to say, these same banks now need to rid their balance sheets of the substantial numbers of REO properties and take the losses before we’ll see any improvement in today’s stringent credit standards for a new mortgage loan.

PBL - Thanks Don.

Despite the improved delinquency rate, statistics in the Fed report indicate that the national debt crisis is far from being resolved and consumers are still carrying enormous amounts of debt.

• Total consumer debt declined for the seventh consecutive month to $11.7 trillion, a reduction of $812 billion (6.5%) from the peak at 9/30/2008.
• Mortgage debt declined by 6.4% from the peak in 2008 to $9.4 trillion.
• Consumer debt excluding mortgages has fallen 8.4% from the 2008 peak and now stands at $2.3 trillion.

Total Debt By Composition

Delinquencies are still a major problem that will take years to resolve.

• At June 30, a stunning 11.4% of outstanding debt was in some stage of delinquency compared to 11.9% at March 31.
• There is currently $1.3 trillion of consumer debt that is delinquent of which $986 billion is seriously delinquent, at least 90 days past due.  Although delinquent balances are down 2.9%, serious delinquencies are up 3.1%.
• In the quarter ending June 30th, 496,000 foreclosures were initiated, an 8.7% increase from the first quarter.
• Bankruptcies increased 34% during the quarter to 621,000 from 463,000.

The Fed report dryly notes that mortgage delinquency rates remain at “very unfavorable levels by pre-crisis standards”.

New Delinquent Balances

New Foreclosures and Bankruptcies

The Fed report notes that approximately 272 million credit accounts were closed and 161 million accounts opened over the past year.  The vast majority of the reduction in credit was in the credit card category as lenders canceled accounts due to defaults and less lenient credit standards.  The number of credit card accounts has declined by 23.2% from the 2008 peak.

Accounts By Loan Type