The money squeeze

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By Doug Childers

Here’s something homeowners facing foreclosure may find ironic: Large commercial and investment banks are caught in a squeeze, too.  They’re scrambling to raise capital.  All those subprime mortgages and related securities have cost banks billions, and it’s affecting their ability to extend more loans. That could impair a recovering economy, which needs new loans to help stimulate growth.
The risk faced by financial institutions is significant. In July, federal regulators seized IndyMac Bank, a large thrift, after it failed to raise new capital. (Treasury Secretary Henry M. Paulson Jr. expects the number of troubled banks to grow in coming months but says the banking system is essentially sound.)
Meanwhile, suspicions about insufficient capital were at the heart of recent stock market turmoil over Fannie Mae and Freddie Mac, which hold or back $5 trillion in mortgages. The Federal Reserve and the U.S. Treasury Department have announced plans to bolster the mortgage finance companies in a crisis. McLean-based Freddie Mac also wants to raise $5.5 billion by issuing common and preferred stock.
So far, banks have raised $260 billion or so worldwide to offset subprime-related losses, according to Investor’s Business Daily, but they’ll need more to recover fully. How much more is unclear.
“I don’t think anybody knows the full scope of this mess, and they probably won’t for a couple years,” says John McCune, research director for SNL Financial, a Charlottesville-based distributor of financial information. Write-downs have already topped $400 billion worldwide. “The challenging part is the losses are still being felt.” The International Monetary Fund has estimated that total losses could approach $1 trillion.

Benefits of shakeout
Luckily for Virginia, the crunch isn’t as painful here.  In fact, Virginia’s community banks may profit from the shakeout from the subprime mess. “Many mortgage origination groups have gone away, and Virginia banks will see an uptick in loan demand,” predicts McCune.

While the subprime crisis has affected McLean-based Capital One Financial Corp. — the nation’s 13th largest bank in deposits — it has weathered the situation better than many other large institutions.  Capital One saw second-quarter profits drop 40 percent because of a sharp rise in its loan-loss provision, but the company continued to generate excess capital. Its deposits increased $4.7 billion to $92.4 billion and available liquidity rose $3 billion to $33 billion. 

Smaller banks have escaped unbruised because they sat out the subprime game. “FDIC-insured banks are doing pretty well in a poor economy because they’re well-capitalized,” says Bruce T. Whitehurst, president and chief executive officer of the Virginia Bankers Association. As a rule of thumb, banks can lend no more than six to eight times their capital reserve. (The exact ratio varies, depending on bank charters.) The commonwealth’s diverse economy is helping Virginia’s banks, too, Whitehurst adds.

While Virginia’s community banks aren’t feeling the subprime pinch, they aren’t necessarily facing a carefree future, either. That will depend on “the general health of the economy and its effect on Virginia business and consumers,” says Joe Face, commissioner of the State Corporation Commission’s Bureau of Financial Institutions.

Options depend on size
So what options do banks have when it comes to adding capital? Several, actually. Choosing the best one depends on a bank’s size and its needs.
“Banks raise capital primarily by offering additional stock to the public, either domestic or foreign, or through trust-preferred stock or securities,” Face says. “Large banks and investment banks might pursue all of these avenues, but they would focus more on domestic or foreign capital. Smaller community banks would focus more on domestic capital and/or trust-preferred stock.”
Factors such as how long the bank will need funding may influence a bank’s capitalization strategy. For example, borrowing from the Federal Home Loan Banks (FHLB) would be a good first option for community and regional banks looking for short-term funding, McCune says. Loans are available to all banks that are members of the FHLB, and the application process is simple because the relationship between the two institutions is already established.

Virginia’s?banking institutions have increased FHLB borrowings by more than 70 percent ($25.7 billion) since the first quarter of 2007, according to SNL Financial.? “This is heavily weighted by Countrywide Bank FSB (increase of $19.5 billion), Capital One NA (increase of $6.4 billion) and E*TRADE Bank (decrease of $1.2 billion),” says SNL Financial analyst Sebastian Hindman.? “Excluding these larger institutions, the state still has increased its dependence on FHLB borrowings, with 50 institutions increasing their balances, as opposed to 16 decreasing their balances.? This amounts to slightly?more than a 33.3 percent increase or approximately $1 billion.”

Foreign investors
On the other hand, banks may find another well-established source for capital is drying up. In the early days of the present credit crunch, some large institutions looking to raise capital turned to foreign governments, especially China and oil-rich countries in the Middle East. “We’ve seen foreign governments investing recently, but it’s driven by the relationship between the decision makers on both sides and the perception of the bank in the market,” McCune says. “Prince Alwaleed bin Talal bin Abdulaziz Alsaud, who is part of the Saudi royal family, has a tight relationship with Citigroup, for example, but I can see others being more conservative until this gets cleaned up.”
In general, both domestic and foreign stock issuances are good options for large institutions looking to raise significant capital, even though it dilutes ownership and stock value, says McCune. “If it keeps the institution afloat, it’s good.”

Stock dilution may be an unavoidable drawback to stock issuances, but distributing a stock widely is a good way to avoid one entity gaining too much control of a bank. “As regulators, we like capital and more capital since it provides a cushion against losses,” Face says. “However, banks must be careful when allowing one party or a group of interested parties to gain too much control of an institution.”?
Because of their advantages, banks may find trust-preferred securities more appealing overall than stock offerings.  “These securities are generally issued by bank holding companies and have characteristics of both subordinated debt and preferred stock,” Face says. “The advantages of these hybrid characteristics are favorable tax, accounting and credit treatment, with an added advantage for banks: It is treated as capital rather than as debt for regulatory purposes.”

Trust-preferred securities are particularly attractive to smaller banks because they can pool their offerings with other banks. “The downside: They tend to carry a higher cost,” McCune says. “They’re loans, essentially, and you’re paying an interest rate that is higher than it was a few years ago.”
Of course, the best, cheapest way to access additional funding is to grow a bank’s depositor base, but it’s also the hardest to implement. “If you and I operate different banks in a town, I’ll have to compete by offering higher yields on deposits,” McCune says. “It tends to increase deposit costs for all banks in the area.” Because it’s hard to raise $1 billion by increasing depositors, this strategy is most effective for smaller community banks. “Acquisitions are always an option, especially if you can acquire a bank with a good deposit base,” McCune says. 

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