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The Recession's Domino Effect

By: Russ Wiles - Sept. 13, 2009 12:00 A.M.
The Arizona Republic

If it's a Friday evening in 2009, chances are regulators, somewhere, are taking over a bank.

Whether it's in Arizona or Georgia, Illinois or California, the number of shutdowns has been accelerating. When borrowers can't repay their loans and the value of collateral erodes, bank failures often follow.

Recent casualties haven't included the big "money center" banks, which received billions of dollars in federal bailout money. Many failed banks were small and operated only in one state, having attracted only a tiny percentage of deposits within their markets. Many shutdowns have been tied to real-estate loans gone bad, putting particular pressure on institutions in states like Arizona where the boom has gone bust.

First State Bank of Flagstaff closed over last weekend, reopening Tuesday after its shotgun wedding to acquire Sunwest Bank of Tustin, Calif.

It was the third Arizona bank to fail in a three-week stretch, compared with just one failure over the prior 6 1/2 years. Nationally, 92 banks have failed so far in 2009, up from 53 over the prior nine years combined.

More failures could be on the horizon, considering that three in four Arizona banks lost money in the first and second quarters of the year, and nearly two in three saw their capital erode. The number of banks on a federal troubled-bank watch list is at a 15-year high.

A rising failure rate raises various concerns.

It means the economy still hasn't healed. It implies banks lack the cash to lend broadly. It could signify more layoffs in financial Services. Also, nearly every failure drains the FDIC insurance fund, with a possible, if not likely, taxpayer impact.

Things could get worse before they get better, especially for cash-starved small banks. Most of the roughly 60 banks operating in Arizona are modest in size, with only one or a few branches. Often called community banks, they claim to be more responsive than many of the national chains, with local lending officers and other key decision makers.

Most cater to local firms, so when they suffer, the banks do, too.

"Small- and midsized businesses are our (main) customers," said Tanya Wheeless, president and CEO of the Arizona Bankers Association. "We are a reflection of them."

Arizona could be more vulnerable than most states because of the steep descent of the housing market here.

"We do expect failures to continue this year and next and then to taper off," said David Barr, a spokesman for the Federal Deposit Insurance Corp. in Washington, D.C.

Arizona has moved into a fifth-place tie with Nevada, Oregon and Washington for most failures in 2009, as of Friday. Georgia is first, followed by Illinois, California and Florida.

Bad loans tied to the weak housing market are the main culprit, but other factors are emerging. Commercial-real-estate woes also are becoming more of an issue.

"Now we're seeing some of the more traditional economic factors come into play, such as loan problems tied to unemployment," Barr said.

After earning $5.5 billion in the first quarter, bank profitability for the nation slid with a cumulative loss of $3.7 billion in the second.

Bank finances are a lagging indicator, so it's no surprise that failures are rising and profits falling as the economy stabilizes.

"It takes a while for loan losses to roll through at banks," said im Sinegal, a banking analyst at Morningstar Inc. in Chicago. "Bad loans made two or three years ago now are just showing up as losses."

Sinegal calls commercial-real-estate woes the "last straw" for some institutions already weakened by residential lending. Barr acknowledges the FDIC is watching commercial loans more closely.

Glenn Gray, CEO and president of Sunwest Bank, which acquired First State, predicted increased stress generally from commercial lending. "A lot of it was done without sound underwriting guidelines," he said, referring to the often-lax lending criteria of past years.

Dave Ralston, chairman and CEO at Bank of Arizona, said commercial real estate is being crimped by declining demand and tight financing.

"A lot of loans will come up for refinancing, and there will be no place to go," he said.

And as companies shrink their payrolls, they have less need for expanded office space, Ralston said.

Despite the rash of failures, most depositors don't need to worry. Basic FDIC insurance guarantees up to $250,000 per depositor per bank - and that level of protection will continue at least through 2013.

With the three recent Arizona failures, the acquiring banks went further and agreed to honor all deposits, including those above $250,000, Wheeless said.

Before a bank closes, the FDIC usually seeks a "white knight" to take over operations before customers realize what happened. That was the case with First State Bank's six branches, which were closed over the Labor Day weekend and opened Tuesday as Sunwest offices.

"You hope for a non-event," Gray said of the transition of First State branches to Sunwest. "That's what it was."

So, too, for Arizona's two other recent casualties, Phoenix-based Community Bank of Arizona and Gilbert-based Union Bank. They opened as branches of MidFirst Bank of Oklahoma City.

All three Arizona banks were small players, combining for less than 1 percent of statewide deposits. Small banks have an especially tough time raising capital during times of stress. They also can face obstacles attracting more deposits, which can further crimp their ability to lend, said Jack Hudock, public-information officer for the state Department of Financial Institutions.

More non-performing loans, meanwhile, hurt banks' cash flows further, and the declining value of loan collateral erodes their capital base, he said.

The FDIC projects the First State situation will cost the insurance fund about $47 million in bad-loan and other expenses.

Barr said the agency expects to absorb $70 billion in costs and losses tied to bank closures from 2009 through 2013, with $21 billion of that already incurred so far this year.

Banks support the fund by paying insurance premiums and special assessments. If needed, the FDIC also has a $500 billion government line of credit it can tap in a pinch.

When evaluating bank health, the FDIC focuses on six areas: capital adequacy, asset/loan quality, profits/losses, liquidity, management and the ability to manage interest-rate risks.

"We look at many factors, then give banks a rating," Barr said. "It's very difficult to determine who will fail."

The agency doesn't reveal the names of firms on its troubled-bank watch list for fear of inciting a run by depositors. But with 416 names, the list is at a 15-year high.

If there's a silver lining, it's that bank failures open Arizona's banking market to newcomers that typically are more stable.

"We've been wanting to come to Arizona," said Gray at Sunwest Bank, who stressed his company's desire to branch out from its home state. "As difficult as Arizona's economy may be, it's not as challenging as California's."