Is the FDIC Preemtively Cracking Down on Potentially Problematic Loans and Could It Lead to Massive Bank Failures in the Near Term?

Mish at Mish’s Global Economic Trend Analysis is getting emails from readers that tell him that the FDIC is really cracking down on a number of banks’ lending habits. It seems federal auditors are combing through the books of lending institutions and requiring that they downgrade or call in loans that are not yet problematic but could be at risk of becoming problematic over time. This is not good news for small businesses or home buyers. Here’s a portion of a letter he received from someone in the home construction business (Hat tip: Instapundit) :

Banks are forcing developers/builders (especially smaller ones) to give up their properties (unsold homes and lots).

Banks say the reason is that the properties in question are no longer performing assets. I am sure there are some loans out there that are not performing and the owners are going under. I am equally sure that there are plenty of developers that are still selling homes – just not at the pace originally planned on the pro formas.

Having inside information on one of these scenarios that happened today, I cannot help but wonder what is really going on? The bank told a small developer/builder I work for that they were taking back his ongoing subdivision.

He is selling houses and updated pro formas would indicate that the current sales pace would exhaust all remaining lots within 33 months. Yet the bank stated they would only give him until April 15 to find alternative financing. The bank is also willing to let him buy the subdivision at a 33% discount to what is currently owed.

This letter writer also said that from what he’s learned a number of banks are doing the same thing and that they are all working on the same time frame, which is to have these potentially problematic construction loans written off or resolved by the end of the second quarter. Naturally, he was hoping Mish could shed a little light on what might be going on. After contacting a business banker he knows, Mish responded with this (emphasis mine):

Putting 1 and 1 together, I sense the FDIC has decided to take problem loans by the horns, forcing banks to address those problems. Banks with enough capital to take huge writedowns will survive, those that don’t, won’t. Many won’t.

If the above scenario applies to commercial real estate as well as housing, expect a huge wave of FDIC bank takeovers in the third and fourth quarters, spilling over into next year. In the meantime, expect to see more lending contractions as banks fearful of this regulatory crackdown respond with further cutbacks in business lending, especially small business lending.

I’m sure you can all predict the negative consequences that could happen as a result. Small businesses have always been the backbone of America’s economy, but with the already tight credit market, small business owners can’t get loans as it is now and are either laying off employees or closing altogether. Further tightening of the credit markets will force even more people out of work, reducing even further small business’s already shrinking customer base, possibly causing the economy to spiral even more out of control.

Additionally, the housing markets in some states are more brisk than others, but those states whose markets are sluggish at best, which includes my state of Michigan, already have large numbers of homes for sale that have been on the market for a very long time and a continually shrinking credit market will mean they will sit on the market longer still.

Mish then placed an email that he received as an addendum at the end of his post:

A friend of mine is a loan officer at a small regional bank here in Oregon. She told me last week that she cannot get any of her mortgage loans clients approved for loans because the bank has raised the qualifications so high that NO ONE is being approved for home loans. These are all borrowers who are more than qualified. If she does not make her quota this month for closed loans, per her boss, she will be getting her pink slip on March 31.

There is definitely something going on at banks for all types of loans. They are hunkering down. My banker friend believes also that there is going to be a massive failure of many banks in the near future.

Who knows, if normally good candidates for home loans can’t get loans under the newly tightened standards, we might see the land contract make a bit of a comeback as it did in the 1980’s when interest rates were so high no one could afford mortgages.

It is an understatement to say that this news does not inspire confidence, especially since pending home sales dropped 7.6% in January. Some say the bad weather accounts for a lot of that drop; however, if the FDIC crackdown sweeps into the residential housing market, banks will continue to tighten credit requirements and I just don’t see how the housing market can improve under those conditions. And if the housing market continues to show anemic numbers, the economy can’t recover.

Just so I am clear here, I’m not arguing that the FDIC is out of line to require banks to downgrade loans that could cause a problem or to tighten new loan qualification standards. This may be the tough medicine we simply have to accept because of the sub prime mortgage crisis that sent the entire economy into a tailspin. (As an aside, Mark Tapscott at the Washington Examiner published a piece yesterday that pointed the finger directly at Andrew Cuomo and the decisions he made when he was the Secretary of Housing and Urban Development in the Clinton administration.)

I do find it interesting, though, that the FDIC is cracking down on the loan practices of private lending institutions, which could lead to massive bank failures, when just two months ago the federal government removed completely Fannie Mae’s and Freddie Mac’s bailout ceiling for three years, which will allow them to issue loans to their hearts’ desire putting the American taxpayers on the hook for any bad loans.

So, guess where the American people will have to go to get a mortgage if they don’t meet the private banks’ increasingly tough loan qualification standards? The the US government, which is where they may have to go for student loans as well if the Senate passes the Student Aid and Fiscal Responsibility Act.

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