Romantic Fallacy

Yesterday evening I got a call from my bud and long-time blogger George Ure about the movement to take deposit money away from mega-banks and put it with community banks.  I reminded him of the mega-panic brought on by Chuck Shumer’s (ahem) unsolicited and unwelcome June 2008 letter that suggested Indymac Bank was insolvent.

George might be best described as an iconoclastic skeptic — he trusts no one to be telling the unspun truth, no matter the topic.

As an early reader of my manuscript on the unfolding mortgage meltdown in early 2008, George had a little bit of a playbook in front of him when Indymac, Wamu, Fannie, Freddie, Lehman and AIG went down like so many dominoes.

The rest of the world is starting to get the joke — that cutting off funding (deposits for banks, repo for hedge funds, capital markets for REITs, etc.) can be engineered by simply changing the emotional state of investors.

George’s skepticism is rooted in real concerns that the seemingly “back to basics” virtues of investing only with community banks also has its share of systemic risk, particularly for the communities those banks serve.

But how can that be?  Didn’t George Bailey save Bailey Building and Loan and thus save his whole town from evil commercial banker Potter?  After all, Potter would otherwise be foreclosing on those delinquent mortgage loans and turning the town into tenants.

Here’s my issue, one that Capra and Stewart never had to answer:

Wasn’t that quintessential community bank insolvent?  Bedford Falls was in the middle of tough times, and all the capital of the Building and Loan was invested in Bailey Park, a new housing development.

That’s exactly the problem with any locally concentrated bank that lends to local borrowers.  Even very well-capitalized (14% capital) community banks are 7:1 leveraged (that other 86%).  If one in seven of their borrowers are in distress, they are done.

Unfortunately for the community, it’s not uncommon to have local events that hit ten or twenty percent of the borrowers – plant closing, delivery delay or contract dispute on a large project for a large borrower, or even really bad weather or a flood.

Most local communities are not economically diverse.  If all the capital supporting local economies is also dependent on that community, good times and bad times will be amplified by that local lender’s capacity to lend.

I recall seeing an interview with a senior member of the community banker’s association, and he was a sober, honest individual.  He didn’t try to say that all our systemic ills can be solved by devolving back to the pre-Depression system of having thousands of small local banks.

Paraphrasing his words “you can only lend to the businesses that are in your community, so Las Vegas community bankers had no choice but to lend to Las Vegas condo developers.”

What we have here is a case of “careful what you wish for.”



2 Responses to Romantic Fallacy

  1. Eric iousa says:

    My spin on this is the FDIC takes care of failures of small banks and so far have not taken money from my pay check. When the TBTF banks lose on there hedge-fund-go-for-broke bets, I and you and our children pay for that years bonuses and all loses of the banks. I do not approve and no longer will deposit money in a bank that pays traders millions for good bets, and has an explicit Treasury/FED gaurantee against failure. If you can convince me that there is no difference, I will hide my money in the mattress 😉

    • hhill51 says:

      Agree 100% on the TBTF banks, and especially on the leverage junkies that get payoffs in the millions when they bet on red and it wins. I actually think it makes sense to put some friction (a tax) on highly leveraged transactions to build up an FDIC-like fund to pay for the cleanup when (not if) one of those young masters of the universe gets it wrong. I’ll be posting some reactions to the Bair/Shapiro testimony that addresses the incentive compensation structure (even now after the clawbacks and equity heavy versions of same).

      Just pointing out that all is not perfect in community bank world, either.

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