Community banks: surviving unprecedented financial reform.

Croasdale, Kathleen ; Stretcher, Robert

THE BEGINNING: THE REAL ESTATE CRISIS

To veteran financiers, the recent mortgage debacle follows the classic pattern of a typical financial craze. Investors were enthusiastic for an asset (residential real estate in this case), which drove the prices up, which attracted more capital, and inflated prices even more, until prices were so bloated that a market failure was inevitable (Ip, Whitehouse & Luccetti, 2007). Martin Feldstein (2008) summed it up by stating, "The unprecedented combination of rapid house-price increases, high loan-to-value (LTV) ratios, and securitized mortgages has made the current housing-related risk greater than anything we have seen since the 1930s."

At first, there were fundamental reasons for home prices to rise. The economy was in a recession, and the Federal Reserve cut interest rates in 2001 and kept them low until mid-2004 (see Appendix C--Historical Target Fed Funds Rate). A migration of foreign savings into the U.S. market also helped keep mortgage rates low. The environment of rising prices may have lulled both buyers and lenders into a false sense of security about the health and stability of the real estate market. Former Federal Reserve Chairman Alan Greenspan even argued repeatedly that there could be no housing bubble in the U.S. He said in late 2004 that the inconvenience and high cost of moving "are significant impediments to speculative trading and.. .development of price bubbles" (Ip, Whitehouse & Luccetti, 2007).

The Fed began raising interest rates in 2004, and mortgage rates followed suit. Buyers started turning to mortgages with lower initial payments, assuming they could sell or refinance the home before the rate adjusted upwards, so home prices kept ticking up. The higher prices allowed borrowers who had trouble making payments to refinance into even bigger loans. Easy refinancing enabled low default rates, and rating agencies continued to give mortgage-backed securities their blessings and high ratings. By the end of 2006, the value of all homes in the U.S. (excluding rentals) reached 153% of GDP, which approximated $21 trillion, and marked the highest proportion in at least 60 years. Before the end of 2007, home prices began to drop and the market value fell to 150% of GDP (Ip, Whitehouse & Luccetti, 2007).

Between 2000 and 2006, home prices had exploded, increasing 60% over rent levels. But between mid-2006 and early 2008, prices had fallen by 10%. In March of 2008, experts were forecasting an additional downward price correction of 15-20%. Widespread defaults and foreclosures lead to an even more dangerous situation, where prices could fall even more substantially. Historically, homeowners facing default were reluctant to part with their homes, expecting that real estate prices would continue to rise. But in the market of falling home prices, reneging on the obligation became a rational decision in the minds of many debtors, causing a continued spiral of foreclosures (Feldstein, 2008).

There are several factors that fostered the growth and imminent demise of the sub-prime mortgage market. For several years, home prices in the United States had consistently appreciated, which made mortgage lending and investing (of all types) very attractive and very profitable. Fueling the fervor, historical evidence gave market participants a false sense of security that home prices would not fall, but instead would "only moderate, in a soft-landing" (Deutsche, 2008, p. 24). This 'fail-proof market allowed originators, investors, buyers and lenders to get too comfortable.

As confidence in sub-prime lending soared, credit standards loosened. Sub-prime borrowers were being offered loan features that were previously reserved for prime mortgage markets. This hysteria over what seemed to be a foolproof market led to irresponsible lending. Mortgages were being closed with loan-to-value (LTV) ratios of around 100%, and borrowers who previously did not qualify for a conventional loan were acquiring mortgages outside of their means. At the time, this was considered innovative. In retrospect, it was clearly imprudent (Deutsche, 2008). Just as Warren Buffet described the manufactured home crisis of 1997-2000 in his 2008 Berkshire Hathaway Annual Report, the residential real estate crisis involved "borrowers who shouldn't have borrowed being financed by lenders who shouldn't have lent." Both parties were relying on home value appreciation to make everything work (2008, p.11). When values started deflating in 2006, 7% of mortgages had LTVs over 100%. If prices continued to decline, the 20% of mortgages with LTVs over 80% would also move to negative equity (Feldstein, 2008).

To compound the issue, as lenders moved away from holding the mortgage loans they had originated, their stake in the borrowers diminished. What was to prevent an originator from pushing a shaky loan through if there were no financial downside for themselves or their institutions? Mortgages were commonly securitized and sold to investors not just in the U.S., but globally. Even more critical to the current catastrophe is that mortgages are bundled together in complex, mortgage-backed securities (MBS). Investors own the rights to the payment streams of these MBS, but not the actual mortgages, which means it is impossible for borrowers and lenders to re-negotiate terms in an effort to prevent foreclosures (Feldstein, 2008). The question then arises: if originators were still holding onto at least a portion of those loans they pushed through rather than selling them off to bond markets, would the crisis have gotten to the current level?

SYSTEMIC RISK/TOO BIG TO FAIL: UNTANGLING THE WEB

After the housing bubble burst, falling home prices and increasing foreclosures were triggering fears on Wall Street. What would follow, a case-by-case rescuing of colossal financial firms, led ultimately to the creation of the "Bailout Bill" and the nationalization of many Wall Street giants. Below is a timeline of events that quickly changed the financial industry as we know it:

* Summer, 2007--The housing market begins showing signs of trouble--prices are falling and foreclosures and inventories are rising.

* June 1, 2007--Two Bear Stearns hedge funds (invested in AAA-rated mortgage-backed securities whose values plummeted) are forced into bankruptcy.

* January 1, 2008--Bank of America purchases mortgage lender Countrywide Financial for a substantially deflated price, rescuing it from failure.

* March 24, 2008--After uncovering billions of toxic subprime mortgages, and hundreds of billions in credit default swaps, Bear Stearns is rescued through a purchase by JPMorgan Chase. The purchase is facilitated by the Fed in an effort to prevent the failure of other Wall Street firms that Bear was indebted to (as a matter of systemic risk).

* July 11, 2008--IndyMac Bank is closed by the Office of Thrift Supervision (OTC). The FDIC protects the bank's deposits.

* September 7, 2008--The U.S. Treasury takes 80 percent ownership in Fannie Mae and Freddie Mac, nationalizing the mortgage firms. The firms combined had $5 trillion in mortgages on the books.

* September 15, 2008--Lehman Brothers collapses after the Fed refuses to bail the firm out, and no buyer comes forward. While Lehman was a larger firm than Bear, the perception of moral hazard outweighed the systemic risk.

* September 15, 2008--The Dow Jones Industrial Average (DJIA) plummets more than 500 points in a single day.

* September 16, 2008--Insurance giant AIG is nationalized after insuring Lehman's credit default swaps without sufficient cash in the bank to cover the commitments. The government takes an 80% ownership and agrees to an $85 billion loan, in the first of many steps to rescue the firm.

* September 17, 2008--The DJIA tumbles 449.36 points.

* September 21, 2008--Goldman Sachs and Morgan Stanley, the last two investment banks on Wall Street, become bank holding companies regulated by the Federal Reserve.

* September 25, 2008--In a transaction facilitated by the FDIC, JPMorgan Chase acquires Washington Mutual upon closure by the OTC.

* September 29, 2008--The first version of the Bailout Plan is rejected by the House of Representatives, sending further shockwaves throughout Washington and Wall Street.

* September 29, 2008--The DJIA tumbles 777.78 points. This is the largest one-day point loss in the index's history.

* October 3, 2008--Congress passed the Emergency Economic Stabilization Act of 2008 (the Bailout Plan) and established the $700 billion Troubled Asset Relief Program (TARP).

* October 3, 2008--Deposit insurance is increased by the FDIC from $100,000 to $250,000 (as authorized by the EESA of 2008).

* October 12, 2008--Wells Fargo purchases the nearly-collapsed Wachovia.

* October 13, 2008--U.S. Treasury Secretary Paulson requires the CEOs of the nation's 9 largest banks to accept billions of dollars in direct cash infusions: JPMorgan, Bank of New York/Mellon, Merrill Lynch, State Street, Morgan Stanley, Goldman Sachs, Bank of America, Citigroup, Wells Fargo.

* November 10, 2008--AIG receives an additional $30 billion in federal aid.

* June 17, 2009--$68 billion in TARP money is repaid by the 10 largest recipient banks.

* December 11, 2009--The House passes the Wall Street Reform and Consumer Protection Act of 2009

** * Timeline sources: Kirk, 2009 and http://www.dems.gov/ financial-timeline

DERIVATIVE TRADING

As the firms were dismantled, and portfolios deciphered, it became very apparent that the subprime mortgage crisis was created by more than just the toxic assets. As mentioned previously, the loans were "securitized" and bundled and sold to bond funds that were touted as investment-grade mortgage-backed securities (MBS). These bonds were then "insured" via credit derivatives, namely credit default swaps. These financial contracts allow a party to reduce or remove credit exposure from a bond, loan or index [without any direct investment into the underlying asset or firm] (OCC, 4th Quarter 2008). Problems arise when these investments are being traded by commercial banks and investment firms over-the-counter, with very little regulation or oversight.

Warren Buffet explained to the shareholders of Berkshire Hathaway the dangers of derivatives in his 2008 annual report. He stated, "They have dramatically increased the leverage and risks in our financial

system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these institutions, totally missed the cooking of the books" (Berkshire Hathaway, 2008, 16).

In this speculative market lies the regulatory issue. Because derivative activities are netted against each other, it is virtually impossible to truly determine a firm's position.

Figure 1 shows the number and value of the derivative contracts, and the net value of the receivables less the payable. It does not, however, give any representation to the counterparty or counterparties that are on the other side of the transaction. As these are traded in an over-the-counter market, and often traded secondarily without the other party's notice, the riskiness of the portfolio cannot be easily measured. Buffett continues his warning on derivatives by saying, "I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can't audit these contracts, and regulators can't regulate them. When I read the pages of 'disclosure' in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don't know what is going on in their portfolios (and then I reach for some aspirin)" (Berkshire Hathaway, 2008).

According to the OCC's Quarterly Reports on Bank Trading and Derivatives Activities (3rd Quarter 2008--1st Quarter 2010), over-the-counter derivative portfolios are still very much alive and well in many of our largest commercial banks. In fact, as of March 31, 2010 five large commercial banks represent a staggering 97% of the total banking industry notional amounts, and 86% of industry net current credit exposure. Figure 2 represents the top 5 commercial banks' total derivative credit exposure as a percentage of risk based capital. HSBC was previously in the top five, so is also shown to represent the overall market more closely. Wells Fargo and Wachovia data are combined as of 2Q 2009.

[FIGURE 2 OMITTED]

While not all derivative investments carried by banks are credit derivatives, they do make up over $14 trillion of the $216 trillion market. Also noteworthy: the total assets of the commercial banks and trust firms carrying these stupefying balances approximate only $10.5 trillion (Comptroller of the Currency, 2010).

It is interesting that in an industry where risk is to be mitigated, and portfolios managed prudently, that this type of investment is allowed, especially for speculative purposes. In 2009, the House Financial Services Committee presented the Wall Street Reform and Consumer Protection Act. One of the facets of the proposal is to attempt to regulate derivatives. The proposed legislation has not yet been passed into law, so only time will tell if any serious progress is made in truly cleaning up Wall Street firms.

THE FEDERAL RESERVE AND FDIC STEP IN

Bailing these giants out did not bring an end to the Too Big to Fail (TBTF) phenomenon, nor did it bring an end to derivative trading. In fact, the recent bank and broker-dealer stress tests increased the number of TBTF firms from 11 to 19. While the stress test threshold appears to be $100 billion in assets, where a bank is determined to be systemically critical is still a blurry line. In order to clarify, capital standards would need to be augmented, and regulators and the markets would need to downsize these companies. Additionally, at some point, the government guarantees would need to be un-tethered from these Goliaths (Heasley, 2009e, p. 31).

The Federal Reserve had dropped its overnight Fed Fund rates to floating between 0 and 25 basis points in an effort to encourage lending. Those that received TARP funds had no incentive to lend, because the greater fear was being caught in the middle of another run with insufficient capital. Those banks that were already well capitalized were now drowning in liquidity and earning literally nothing for it. There were no safe bonds to invest in, and credit restrictions were such that cold hard cash had nowhere to go.

The Federal Deposit Insurance Corporation (FDIC) also began preparing for a run on the banks. Consumers that do business with any bank, not just the Goliaths of Wall Street, began to panic. To assure consumers that their money was still safer in the bank than hidden under a mattress, FDIC insurance was temporarily increased from $100,000 to $250,000 per depositor on October 3, 2008. This became effective immediately upon President George W. Bush's signature and was due to expire on December 31, 2009 (Federal Deposit Insurance Corporation, 2008b). The expiration date was extended to December 31, 2012 when President Barack Obama signed the Helping Families Save Their Homes Act on May 20, 2009 (Federal Deposit Insurance Corporation, 2009b). The increase to $250,000 was made permanent on July 21, 2010 when the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed by President Obama.

Less than 2 weeks after the temporary deposit insurance increase was granted, the FDIC had also provided for full FDIC deposit insurance coverage for non-interest bearing transaction accounts held at participating FDIC-insured institutions, currently set to expire on December 31, 2010 (Federal Deposit Insurance Corporation, 2010a). The FDIC was not only concerned about the public making a mass exodus from the federally-insured banks, but also on what the impending bank failures effect would be on the Deposit Insurance Fund (the Fund, or DIF). As it became very clear that numerous banks were in trouble, a series of increased assessments were charged against all FDIC-insured institutions, regardless of their portfolios, solvency or stability.

Announced December 16, 2008 and effective January 1, 2009 the FDIC increased assessment rates by seven basis points (bp) annual rate uniformly across all risk categories for the first quarter 2009 assessment period, and promised that more changes were coming early in 2009 (Federal Deposit Insurance Corporation, 2008a). On February 27, 2009 the FDIC, as promised, adopted a final rule modifying the risk-based assessment system. Effective April 1, 2009 initial base rates were set at 12-45bp, depending on the financial institution's risk category. Also, because the fund reserve ratio fell below 1.15 % in June 2008, and was expected to remain below 1.15%, the newly implemented Restoration Plan period was extended from five years to seven years due to extraordinary circumstances (Federal Deposit Insurance Corporation, 2009b). Figure 3 depicts the exponential growth in regular, quarterly assessment fees charged to FDIC-insured financial institutions since 2007.

[FIGURE 3 OMITTED]

In May 2009, the FDIC imposed an additional special assessment in an effort to save the DIF from falling to a level that the Board felt would adversely affect public confidence, or to a level that would be close to, at or even below zero. The final rule imposes a five bp special assessment on the institutions' assets minus Tier 1 capital as reported as of June 30, 2009 (Federal Deposit Insurance Corporation, 2009f). Most recently, in November 2009, it was determined that "institutions must prepay their estimated quarterly risk-based assessments for the 4th quarter of 2009, through the 4th quarter of 2012, along with their risk-based assessments for the 3rd quarter of 2009" (Federal Deposit Insurance Corporation, 2009c). A five percent annualized growth rate is worked into the prepayment, as well as a 3 basis point increase in the assessment rate itself (Federal Deposit Insurance Corporation, 2009c).

To better illustrate the affect this has on financial institutions, consider a well capitalized, Risk Category I firm with approximately $225 million in assets (as of September 30, 2009) as an example. In recent years, say 2004-2007, this bank would have paid about $25,000 in annual assessment fees to the FDIC. As fees began to increase in 2008, this same healthy firm would pay almost $100,000 in assessment fees for the year. In 2009, that same firm could expect to pay over $375,000 in quarterly and special assessments. In a span of two years, insurance expense has grown exponentially. Regular quarterly assessments grew at a rate of 300% from 2007 to 2008, and an additional 275% from 2008 to 2009. The prepaid assessments for 2010-2012 will result in additional check made payable to the FDIC in the amount of approximately $1.1 million. See also Appendix A for a depiction of historical FDIC assessment rates.

LET THE REFORM BEGIN: CFPA

The underlying theme for much of the unprecedented regulation proposal is to protect the consumer from future financial ruin. The first, and foremost, concern to bankers is the proposed Consumer Financial Protection Act (CFPA).

In late June of 2009, the administration circulated a white paper expressing its ideas for regulating the financial system, including the creation of the CFPA as a new federal-level agency whose focus in entirely on consumer protection. The proposal, in essence, would deny certain financial products and/or services to consumers who are deemed inadequately sophisticated, experienced or educated in financial products.

According to the white paper, investment products and services already regulated by the Securities and Exchange Commission (SEC) or Commodity Futures Trading Commission (CFTC) would be excluded from the umbrella of CFPA regulation. In some aspects, the proposed plan is self-contradictory. The white paper call for consistent standards, but the legislation draft leaves the SEC and CFTC jurisdictions untouched, as well as the states' jurisdiction over insurance. The legislation actually creates arbitrage opportunities by separating the banks and financial services firms under the CFPA, and leaving insurance and securities under their current regulators (Wallison, 2009, p. 1-2). The jurisdiction would, however, cover all credit, savings and payment products and according to its mission: "to help ensure that ... consumers have the information they need to make responsible financial decisions ... [and] are protected from abuse, unfairness, deception or discrimination" (U.S. Department of the Treasury, 2009, p. 57). Funding of the agency will come from the fees imposed on those companies that are subject to the legislation, including: banks, credit card companies, local finance companies, department stores, etc. (Wallison, 2009, p. 2).

Part of the new jurisdiction will include consumer disclosures. Historically, consumers were expected to make decisions for themselves based on receiving necessary information. According to the U.S. Department of Treasury's "Financial Regulatory Reform: A New Foundation," the new "reasonableness" standard requires a "balance in the presentation of risks and benefits, as well as clarity and conspicuousness in the description of significant product costs and risks" (Wallison, 2009, p. 2).

Clear and concise disclosure is appropriate and necessary for investors to make informed decisions, but the trouble will begin if and when the standards implement what the white paper calls "plain vanilla" products and services, or what the draft calls "standard consumer financial products or services", that are to be both "transparent" and "lower risk". In other words, the CFPA will be authorized to require all financial providers and their intermediaries to offer uniform, government-approved products alongside any other "lawful products" the firm chooses to offer (Wallison, 2009, p.3).

By requiring firms to provide the same "plain vanilla" products and services in addition to other products of the companies' choice, it is then left to the provider to decide who is capable of understanding products deemed too complicated, and who should only be allowed to invest in "simple" products (Wallison, 2009, p.3). The white paper notes: "Even if disclosers are fully tested and all communications are properly balanced, product complexity itself can lead consumers to make costly errors" (U.S. Department of the Treasury, 2009, p. 66). It becomes a matter of denying access to some people because of actual or perceived deficiencies in experience, sophistication and even intelligence, but without any specific guidelines on how that is to be determined.

Wallison poses a simple, yet pertinent question, "if there is a plain vanilla product, who is going to be eligible for the product that has strawberry sauce?" (2009, p. 3). Some very troubling questions being posed by financial service providers include how are these determinations of intelligence or sophistication going to be made, and who has to do the determining? What standards will be followed? Will the CFPA provide guidelines to protect the institutions it is intended to regulate, or is it just going to be a lawsuit free-for-all when consumers figure out they were offered one type of product over another, without ever being given a choice? Whether a provider offers "safe" products to ordinary consumers, or complex products to the well educated and sophisticated, the providers will be at increased risk of litigation (Wallison, 2009, p.3).

There are several possible victims to the current proposed legislation. Consumers will have their financial decisions largely made for them based on their perceived ability to handle certain types of products. Financial providers will be caught in the middle of risking either a CFPA enforcement action or a possible lawsuit, in trying to determine whether a particular consumer is eligible for each category or type of product. Innovation will also suffer. Fewer will be willing to risk creating a new product, when it will be safer and easier to simply offer what the government has deemed "plain vanilla". Low-cost credit will also be affected. The cost of obtaining approval--by whatever means will be required--on any product beyond plain vanilla will increase substantially, and reduces the availability of said innovative products (Wallison, 2009, p.5).

On July 21, 2010 President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which among other things, established the Bureau of Consumer Financial Protection. The "Bureau" is the new federal regulator and has been empowered to regulate the 'offering and provision of consumer financial products or services'. Bankers are anticipating more restrictive requirements for offering consumer products and services as the Bureau begins issuing new regulations (Independent Bankers Association of Texas, 2010).

One of the most interesting elements of the proposal is the transferring of authority to enforce the Community Reinvestment Act (CRA) to the CFPA. The white paper notes that those that argue that CRA had anything to do with the sub-prime meltdown and subsequent financial crisis are unfounded, and lack any evidentiary basis (U.S. Department of the Treasury, 2009, p. 69). Clearly, those that disagree with the statement are ignorant to the basic functionality of CRA, and its significance in generating sub-prime and other non-traditional mortgages (Wallison, 2009, p.6).

From the National Community Reinvestment Coalition's 2007 publication entitled CRA Commitments: "Since the passage of CRA in 1977, lenders and community organizations have signed over 446 CRA agreements totaling more than $4.5 trillion in reinvestment dollars flowing to minority and lower income neighborhoods." (Wallison, 2009, p.6). In order to obtain an "outstanding" rating, banks must demonstrate the "extensive use of innovative or flexible lending practices." (Wallison, 2009, p.6).

While the CRA requirements encourage innovation, the new CFPA language discourages anything outside of plain vanilla. It is unclear yet which the administration will hold in higher regard, but one banker's sentiment as expressed to his shareholders in early 2009, is very clear towards the affect CRA had on the sub-prime mortgage crisis:

"Under the umbrella of the Community Reinvestment ACT (CRA), a tremendous amount of pressure was put on banks by the regulatory authorities to make loans, especially mortgage loans, to low income borrowers and neighborhoods. The regulators were very heavy handed regarding this issue. I will not dwell on it here but they required [our bank] to change its mortgage lending practices to meet certain CRA goals, even though we argued the changes were risky and imprudent" (Wallison, 2009, p.6).

For years, bankers have been encouraged to make more loans to the underprivileged, which generally includes those that have blemished credit, low credit scores, insufficient down payments, insufficient employment history, and low incomes. These are not borrowers that will qualify for prime mortgages. To these borrowers, plain vanilla is not a viable option. These subprime and non-traditional loans were then bundled into mortgage-backed securities, sold to Fannie, Freddie Mac and Wall Street investment banks. It is unclear how the "rigorous application" of the CRA program by the proposed CFPA will work. The innovative and flexible lending practices that have been pushed by CRA for so many years are a direct contradiction of the CFPA's goals (Wallison, 2009, p.6-7).

Most would agree that clear, concise disclosure is critical to sound decision-making by consumers. However, the CFPA proposal reaches far beyond just making sure the average investor is aware of the risk and possible reward of each investment. The underlying purpose of the CFPA likely comes from a desire to protect consumers from hazardous investments. In the wake, however, will be many Americans with reduced financial services options, while those considered to be more sophisticated and/or better educated will see little impairments at all to their choices.

Community banks, in particular, had very little to do with the current economic meltdown, yet the industry is being subjected to over-reaching legislation that is intended to reign in those deemed too big to fail. Community bankers did not offer the same non-traditional or sub-prime mortgages and investments that are at the core of the onslaught of regulation such as the CFPA. The litigation risk alone is substantial to a community bank, that does not have its own legal team on stand-by, and who doesn't have the implicit guarantee that the U.S. government will bail them out if they make too many bad decisions.

UDAP AND ODP

Another area of contention for regulators regards the activities that are deemed to be unfair or deceptive. There is an entire regulation dedicated to preventing these activities known as the Unfair and Deceptive Acts or Practices (UDAP) statute. Recently, overdraft privileges on checking accounts came under UDAP fire.

Senate Banking Committee Chairman Chris Dodd discussed the proposed changes on overdraft coverage programs, including the requirement to get a customer's consent before enrolling them in a program. Additional consumer protections proposed in The Fairness and Accountability in Receiving (FAIR) Overdraft Coverage Act include:

* Opt-in signed by customer before allowing coverage in an overdraft protection program,

* Limiting the number of fees banks can charge per month and per year for overdraft coverage,

* Requiring that fees be proportional to the cost of processing the overdraft item,

* Ending the institutions' ability to manipulate the order in which transactions are posted (e.g., paying the largest item first and incurring more fees),

* Requiring that customers are notified by email, text, or traditional mail when they overdraw their account,

* Requiring that customers are warned if an ATM or teller transaction will overdraw their account, and to be given an opportunity to cancel the transaction.

** (Source: United States Senate Committee on Banking, Housing and Urban Affairs, 2009b).

The implications of such legislation are far-reaching in the banking industry. These changes will effectively change the nature of the banking and payments business. Certain products and services will not survive the reform if it is passed as written. The proposed regulations are intended to address what the agencies see as a critical deficiency in the banking market: those with the least financial assets often pay a premium for basic banking services, and those prices or fees may not be fully understood by them (Fine, Goldberg & Hayes, 2009, p. 33).

Fees are a crucial revenue source to banks. Consumer deposits generate $50 billion in pre-tax earnings industry wide. Demand deposit accounts represent less than 20% of total consumer deposit balances, but account for over 35% of consumer deposit profits. There are two factors that fuel that income. First, there is little to zero interest paid on these types of accounts so they generate a higher net interest margin. Second, the fee income is greater on demand transactional accounts than other types of deposit accounts. Fee income, however, has changed over the past 15 to 20 years as the Free Checking account has regained popularity. Rather than charge every single customer a flat rate simply for having a checking account, incident fees are generated from other sources, such as overdraft protection. Incident fees are intended to promote responsible money management, and to compensate the bank for the cost and risk uncured by extending the overdraft protection (Fine, Goldberg & Hayes, 2009, p. 34).

Lightspeed Research in Cambridge, Massachusetts released a study on overdraft fees and found that most customers do not habitually overdraw their checking accounts. Below is a depiction of the typical number of overdraft fees paid in a 12-month period based on the Lightspeed data. Note that 63% of the customers paid $0 in overdraft fees, while only 1% paid 51 or more fees in the year (Fine, Goldberg & Hayes, 2009, p. 37).

While most would agree that an overdraft fee is a fair penalty for misuse of a checking account, the administration feels this is an example of the few paying for the many. While the majority of banking consumers do enjoy free checking privileges, a small percentage of consumers bear the brunt of a disproportionate share of the fee burden, and this is what Congress wants to change. Tragically, changing the fee structure of the banking industry is not going to come without costs. As banks are forced to make up much needed fee income from other sources, the odds are good that products such as the Free Checking account will be a thing of the past. Banks will likely re-institute monthly service charges on checking accounts (Fine, Goldberg & Hayes, 2009, p. 36).

Furthermore, it is likely that the overall cost of banking to the consumer will actually increase rather than decrease as the fee revenue is shifted away from the conservatively regulated banking industry and towards the free market. The reduction in checks and electronic transactions paid into the overdraft will result in more items being returned to vendors and creditors as insufficient. These vendors and creditors will in turn charge a fee to the consumer for the same returned item that the bank could have paid. In addition to the per item fee, merchants may choose to increase interest rates, refuse future payments, etc.

The changes to the UDAP statute, again, are surely proposed with the best of intentions for the consumers. Overdraft fees, however, are not at the root-cause of the financial crisis and this reform will do little if anything to improve the overall industry, but rather, will potentially increase the average cost per consumer instead of decrease it.

Other areas of the industry under closer scrutiny for consumer protection include credit cards, interchange fees, and lending disclosures. It is an ever-changing market, caught in the middle of the perfect storm. Legislation is constantly being proposed, reformed, revised and implemented. It will be a while before the banking industry settles into its new place, with its new rules, regulations and regulators.

COMMERCIAL REAL ESTATE

As many banks are still treading water to stay afloat due to problems with residential real estate foreclosures, federal regulators are bracing themselves for the next wave--commercial real estate (CRE). CRE is particularly concentrated in the portfolios of smaller community and regional banks, and regulators are encouraging reworking those loans in an effort to prevent the next crisis. CRE loans are the second-largest loan types after mortgages.

Banks hold over half of the $3.4 trillion in outstanding CRE debt, and Deutsche Bank AG has projected up to $300 billion in CRE losses for those banks. Construction and development loans top the list for possible default, not investments on existing properties, because these loans are not generating any revenue from leases or purchases, making it easier to fall behind on note payments (Paletta, 2009c).

Federal regulators have issued guidelines to encourage lenders to restructure problem loans, rather than proceeding with foreclosure. The opinion of the agencies, as well as by many bankers, is that giving borrowers time to recover from diminishing operating cash flows, depreciated values and lulls between completion and the sale of commercial property will the borrowers to salvage their properties and their credit. Critics feel that restructuring slow debt is delaying the inevitable non-payment and foreclosure. In many cases, "the properties are still generating enough income to pay debt service" (Wei, 2009). As long as the borrower is making efforts, it is wise to prudently restructure the debt, and to keep it from becoming a non-earning asset on the bank's books.

So what does this mean for bankers, particularly at community and regional banks? Expect more reform to come down the pipelines, and closer scrutiny by the agencies (OCC, FDIC, NCUA, etc.). Lending restrictions have already tightened, and it will become increasingly more difficult to secure loans using commercial real estate as collateral. Unlike the residential real-estate crisis, these loans are not generally of the sub-prime variety, nor were they written under nontraditional terms. The bottoming out of the economy has directly affected the value of the underlying asset unfavorably and both borrowers and lenders are making efforts to keep afloat.

COMPARATIVE DATA: UNIFORM BANK PERFORMANCE REPORTS (UBPR)

Lobbyists for Wall Street may feel that they have more than paid for the sins of the Too Big to Fail giants, but analysis of the numbers show that in many ways, the smaller community banks are footing a disproportionate burden in the efforts to save the industry. Appendix B compares data from the Uniform Bank Performance Report for peer group 1 and peer group 4. Peer group 1 is comprised of those banks that have an excess of $3 billion in assets. Examples of banks in this category are J.P. Morgan Chase and Bank of America. Peer group 4 is a sampling of smaller community banks that have $100 to $300 million in assets, are located in a metropolitan area, and have three or more full service offices (UBPR data can be found at www.ffiec.gov).

In reviewing available UBPR and Bank Data reports from the FFIEC, it was noted that there has been significantly more turmoil in the smaller asset-sized peer groups. For instance, at September 30, 2007 there were 836 banks in peer group 4. Of these, 41 were in the red ink at quarter's end (roughly 5% of the peer group), with losses ranging from $25,000 to $7,409,000. Fast forward 2 years to 2009 and at December 31 there were only 776 banks in the same peer group with an astonishing 277 banks in the negative (or 35.7%), with more significant losses of $28,000 upwards to $41,387,000.

While mergers and acquisitions can account for a portion of the decrease in financial institutions over a 24-month period, it is quite clear that failures have been a more significant cause. Appendix B compares additional trends between the mega-banks and the community banks. While both classes are struggling in nearly all areas when compared to December 31, 2006, community banks are taking a bigger hit across the board. The number of banks in peer group 1 has only decreased by roughly 1.1% while peer group 4 is over an 8% decline. Net income is also on a steady decline, with peer group 1 banks reporting a negative change in income of approximately 85%, peer group 4 banks have shrunk income by a whopping 122% in 3 years (Federal Financial Institutions Examination Council, UPBR).

It is also interesting to look at various interest streams, both income and expense. Smaller banks typically rely more on interest-generated income and less on service fees. As well-capitalized community banks struggle to generate interest income by lending to qualified borrowers or investing in overnight funds, the mega-banks continue to increase non-interest and fee-based income. Peer 1 banks actually show a nearly 7% increase in non-interest income to average assets over a three year period. A final comparison is between the rates earned on overnight investments in Fed Funds purchased, and conversely the cost of funds to provide interest-bearing deposits to consumers. Appendix B shows that the larger banks consistently earn a slightly higher rate on overnight investments with the Fed, and also enjoy a lower cost of funds. Both interest streams have been more negatively affected for community banks than for Wall Street and other conglomerate banks. This is an example of how a bank that is implicitly, and now in many cases explicitly, guaranteed by the Federal government reaps the benefits even when it comes to borrowing and lending interbank funds.

CONCLUSION

As of September 18, a staggering 119 financial institutions have failed in 2010 according to the statistics found on www.fdic.gov. Additionally, 140 banks closed in 2009, compared to only 25 in 2008 and 3 in 2007. At the heart of the current economic disaster are questionable lending practices and the faith that was put into the continued success of those mortgages and their derivatives. The disintegration of the housing market has affected almost everyone from Wall Street to Main Street to Elm Street. In addition to billions of taxpayer dollars being injected into the financial system in a desperate effort to save the U.S. economy, federal regulators are taking actions to ensure that consumers are not victimized any further by unfair and deceptive practices, or murky disclosures. While the clear culprits in the fiasco are the people and programs that pushed for unsuitable and lax mortgage underwriting, and the firms that invested too heavily in both sides of sub-prime lending, it will ultimately be the community banks and consumers that pay the highest price as reformation intended to protect, will ultimately come at a much higher price.

Appendix A: Historical Quarterly FDIC Assessment Rates

January 1,1997-December 31, 2006

                                         Supervisory Group

                                  A              B              C
Capita] Group                (CAMEL 1-2)     (CAMEL 3)     (CAMEL 4-5)

1--Well Capitalized              0 bp           3 bp          17 bp
2--Adequately Capitalized        3 bp          10 bp          24 bp
3--Under Capitalized            10 bp          24 bp          27 bp

January 1, 2007-December 31, 2008

                                         Supervisory Group

                                  A              B              C
Capital Group                (CAMEL 1-2)     (CAMEL 3)     (CAMEL 4-5)

Well Capitalized                  I              II            III
Adequately Capitalized          5-7 bp         10 bp          28 bp

                                 III                            IV
Under Capitalized               28 bp                         43 bp

January 1-March 31, 2009

                                         Supervisory Group

                                  A              B              C
Capital Group                (CAMEL 1-2)     (CAMEL 3)     (CAMEL 4-5)

Well Capitalized                  I              II            III
Adequately Capitalized         12-14 bp        17 bp          35 bp

                                 III                            IV
Under Capitalized               35 bp                         50 bp

April 1,2009-??

                                  Supervisory Group

                                 Risk           Risk
Capital Group                 Category I    Category II

Initial Base Assessment
  Rate                         12-16 bp        22 bp
Unsecured Debit
  Adjustment (added)          -5 to 0 bp     -5 to 0 bp
Secured Liability
  Adjustment (added)          0 to 8 bp      O to 11 bp
Brokered Deposit
  Adjustment (added)             N/A          O to 10
Total Base Assessment            7 to          17 to
  Rate                         24.0 bp        43.0 bp

                                  Supervisory Group

                                 Risk           Risk
Capital Group                Category III   Category IV

Initial Base Assessment
  Rate                          32 bp          45 bp
Unsecured Debit
  Adjustment (added)          -5 to 0 bp     -5 to 0 bp
Secured Liability
  Adjustment (added)          0 to 16 bp    0 to 22.5 bp
Brokered Deposit
  Adjustment (added)           O to 10        O to 10
Total Base Assessment           27 to          40 to
  Rate                         58.0 bp        77.5 bp

http://www.fdie.gov/deposit/insurance/assessments/proposed.html

Appendix B: Uniform Bank Performance Report Comparative Data
Peer Group 1 vs. Peer Group 4

                            12/31/2009    12/31/2008    12/31/2007

Number of Banks in PG
  PG 1                             130           137           137
  PG 4                             776           807           832
Net Income (in 000s]
  PG 1                          13,744         3,079        66,087
  PG 4                           (391)           353         1,373
Interest Income/Average Assets
  PG 1                            4.37          5.25          6.17
  PG 4                            5.22          5.99          6.84
Interest Expense/Average Assets
  PG 1                            1.29          2.06          2.96
  PG 4                            1.65          2.30          2.91
Non-Interest Income/Average Assets
  PG 1                            1.38          1.16          1.25
  PG 4                            0.67          0.70          0.75
Non-Interest Expense/Average Assets
  PG 1                            2.83          2.94          2.66
  PG 4                            3.30          3.25          3.24
Net Interest Income (TE)/Average Earning Assets
  PG 1                            3.29          3.42          3.51
  PG 4                            3.86          3.96          4.23
Yield: Fed Funds Sold & Resales
  PG 1                            0.35          2.21          5.20
  PG 4                            0.20          2.13          5.07
Cost of All Interest-Bearing Funds
  PG 1                            1.60          2.53          3.65
  PG 4                            2.13          3.01          3.84

                                           % Change
                                           12/31/06-
                            12/31/2006     12/31/09

Number of Banks in PG
  PG 1                             132        -1.10%
  PG 4                             846        -8.27%
Net Income (in 000s]
  PG 1                          92,027       -85.06%
  PG 4                           1.740      -122.46%
Interest Income/Average Assets
  PG 1                            5.95       -26.55%
  PG 4                            6.62       -21.15%
Interest Expense/Average Assets
  PG 1                            2.70       -52.22%
  PG 4                            2.49       -33.73%
Non-Interest Income/Average Assets
  PG 1                            1.29         6.98%
  PG 4                            0.78       -14.10%
Non-Interest Expense/Average Assets
  PG 1                            2.56        10.55%
  PG 4                            3.21         2.80%
Net Interest Income (TE)/Average Earning Assets
  PG 1                            3.55        -7.32%
  PG 4                            4.44       -13.06%
Yield: Fed Funds Sold & Resales
  PG 1                            5.01       -93.01%
  PG 4                            4.97       -95.93%
Cost of All Interest-Bearing Funds
  PG 1                            3.34       -52.10%
  PG 4                            3.32       -35.84%

REFERENCES

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Federal Deposit Insurance Corporation. (2008b). Deposit insurance coverage, temporary increase in coverage (Financial Institution Letter No. FIL-102-2008). Arlington, VA: FDIC Public Information Center.

Federal Deposit Insurance Corporation. (2008c). Temporary Liquidity Guarantee Program; FDIC announces temporary program to encourage liquidity and confidence in the banking system. (Financial Institution Letter No. FIL-103-2008). Arlington, VA: FDIC Public Information Center.

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Federal Deposit Insurance Corporation. (2009b). Deposit insurance assessments, final rule on assessments: amended FDIC restoration plan; interim rule on emergency special assessment (Financial Institution Letter No. FIL12-2009). Arlington, VA: FDIC Public Information Center.

Federal Deposit Insurance Corporation. (2009c). Prepaid assessments, final rule. (Financial Institution Letter No. FIL-63-2009). Arlington, VA: FDIC Public Information Center.

Federal Deposit Insurance Corporation. (2009d). Regulation Z--Open-end consumer credit changes, notice of immediate and 90-day changes. (Financial Institution Letter No. FIL-44-2009). Arlington, VA: FDIC Public Information Center.

Federal Deposit Insurance Corporation. (2009e). Special assessment, final rule. (Financial Institution Letter No. FIL-23-2009). Arlington, VA: FDIC Public Information Center.

Federal Deposit Insurance Corporation. (2009f). Special Assessments Final Rule. (12 CFR Part 327, RIN 3064AD35). Arlington, VA: FDIC Public Information Center.

Federal Financial Institutions Examination Council. Uniform bank performance report peer group data. Retrieved from www2.fdic.gov/ubpr/

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Kathleen Croasdale, First Bank of Conroe

Robert Stretcher, Sam Houston State University

Figure 1. Derivatives Position Example.

                               XYZ Firm Portfolio

                                # of         $ of
                             Contracts    Contracts

Contracts with Positive          8          $1,000
Value
(derivatives receivable)

Contracts with Negative          5           $800
Value
(derivatives payable)

Total Contracts                  13          $200

                             Credit Measure/Metric

Contracts with Positive      Gross Positive Fair Value
Value
(derivatives receivable)

Contracts with Negative      Gross Negative Fair Value
Value
(derivatives payable)

Total Contracts              Net Current Credit
                             Exposure (NCCE)
                             to XYZ Firm

(Modified from OCC Quarterly Report on Bank Trading and Derivatives
Activities)

Figure 4. Overdraft Fees Breakdown.

0 OD       63%
1 OD       10%
2-5 OD     13%
6-10 OD     4%
11-25 OD    5%
26-50 OD    3%
51+ OD      1%

(Re-created from data provided by Fine, Goldberg & Hayes, 2009)

Note: Table made from pie chart.