As published in the August 1, 2011 Toledo Business Journal
William Isaac,
Fifth Third Bancorp
Can banks grow their
loan portfolios?
Toledo Business Journal recently interviewed William Isaac, former chairman of the Federal Deposit Insurance Corporation (FDIC) and new chairman of Fifth Third Bancorp. He shared the following thoughts:
Toledo Business Journal: Nonperforming Assets of FDIC-insured banks began rising significantly in 2007. Was this an advance signal of the coming banking crisis and did officials use this information to take action?
William Isaac: Yes, it was a signal, and, yes, officials took note of it and began to take some actions, but I don’t think anyone in the regulatory community had any sense of what was to come. I had conversations with regulators during that time and there were concerns about this bank or that bank, but nobody could have predicted what ultimately happened and how serious it would become.
TBJ: Can you share your opinion of the amount or percentage of loan loss reserves that will be able to be recovered?
WI: Most of the banks – at least the public companies – have established very large loan loss reserves, Fifth Third included. Banks are now pulling that money out of the provision because they don’t need as much as they reserved for. Most of the banks – out of an abundance of caution – have over-reserved for losses. There is a formula that the banks use to decide how much allowance they need at any given time and sometimes the formula will say you need more and sometimes the formula will say you need less. We are in that period now. Right now, most of the banks are pulling down their loan loss reserves because the mathematical models they use are telling them they have too much.
Fifth Third and other major banks around the country have been bringing back into income some of the money that was taken from income and taken into the reserves in the past three or four years. Fifth Third was pretty aggressive about doing that, as were other banks, and now they are starting to bring it back in. The issue for banks right now is that because of the weak economy their loan portfolios are not growing as rapidly as we would like. The question that people have is, can the banks make good profits apart from the profits they are getting from bringing reserves back in.
Fifth Third is generating substantial amounts of new loans, in some cases record amounts, and more than we’ve ever generated before. The problem though in getting a loan portfolio to grow is that a record number of existing borrowers are paying down their loans and so you have to run to stay ahead. That’s why you are seeing that the net loan growth is comparatively modest for the industry as a whole. While banks are producing new loans, they are also having a lot of existing loans paid out because companies are becoming more conservative.
The questions that analysts have about the industry is where are the profits going to come from if you don’t have a lot of net loan growth, which is where most bank profits come from. Fortunately, there are profits coming right now from reducing provisions, which are too large. At some point, you run out of that. One hopes that by the time that happens, the net loan growth will be increasing substantially, because borrowers can only pay off so much debt. That will run its course too.
TBJ: How many banks have been shut down since the beginning of the crisis?
WI: Fewer than 400 banks have shut down nationally. During the 1980s when I was running the FDIC we had 3,000 bank failures. We are coming to the end this time because the problem and failed banks are beginning to trail off as they do in an economic recovery. I do not expect to see a lot more failures unless the economy goes into another recession.
TBJ: Approximately how many additional banks do you see being closed in the next 12 to 18 months?
WI: Right now there are about 900 banks on the problem list. Generally speaking, as an average, about 20% of problem banks actually fail, so that would suggest 180 more failures. The problem with that is that when you are moving into recovery that 20% number goes down a lot. At the end of 1991, after 3,000 banks and thrifts had already failed, we still had on the FDIC’s problem list 1,500 institutions. Almost none of those failed. When you get to the end of the cycle and you’re in recovery, problem banks have a way of recovering that they wouldn’t have had if the recession had continued.
Barring a recession, I think we are getting close to the end on failures. I can’t tell you in the next year whether it’s going to be 25 or 50 or 100, although, I would be surprised if it was as high as 100. It would mean we have more problems with the economy then we thought we did.
TBJ: What role did Fannie Mae and Freddie Mac play in the mortgage meltdown?
WI: Fannie and Freddie played a very large role. They were engaged in uncontrolled growth with reckless lending standards encouraged by Congress, particularly the Democrats. The Democrats in Congress and the Clinton Administration really pushed Fannie and Freddie to lower their credit underwriting standards to the point where people didn’t have to make down payments and they didn’t have to abide by serious rules relating to the percentage of income that they could spend on a mortgage. When I came out of school and bought my first house, the rules were 20% down and no more than 25% of your income could be spent on your mortgage payment. That was the standard underwriting rule for real estate and Fannie and Freddie have been making loans with no down payment requirements even after this crisis.
Fannie and Freddie had earnings of approximately $150 billion total in their 35 years. In the last five years they have lost around $280 billion. They have wiped out around 30 years of profits and added that much more loss on top of that.
I’m not happy with our bank regulatory system and that is a major failing of the Dodd-Frank reform law. I don’t think Dodd-Frank fixed anything or that it could have prevented the last crisis and it’s not going to prevent the next crisis. One of the things that needed to be fixed that wasn’t touched is the bank regulatory system. The bank regulatory system has too many regulators and the bank regulations are too fragmented and politicized. The system has been proven ineffective by three major bank crises in my career; the ‘72-‘74 crisis; the 1980s; and the latest crises. The bank regulatory process is broken and I argued strongly that it needed to be fixed and Congress did nothing to fix it, in fact they made it worse. If we don’t fix that then we will be back here again.
TBJ: What impact do you see in terms of pending write-offs from nonperforming loans in the commercial real estate market?
WI: I think commercial real estate has been part of the problem already. The write-downs we’ve been seeing are not just coming from the residential side, they are coming from commercial as well. Commercial has declined in price as much as, if not more than, residential. We’ve already been dealing with those problems. I believe we are working through those problems right now.
TBJ: Can you explain “mark-to-market” accounting and share your opinion of its impact in the recent financial crisis.
WI: Simply put, mark-to-market accounting requires banks to mark financial assets to whatever price they are worth on any given day. It produces a great deal of volatility and is a highly inappropriate way to determine the value of loans or other long-term assets. It is highly procyclical, meaning it exaggerates market swings whether up or down. The move to mark-to-market accounting rules was, without question, a very significant contributor to the panic of 2008 and ensuing severe recession.
The sad thing is that these very bad accounting rules were instituted as a result of a serious misdiagnosis of what went wrong in the S&L industry. No accounting system can work when the Administration, the Congress, and the regulators make a conscious decision to subvert it, as they did in handling the S&L problems in the 1980s.
Virtually everyone knew that the entire S&L industry was badly insolvent, but government leaders did not want to deal with it. The Treasury argued that the S&L problem was not a “solvency” problem but a “liquidity and earnings” problem – the S&Ls just needed broader powers and more time so they could grow their way out of their problems by amassing new, higher-yielding assets to offset their older, lower-yielding assets. It was the height of folly.
The FDIC in the 1980s did not resort to accounting gimmicks to mask the savings bank problems despite considerable pressure to do so. It applied instead historical cost accounting as it was intended to be applied, and resolved the problems in an orderly way at a reasonable cost. The accounting system was not broken and did not need to be fixed.