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… Or: “Is Banking Tanking? - Phase 2″

Comptroller of What?:

Maybe the most important public servant you’ve never heard of: John C. Dugan is the current and 29th Comptroller of the Currency for the United States.
The Office Of The Comptroller Of The Currency (OCC) is established as a Bureau of the Department of the Treasury, and performs the role of administrator of National Banks via a national team of Bank Examiners who review National Bank financial statements and management reports. To quote the OCC tag-line, their role is “Ensuring a Safe and Sound National Banking System for all Americans”. The Comptroller of the Currency is appointed by the President for a five-year term.

The OCC was set up during the Civil War to provide the rules and regulations necessary to enable national banks to print money to a value equivalent to the value of Government Bonds they held. This cash was needed to fund the war effort.

Today the OCC still issues rules and regulations for banking and ensures compliance from the national banks. Non-compliance is met with firm interventions, and the OCC has the power to remove officers and directors, negotiate agreements to change banking practices, and issue cease and desist orders as well as civil money penalties. Those “cease and desist orders” can cover an individual banking activity, or all the activities of the bank (ie: closing the bank, and appointing a receiver, such as FDIC).

Here’s a recent example from January 25, 2008:

OCC Closes Douglass National Bank and Appoints FDIC Receiver

http://www.occ.treas.gov/ftp/release/2008-7.htm

The OCC examines lending practices, risk and capital management practices and policies, and liquidity, as well as bank management’s ability to identify and control risk. They also issue rules and regulations governing bank investments, lending, and other practices, and examine compliance with these regulations.

Where non-compliance or undue prudential risk is identified the OCC can enforce some pretty severe supervisory conditions. Here’s a recent example from January 8, 2008:

AGREEMENT BY AND BETWEEN Texas National Bank, Mercedes, Texas and The Comptroller of the Currency

http://www.occ.treas.gov/FTP/EAs/ea2008-004.pdf

OK, so the OCC and the Comptroller have some fairly draconian powers necessary to ensure a safe and sound banking system. But which banks are covered by these powers? National banks are those banks registered at a national level (approx 1710 banks), plus overseas banks and institutions with banking operations in the US (approx 50). There are many instances of small, community banks being registered at a national level (like the above two examples from Kansas and Texas), so “national bank” covers the full gamut from community bank with $40m or so of assets to the big international players like Citi. In total they represent over 2/3rds of all US banking assets.

So these are the folk who should fear Mr Dugan and his team - but only if they have broken the rules or been imprudent with lending or risk management. So have they been naughty with your money?

Well, Mr Dugan provides the answer, and it’s an emphatic “YES!” …. But more on that later. Let’s follow a fascinating trail that leads us there.

I smell a rat:

Eliot Spitzer, Governor of New York, has a nose for trouble, and has had a long-running battle with the OCC. His assertions that the OCC has turned a blind eye to predatory lending practices at national banks and made it difficult for state agencies to enforce state legislation against predatory lending practices at a state level, appear to be negated by the facts and figures available.

In reality it appears the OCC has done its job well, in a preemptive manner, while the states have been largely reactive. Still, Mr Dugans recent response to Governor Spitzer’s assertions contains the clue that leads us on a trail that does indeed uncover failure at the OCC.

Here’s what Mr Dugan wrote on February 14, 2008:

Comptroller Dugan Responds to Governor Spitzer

http://www.occ.treas.gov/ftp/release/2008-16.htm

Here’s the full text of his response:

“Almost everyone who has paid attention to the subprime lending crisis has concluded that OCC-regulated national banks were not the problem. Instead, the worst abuses came from loans originated by state-licensed mortgage brokers and lenders that are exclusively the responsibility of state regulators.

However, comments from today assert that the OCC and national bank preemption have prevented the states from taking action against predatory or abusive lenders. That’s just plain wrong.

The OCC extensively regulates the activities of national banks, including mortgage lending. The OCC established strong protections against predatory lending practices years ago, and has applied those standards through examinations of every national bank. As a result, predatory mortgage lenders have avoided national banks like the plague. The abuses consumers have complained about most — such as loan flipping and equity stripping — are not tolerated in the national banking system. And the looser lending practices of the subprime market simply have not gravitated to national banks: They originated just 10% of subprime loans in 2006, when underwriting standards were weakest, and delinquency rates on those loans are well below the national average.

Nothing the OCC has done has prevented the states from regulating and preventing abuses among the lenders that they license – lenders that are the source of most of today’s problems. The states have ample authority – as well as clear responsibility – to set standards for these lenders and enforce them. It defies logic to argue that preemption was an impediment. National banks are bound to obey the strict standards enforced by the OCC everywhere they operate – even in states that had far less rigorous standards. The states should have applied equally rigorous standards to the non-bank lenders that were responsible for the bulk of the problems.” [my emphasis added in bold italic].

So we have “state-licensed mortgage brokers and lenders” identified as the culprits, and these “lenders” are further revealed to be “non-bank lenders”. So who are they, and are the national banks really “squeaky clean”?

Luckily one of Mr Dugan’s deputies sheds some light on this:

Extract from: TESTIMONY OF ANN F. JAEDICKE
DEPUTY COMPTROLLER FOR COMPLIANCE POLICY
OFFICE OF THE COMPTROLLER OF THE CURRENCY
BEFORE THE COMMITTEE ON FINANCIAL SERVICES
OF THE U.S. HOUSE OF REPRESENTATIVES
FEBRUARY 13, 2008

http://www.occ.treas.gov/ftp/release/2008-15b.pdf

“In contrast, over half of subprime mortgages of the last several years – and the ones with the most questionable underwriting standards – were originated through mortgage brokers for securitization by nonbanks, including major investment banks.”

Aha! So it’s the like of Bear Stearns and others who are the real culprits here! No wonder they have big problems now. Ah, but hang on a moment - the weasel words of the civil servant bureaucrat need to be scrutinized a bit more closely. What does “securitization by nonbanks” really mean, how does it work, why is it done, and are those national banks really so squeaky clean?

Let’s start with “why is it done?”: banks are constrained under law to act and lend prudently. This means focusing on good quality lending and not over-extending themselves in comparison to their capital or asset bases (referred to as “capital adequacy”).

So how can they grow their profits by “enabling” lower quality lending without damaging their capital adequacy ratios? Enter securitization. Securitization results in the national banks being the “managers” of the loans, but not the “owners”. Here’s how it works: Big Bank America agrees to allow Stares Burn Investment Group to securitized its lower quality mortgages. To do this, Stares Burn have to stump up the capital for the loans, plus fees to Big Bank for the management costs of the loans. Effectively, Big Bank turns itself into a broker, offering its loans to the highest-bidding non-bank. Because this is all agreed up-front, the loans never exist on Big Banks books, as they are considered off-balance sheet items. This is because the risk is carried by Stares Burn, not Big Bank.

So these loans are of no interest to OCC as Big Bank is not viewed as the “originator” - Stares Burn is.

Now let’s just step back and address that question: are the national banks really so squeaky clean?

Throughout most of the history of bank lending, banks have had one big incentive for lending prudently: they have carried the risk of the loans. So aside from the possibility of breaking the law, they had a huge commercial incentive to lend prudently. That is, until securitization came along. So long as Big Bank can clip the ticket and make a profit, do they really care if Stares Burn takes on too much risk? Of course not! We like to think of bankers as honest and conservative, but in reality these days they are no different to folk anywhere operating in this commercial world: they take a profit and look after their own interests. Believe me: I’ve worked for a few.

Forcing banks to carry their own lending risk was the one powerful lever the Government had to ensure prudential lending and protection of consumers, and they gave it away by allowing securitization.

Did Big Bank know Stares Burn was doing unwise lending and their loans were being pushed by brokers using questionable practices? Of course they did! These are the nations lending EXPERTS. They probably understood the predicament better than Stares Burn did.

I smell a rat, and it ain’t squeaky clean.

But this isn’t the failure of the OCC I referred to earlier. To find that we need to continue the trail:

Seedy CDO’s:

So what happens to those securitized mortgages at Stares Burn? They don’t just sit on them. Not when there is (was?) a profit opportunity. Securitized mortgages were packaged up with other mortgage-backed securities and bonds to form derivatives like CDO’s (Collateralized Debt Obligations), and sold to eager investors. After all, they had a premium risk status from Standard and Poors.

A typical CDO may be composed of 3% sub-prime mortgages, 2% commercial junk bonds, and 95% asset-backed commercial paper and prime mortgages (yes, also bought from Big Bank). S&P verdict: brilliant diversification and risk balance. They continued to rate CDO’s this way until well after the wheels had fallen off the housing bubble juggernaut.

The investment market couldn’t get enough of CDO’s and other packages: individual investors, pension funds, hedge funds (yes, even Stares Burn’s own hedge funds), other investment companies …. the demand was insatiable. What was poor Stares Burn to do?

Well the CDO’s were premium-rated assets on their balance sheet, so off to Big Bank they went: “We’d like to borrow $xx million. We’ve got great security (just ask S&P) and by-the-way: we’d like to use the funds to buy more of your prime mortgage book, some of that yummy asset-backed commercial paper you sent our way last time, and of course securitize some more loans from the risky end of your customer base (with you getting the management fee, as always).”

Ka-ching ka-ching. Big Bank smiles. “Of course, our most valued customer, we’re here to serve”.

Unfortunately one part of Big Bank has taken on the risk that another part sold off. Still, sub-prime is a small part of the CDO picture. Stares Burn would never default on a payment would they?

Well, we all know what’s happened to sub-prime, and junk bonds have returned to junk status, where they belong. But the other 95% of that CDO risk is safe isn’t it?

Is it?

Defaults on prime mortgages have increased, but off a very low base, and are not yet at concerning levels nationally. That leaves the question of asset-backed commercial paper. To learn the status of that, just look at how commercial mortgages are performing - these are referred to as CRE Loans (commercial real estate loans) within the banking sector.

Of course most of these (by value) come from the national banks, like Big Bank. And here’s where the trail leads back to OCC and their failure.

It seems that CRE loans are creeping out of control.

Of everyone involved in the banking business nation-wide, there’s nobody better placed to have an insiders overview of what’s going on than John C Dugan. Nobody.

A Self-confession:

So when he raises concerns about CRE loans we should all listen. Here’s what he had to say on January 31, 2008, to a gathering of bankers in Florida:

Remarks by John C. Dugan
Comptroller of the Currency
Before the Florida Bankers Association
Miami, Florida

“Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital. Here in Florida, as in other states where housing is so important to local economic growth, the concentration levels are more pronounced. Over 60 percent of Florida banks have CRE loans exceeding 300 percent of capital, and more than half have C&D loans exceeding 100 percent of capital. …. nevertheless, the trend is unmistakable, and the potential consequences are magnified in this credit cycle by the fact that so many community banks have CRE concentrations that are so much higher than has ever been the case in the past.
Given these circumstances, what do we see as the consequences in the coming months? Not surprisingly, there will be more frequent interaction between supervisors and banks with concentrations in CRE loans that are declining in quality. There will be more criticized assets; increases to loan loss reserves; and more problem banks. And yes, there will be an increase in bank failures. Last week we saw the first failure of a national bank in nearly four years – the longest such period in the 145-year history of the OCC. I am quite sure that the period before the next one will not be nearly so long.” [My emphasis].

http://www.occ.treas.gov/ftp/release/2008-9a.pdf

Clearly, the Comptroller’s Office is in for a busy 2008. So if you’ve recently lost your banking job, maybe you should check out the nearest OCC office: they may be hiring.

Mr Dugan is clearly sending a signal that the OCC is going to take a close look at “banks with concentrations in CRE loans that are declining in quality”. But why now?

If you read Mr Dugan’s words from a different perspective they read as something of a self-confession: “things have gotten really out of control, I’m not sure how they got this bad, but I’ve got to take strong action now (my jobs on the line)”.

A Better Spitzer Question:

A better question from Governor Spitzer might have been: “How come over 60% of Florida banks have CRE loans over 300% of their capital base? Did the OCC staff come to work one day and find banks had gone crazy overnight and were forcing CRE loans on unsuspecting passersby in downtown Miami? Or was the OCC simply asleep at the wheel, while banks accumulated CRE loans from 50% to 100% to 200% to 300% of their capital base?”

The sight of some community banks closing won’t be pleasant, especially not for their customers. But what Mr Dugan and others overlook is the impact on Stares Burn, and (ultimately) Big Bank. As the quality of their asset-backed CDO’s becomes impaired, the market value of them will plunge. CDO’s may become worth little more than the junk bonds that currently make up a small portion of their mix. And then Stares Burn will have real problems. As will Big Bank.

Maybe the rats won’t escape unharmed after all.

And the answer to my question: “who should fear this man?” Maybe we all should.

My thanks to Michael Shedlock, whose article set me on the trail:

Borrowed Reserves And Tin-Foil Hats
Michael Shedlock
February 11, 2008
http://seekingalpha.com/article/64145-borrowed-reserves-and-tin-foil-hats

Tags: Americas banking sector banks CDO Global Stock Markets Market Articles Market Updates & Comments (Stocks & Forex) securitization Spitzer sub prime subprime

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