Community banks fail over technicality: Study

The so-called 'mark-to-market' rule, put in place for transparency, made some banks' finances appear more troubled than they really were when the housing crisis hit.

Since the banking crisis hit hard in 2008, Georgia has seen more than 80 banks go under. That’s more than any other state. Most have been small, community banks whose assets were tied to the housing market. But did those banks have to fail?

A new report from the University of West Georgia says in many cases, the answer is no. The reason so many did, the report finds, is because of an accounting rule called “mark-to-market,” which regulators put in place after the collapse of Enron.

Here’s how it works. Say you buy a house for $100,000. The economy tanks, and the value falls to $50,000. You keep paying on the hundred grand, but the bank must report on its books $50,000 -- the diminished fair market value of the asset.

“As the bottom fell out of the real estate market, with that rule in place, that has destroyed in an artificial way a lot of capital in banks,” says Danny Jett of the Georgia think tank Main Street Solutions.

The non-profit funded the University of West Georgia study looking at the effect of the mark-to-market rule on small banks.

“Context matters,” says Dr. Joey Smith of the University of West Georgia’s Richards College of Business. He found the mark-to-market rule doesn’t always paint an accurate picture of a bank’s solvency.

“You have to take into consideration what’s happening around the bank, and other banks, because it’s one big relationship,” he says.

The study’s findings show that in the recent crisis, banks had to unload loans that were bad on paper, although they may have been paid as agreed upon. And that created a snowball effect.

The rule was revised in 2009, but Smith says if mark-to-market isn’t revisited, we’re likely to see more community banks collapse in a future crisis.

About the author

Jim Burress is a reporter for WABE in Atlanta.
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I'm no expert on "mark to market" so I'll accept that some changes need to be made but pay attention to the list that's referenced in the first paragraph. Of the 88 closings, a full 50 occurred within 24 months of the worst financial crisis since the great depression. As referenced in an earlier post, all of these banks were likely wrapped up in taking in a large number of poor mortgage loans.

It's unfortunate but these banks needed to go. That is, after all, capitalism. Few were closed, most were purchased by other mid-sized banks that had managed their money better.

But the point is that, as interesting as the study is, the main reasons these banks failed was because of their portfolio of liabilities and not mark to market accounting.

I believe Main Street Solutions proved a funding grant to the University of West Ga for this study. The study was done by the University and will adhere to strict academic standards I'm sure. This is an unbiased study and brings far greater credibility than pure editorial opinion such as that referenced in an earlier post here.

To me, the question is, "Were these small banks repackaging their mortgages as CMOs and then selling bonds based on those instruments?"

If a small bank is simply engaged in the process making loans to homeowners, and the homeowners are paying, I don't see the need for mark to market. When enough homeowners stop paying, the bank goes out of business.

If a bank is bundling loans into CMOs, then they need to abide by the rules that govern the special purpose entities that must be created to sell bonds based on those instruments.

It's not mark-to-market accounting that caused Georgia banks to fail. Too many banks along with bad loans from crooked bankers to unscrupulus developers caused banks to fail. This is from Paul Krugman's article from April 11, 2010:

...banks went wild, in a scene strongly reminiscent of the savings-and-loan excesses of the 1980s. High-flying bank executives aggressively expanded lending — and paid themselves lavishly — while relying heavily on “hot money” raised from outside investors rather than on their own depositors.

It was fun while it lasted. Then the music stopped.

Why didn’t the same thing happen in Texas? The most likely answer, surprisingly, is that Texas had strong consumer-protection regulation. In particular, Texas law made it difficult for homeowners to treat their homes as piggybanks, extracting cash by increasing the size of their mortgages. Georgia lacked any similar protections (and the Bush administration blocked the state’s efforts to restrict subprime lending directly). And Georgia suffered from the difference.

This is from your own report from September 13, 2011:

BURRESS: Joe Evans walks through the lobby of State Bank and Trust's Atlanta headquarters. He's president of the community bank that took over the failed institution that used to be here. Anytime a bank fails, the federal government steps in to protect customers' deposits, and then usually assigns another financial institution to take it over. Evans says Georgia's banks are tied closer to the housing industry than other state's.
EVANS: Georgia, because of its legacy of many small, community banks, wound up with many small, community banks that were heavily concentrated in residential lending.
BURRESS: Unlike other regions, where national banks dominate the landscape, community banks are a staple in Georgia. Each of the state's 159 counties had at least one, often more, Evans says.
EVANS: The perpetuation of that culture of many small financial institutions worked well for many, many decades. And it just so happened that this downturn was particularly painful to community banks.
BURRESS: Mom-and-pop homebuilders looked to their local community bank for funding, and cash was easy to come by. New banks sprang up just to meet the demand; helped, in part, by favorable state financial regulations and a view that past growth was a future guarantee.
BYRON RICHARDSON: I think the worst is over for Georgia.

Why don't you research who funded the report; Main Street Solutions?

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