macroblog

Small businesses, small banks, big problems?

In a speech on Tuesday, Federal Reserve Bank of Atlanta President Dennis Lockhart drew some connections between the current commercial real estate (CRE) problems and the prospects for a small business-led recovery.

The starting point was an observation made in an earlier macroblog post that identified the important role small businesses have traditionally played in job creation in the economy and how they had been disproportionately negatively affected in this recession.

What are the connections between CRE and small business? An obvious direct link running from small businesses to CRE is that small businesses are an important source of demand for many types of commercial space. A link from CRE to small businesses is that CRE problems in banks could potentially affect credit availability for small businesses.

CRE pressures
The problems currently facing the CRE industry have been building for some time for both property owners and the holders of CRE debt:

• The income generated by nonresidential/nonowner-occupied CRE has generally been falling as vacancy rates on commercial space rose, and capitalization rates–the ratio of income to valuation–have climbed sharply.
• The decline in CRE valuations has created a significant amount of "rollover risk" when CRE loans and mortgages mature and need to be refinanced (about $340 billion in CRE debt is estimated to mature in 2010 and 2011). At the same time, delinquency rates on CRE loans have been increasing sharply, especially for CRE lending for residential construction and development purposes.

This recent Cleveland Fed report captures some of the dimensions of the banking systems exposure to CRE, as does this Wall Street Journal piece from March.

Small business lending
Banks have already responded to the generally weakened economic conditions and reduced creditworthiness of borrowers by raising credit standards for all types of lending, including commercial loans, credit cards, and home equity. But there is a risk that additional bank problems, such as the realization of substantial CRE losses, could further constrain bank lending right at the time when credit is needed to support economic growth.

President Lockhart draws the connection between further bank problems and the prospects for small business-led recovery by observing that small businesses depend significantly on the banking sector as a source of financing. (A 2003 Federal Reserve survey of financial services used by small business showed over 50 percent of small businesses had a credit line or bank loan. In addition about half of small businesses use a personal or business credit card.)

The dependence of small businesses on banks is particularly problematic if the banks facing the most severe CRE problems also are a significant source of loans to small businesses.

It turns out that much of the CRE exposure is concentrated among the set of 6,880 or so smaller banking institutions (banks with total assets under $10 billion). Based on the June 2009 Bank Call Report data, these banks represented 20 percent of total commercial bank assets in the United States but hold almost half of the CRE loans.

It seems reasonable to assume that the banks with high exposure to CRE (say, those with CRE exposure as measured by a CRE loan book that is more than three times their tier one capital) are likely to take a conservative approach toward additional loan growth. The bad news is that the banks with the highest CRE exposure also account for about 40 percent of all commercial loans under $1 million–the types of loans most likely used by small businesses.

It is important to recognize that this analysis does not automatically imply small businesses will not be able to get needed funding when demand increases. For instance, even if banks with high CRE exposure are unable to expand lending as demand increases, it is possible that other banks that are less constrained will be able to step in to provide the needed financing. Also, small businesses depend a lot on other sources of financing, such as credit cards, and the large card issuers tend to have low CRE exposure.

Today, the number one challenge for small businesses remains poor sales rather than access to credit. But tomorrow, it will be important that small businesses also have access to funding if they are going to play their traditional role as an engine of growth.

By John Robertson, a vice president in the Atlanta Fed’s research department

Déjà vu all over again

I have, recently, been experiencing a strange sense of familiarity watching the Congressional Budget Office's (CBO) efforts to monitor the budgetary implications of the Troubled Asset Relief Program (TARP). On the one hand, the long-term costs are rising:

"Since January, CBO has raised its estimate of the net cost (on a present-value basis) of the transactions covered by the TARP by $152 billion for 2009 and by $15 billion for 2010. Those revisions stem from three factors—changes in financial market conditions, new transactions, and a small shift in the anticipated timing of disbursements."

On the other hand, the CBO wants to book less spending in the near term than what the Treasury has in mind, for reasons that have to do with accounting procedures and the pace of actual TARP spending:

"Budget accounting issues are clouding the deficit forecasts for this year. The above estimate of this year's deficit to date includes outlays of about $290 billion for the Troubled Asset Relief Program (TARP). Although the Treasury has been recording most spending for the TARP on a cash basis, CBO believes that the budget should record the program's activities on a net present-value basis adjusted for market risk. Using that approach, CBO estimates that outlays of $140 billion should be recorded for the TARP through March. That approach would yield an estimated deficit of $803 billion for the first half of the year."

After a few minutes of pondering why it seemed like I had seen this before, I flashed back to my early days in the Federal Reserve System and the saga of the Resolution Trust Corporation, the Congress-created vehicle that helped the country work its way through the aftermath of the 1980s savings and loan crisis. In August 1989, here's what the Congressional Budget Office was thinking:

"The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (Public Law 101-73) is a complex measure affecting federal government taxes, premiums, spending, borrowing, and regulation. While the bill strengthens the government's system for insuring commercial banks, its primary focus lies in addressing the huge liabilities forced on the government by failed and insolvent savings and loan institutions.

"… The legislation establishes a new Resolution Trust Corporation (RTC) to merge or close currently insolvent insured thrifts. The RTC is to spend a total of $50 billion on this task… The $50 billion in resources available to the RTC are sufficient, in the Administration's estimate, to cover the government's liabilities for currently insolvent thrifts with $10 billion left over to help defray interest costs…"

The CBO, however, was not convinced that the RTC's resolutions would come so cheap.

"… many observers, including CBO, doubt that this level of resources is enough."

And in January 1990, the CBO was unhappy with the Treasury's accounting procedures:

"Last year's Financial Institutions Reform, Recovery, and Enforcement Act effectively excluded about $30 billion of deposit insurance spending from budget totals in 1990 and 1991, by having the funds borrowed through a newly chartered, government-sponsored enterprise, the Resolution Financing Corporation (REFCORP).

"REFCORP's status as a government-chartered enterprise is critical to the budgetary treatment of its borrowing. Normally, the U.S. Treasury conducts any necessary financing for the government. Treasury borrowing finances the deficit; it does not reduce the deficit. Otherwise, the budget would always be balanced. But because REFCORP is technically private, the funds that it borrows and turns over to the (on-budget) Resolution Trust Corporation count as offsetting collections. These funds offset the associated spending to resolve failed savings and loans. …

"CBO believes that REFCORP is a government entity, that its borrowing is government borrowing, and that the budgetary treatment that has been adopted is inappropriate."

By accounting for things the way they thought they should be accounted for, the CBO estimated as of August 1991 that the costs of the resolution process would in fact be quite a lot higher than initially assumed:

"CBO now believes that the RTC will pay total losses of about $155 billion (in 1990 dollars) for a caseload of about 1,500 institutions."

What is more, the whole process was taking quite a bit more time than originally hoped:

"CBO assumes that the RTC continues resolving institutions through calendar year 1994, more than two years longer than originally scheduled."

In August 1992, even that time frame was looking optimistic…

"CBO assumes that the RTC or a successor will deal with a heavy caseload through 1998…"

But the news wasn't all bad:

"CBO estimates the cleanup's cost at $135 billion. Sobering as this figure is, it actually represents a glimmer of good news: CBO's former estimate was about $155 billion."

Movement in the right direction notwithstanding, Congress did not exactly jump at the opportunity to extend the RTC's life span. From the January 1994 Economic and Budget Outlook:

"The savings and loan cleanup is forging ahead after a prolonged interruption in its funding. From April 1992 until December 1993, the Resolution Trust Corporation (RTC) had only very limited authority to incur losses. It was largely confined to selling off its portfolio of assets and to resolving the occasional institution that could be closed or merged at little or no loss to the government; hence, the RTC recorded negative outlays in both 1992 and 1993.

"The Congress brought this drought to an end in late 1993 with the Resolution Trust Corporation Completion Act."

And when Congress eventually acted, the picture was brighter yet:

"There is good news on the RTC front: the agency will not fulfill the gloomy predictions that were common even a year or two ago. CBO now estimates the total value of losses covered by the RTC since its inception in 1989 at about $90 billion (expressed, by convention, in 1990 dollars)."

And that is about where it ended up:

"The total tab for the RTC lies somewhere between the sunniest and gloomiest projections made during its early years. CBO now estimates the total value of losses covered by the RTC and its successor through 2000 at about $90 billion (expressed, by convention, in 1990 dollars). …

"Four and a half years ago, CBO feared that the RTC's costs alone could be as high as $185 billion, and some outside experts were even more pessimistic. (The Bush Administration, in contrast, originally stated that $50 billion would be sufficient.)"

So there you have it. The last great experiment in working through financial crisis took longer than expected, involved some accounting pushing and shoving at the outset, confronted a skeptical Congress, and cost more than initially projected, but quite a lot less than feared.

Make of it what you will.

By David Altig, senior vice president and research director at the Atlanta Fed

What do you mean “Fix It?”

Probably like you, I have been consuming mass quantities of commentary on the Treasury's plan to deal with "legacy assets" via its proposed Public Private Partnership Investment Program. The notices are too numerous to single out—Google "Geithner Plan" if you somehow feel you might have missed one—but the New York Times' Room for Debate feature is a reasonable place to get a one-stop view of some divergent opinions the plan has elicited.

I'm not taking sides on the argument, but I was taken with a metric of success that seemed to permeate the Times discussion:

"The market soared on high hopes that this will solve unfreeze credit and revive the crumbling economy. But is this plan sufficient to restore the banking system to health?"

I added emphasis here (with italics), as the notion of restoring the banking system to health (or not) popped up in various ways in the comments from the article's contributing panel of experts. From Paul Krugman:

"We had vast excesses during the bubble years, and I don't think we can fix the damage with the power of positive thinking plus a bit of financial engineering."

From Simon Johnson:

"Secretary Geithner's plan might work, in the sense of facilitating the removal of some 'toxic' assets from the balance sheets of major banks. But it is unlikely to work, in the sense of restoring the banking system to health."

From Mark Thoma:

"How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem."

From Brad DeLong:

"… the Geithner Plan seems to me to be legitimate and useful way to spend $100 billion of TARP money to improve—albeit not fix—the situation."

The phrases that interest me are "fix the damage," "to work, in the sense of restoring the banking system to health," "solve the problem," and "improve—albeit not fix—the situation." Each author gives some hint of what they mean by those terms, but in my reading the full meanings are not entirely clear—and I bet not uniform across the contributors.

Let me give an analogy that illustrates why these turns of phrase trouble me. Suppose I have a heart attack, which ultimately leads to bypass surgery. The surgery is successful (by its own measure) and the prognosis for recovery is excellent. Did the procedure "fix" the problem? Not exactly. The procedure put me on the road to recovery, but there will be a protracted period in which I am far from "normal." What's more, it will be an even longer period of time before I am fully up and running on full steam. (And along the way, incidentally, I'd better adopt a new set of rules and regulations governing my behavior, lest I find myself in the same condition again. That will take some getting used to as well.)

So, I wonder, what do most people have in mind when they refer to "fixing" the financial situation, of restoring the patient to health? Do they mean getting back to "normal" or simply being on the road to recovery (even if those travels are slow and painful for some time)?

Given that three of the four authors in the Times debate express the view that more policy steps will be needed, I believe there is an awful lot at stake in determining what success actually looks like.

By David Altig, senior vice president and director of research at the Atlanta Fed

On rescues and bailouts

I’ve been thinking a lot about this topic lately, and though it seems there are a good many folk who approach the issue with great certainty, I do not share their confidence. I have, however, found it helpful to think through the following (not entirely original) scenario:

I am sitting on my back deck one fine afternoon and notice smoke coming from the kitchen window of my neighbor Joe. The color and volume of the smoke—and the fact that I know that Joe is not home—leave no doubt that the kitchen is on fire.

I begin to calculate my possible responses. I think Joe has a sprinkler system installed, so it is possible that safeguards already in place will soon put the fire out. Of course, I’m not entirely sure the system is up to the task—or even if it exists—so I consider a limited intervention in the form of running inside my own house and calling the fire department. They are a pretty efficient unit, but in the best of circumstances it will take them some time to arrive. So I also contemplate the most extreme measure available to me: grabbing my garden house, breaking down Joe’s back door, and addressing the fire directly.

It’s a hard choice, so I begin to think about the costs and benefits of each option. If I rely on the uncertain quality (or existence!) of the sprinkler system, or wait for the fire department to arrive, the fire could spread rapidly and possibly threaten my property. On the other hand, if I rush in with my hose, I could get hurt—the direct intervention could be costly, too. What’s more, my intervention might not do the trick—the fire could be too big, my garden hose too inadequate a firefighting tool.

I decide to throw caution to the wind, grab the hose, and burst into Joe’s house. I am able to successfully quell the flames, escaping with only a few minor burns and watery eyes. I feel pretty good about the whole business, but the truth is I discovered that the sprinkler system was indeed operating and may have put out the fire on its own (though it hadn’t yet). And just as the last flicker expires, I hear the fire engines in the distance. They may have arrived in time to spare my house (though it is clear that the fire was spreading quickly). So, I wonder. Did I do the right thing?

Actually, my dilemma deepens. When the fire marshal arrives, he discovers that the cause of the fire was a cigarette, foolishly left to burn near a stack of old papers. I knew all along that old Joe was the reckless sort, and now I fear that by stepping in and containing the damage that Joe had brought upon himself I may just be encouraging more such carelessness in the future.

Then again, the kitchen is a total loss, and the smoke has permeated Joe’s house and ruined more than a few pieces of furniture. Though it is obvious that Joe has been spared total ruin, will he really feel that his actions have gone without consequence? Will he feel that the fates have bailed him out?

I wonder.

UPDATE: I'm getting some ribbing over the similarity between my scenario and the analogy offered today by a certain well-known candidate for high political office. Though I did note that my story is not entirely original, I assure you that the present coincidence is, well, entirely coincidental.