Small-Bank Skid : Once-Profitable Community Institutions Feel Pinch Like Larger Cousins

James Staes figures that small banks ought to stick to what they know best, but he’s found out that policy doesn’t always work.

As president of Home Bank in Signal Hill, Staes has a history of producing healthy profits-- mostly from loans to community businesses that could be relied upon to pay their debts with revenue from their operations. But this year, his customers haven’t been doing so well, and neither has Home Bank. The bank, with $414 million in assets, was forced to stash $6.75 million in reserve for possible loan losses, contributing to a loss of $1.8 million for the first nine months of this year.

“We’ve got a number of companies hurting, and a community’s ills are reflected by its banks,� Staes said.

When major banks faltered in the 1980s, losing money on Third World loans and major real estate deals, small, independent banks stuck close to home, invested in people they knew and made more money for their size than large banks did.

But now, the independents are facing some of the same woes as their bigger brethren. Their suffering is especially acute in Southern California, where bankers traditionally relied heavily on loans secured by what they believed would be ever-rising land values.

“The economy is so dreadful and the decline so pervasive throughout all segments that community banks have trouble with a number of loans on their books and a great deal of trouble finding good loans to make,� said Los Angeles banking lawyer Barnet Reitner.

Two years ago, when many community bankers began preparing for a downturn, they never expected a recession that has hit so deeply and lasted so long. “I’ve been through four economic downturns,� said D. Linn Wiley, president of Chino Valley Bank in Chino, “and this is the worst.�

And they aren’t encouraged by the news that hits them daily. “When I pick up the paper every day and see major companies laying off people, I don’t see any turnaround,� said Richard Korsgaard, president of Mariners Bank in San Clemente.

The small bankers generally believe that at least part of the blame for their predicament is a continuing onslaught of ever tougher regulations.

Regulators, long leery of Southern California’s skyrocketing property prices, have been looking at real estate collateral in a harsher light, partly because they don’t believe that the slide in property values has hit bottom.

Where once they viewed as serious any loan payments more than 90 days past due, they now are looking at loans that are a month past due and, in some cases, requiring banks to set money aside to also cover those loans as possible losses.

“It may take them (bankers) awhile to be convinced that land values are falling. So it takes time for problem loans to show up,� said Gary C. Zimmerman, an economist with the Federal Reserve Bank of San Francisco, who produced a study last month documenting the problems of community banks.

As a group, the small institutions relied heavily on real estate--63% of all loans were backed by real estate--and earned only 26 cents for every $100 in assets. In better times, community banks have had less than a third of their loans backed by real estate and have earned more than $1 for every $100 in assets, their benchmark for excellence.

By comparison, independents in the Central Valley and in Northern California earned more money and had fewer loans tied to real estate.

Bankers have been revising their game plans in the face of forecasts that the recession will last another year in Southern California.

“We’ve been spending an awful lot of time with community bankers,� said Michael Conover of the Secura Group consulting firm in Los Angeles. “Bankers are looking for alternatives and assessing where they are and where they want to go.�

Most often, the bankers are turning to products that generate fees, such as business loans backed by the Small Business Administration and mortgage banking operations, in which home loans are made and sold to investors. Bankers also are relying more on inventories and assets other than real estate to secure business loans.

And they’re tightening their underwriting--the documentation and analyses that determine whether a loan is approved.

“We’re going back to the criteria we used in the 1960s and the 1970s,� said J. B. Crowell, president of Eldorado Bank in Tustin. “We loosened that up in the 1980s to compete against insurance companies and other non-banks, and look what happened. We’re paying for it now.�

Bank of Newport in Newport Beach, with $283.7 million in assets, is certainly paying for its dependence on real estate loans. It lost $699,909 in the first nine months of this year, mainly because it had to add $3.4 million to reserves for possible loan losses from weak real estate loans and because it spent money on management fees, tenant improvements and other expenses for the real estate it had acquired through foreclosure.

In August, regulators, with the bank’s consent, imposed a cease-and-desist order requiring the bank to reduce its troubled loans. Bad loans accounted for 3.2% of its loan portfolio at the end of September, slightly above the 3% level that triggers regulatory action.

“This has not been as much fun as when you have a better economic climate,� said Ronald Rodgers, Bank of Newport’s president.

What’s particularly depressing, he said, is that his institution is foreclosing on some of the same properties it took back and resold after the last economic downturn 10 years ago.

For instance, two small office buildings that were twice foreclosed have cost the bank about $1 million in expenses and losses. After the early 1980s recession, the bank took the properties back, spent money improving them and sold them to buyers who made “significant� down payments of 20% and 33% of the purchase prices, Rodgers said.

But those owners defaulted. Now, Bank of Newport is about to sell the buildings at reduced prices to new buyers who will be making down payments of 20%, he said. The catch, though, is that the bank must make the loans to the new owners because no other institution will lend on such commercial properties.

“We’re not even making loans like this to anyone else,� Rodgers said. “I don’t think anyone would ever entice me to get into an office building deal again.�

The Bank of A. Levy, long a fixture in Ventura County, has grown to $861.5 million in assets, but its president, Marshall Milligan, said the bank and its 20 branches haven’t strayed from the ideals of small independent banking because the bank serves a select group of customers in a small geographic area.

What the bank has strayed from, though, has been consistent profit. It lost $684,000 for the first nine months this year. Its problems stem as much from plunging real estate values as from growing pains that larger community banks face.

“We all continue to grow, so we see more and more people,� Milligan said. “It’s impossible to be competitive and avoid the risk of dealing with people you don’t know.�

Its real estate-related loans account for “probably 80%� of the bank’s problems, and construction loans in particular account for about half the bad assets, Milligan said. Many of the borrowers now having difficulty repaying loans are new customers, he said.

He acknowledged, however, that the bank was partly at fault for failing to realize that property values were falling as fast as they were.

“We had lagged behind in appraising property, and delinquencies had been building up over the past year,� he said. “We dove in and made a thorough review.�

Regulators speeded up the process. In a routine audit last spring, they forced the bank to recognize losses sooner than it had expected to. The result was a $2.3-million loss for the second quarter.

The bank will likely end up with a loss for the year, but it expects to return to profitability next year, Milligan said. “We’re confident we have the ability to weather the storm,� he said.

Not all community banks, of course, have suffered losses during the recession. Many have simply had to make do with lower earnings, and a few have performed better this year than they did last year.

Trans World Bank in Sherman Oaks, for instance, has relied on a mix of business clients--from manufacturers and wholesalers to retailers and professionals--to help make it less susceptible to economic swings in different industries and to boost its nine-month earnings 8% this year to $1.4 million.

“We can’t be all things to all people, particularly with the amount of regulation coming out now,� said John Marquis, Trans World’s senior vice president. “It just increases your staff costs.�

But what banks can do, he said, is approach each lending situation “very cautiously.� Trans World, he said, has long had stringent lending criteria that has helped it sail through troubled times.

HARD TIMES FOR COMMUNITY BANKS

As California’s economy has worsened, so has the fortunes of the state’s small, community banks, which had avoided some of the problems of the big banks in the 1980s. For example, the percentage of bad loans among independents have soared above the 3% ratio--bad loans as a percent of total loans--that regulators consider dangerous to a bank’s financial health.

1st Qtr. 2nd Qtr. 3rd Qtr. 4th Qtr. 1st Qtr. 1991 1991 1991 1991 1992 Southern California 5.66% 5.71% 6.60% 6.92% 7.35% Northern California 4.20 3.82 4.12 4.46 4.75 Central Valley 3.81 3.47 3.82 3.59 4.61

2nd Qtr. 1992 Southern California 7.45% Northern California 4.85 Central Valley 3.64

Source: Federal Reserve Bank of San Francisco