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The Downside of Keynesian Economics: Santa Barbara Bank & Trust

Econophile's picture




 

From The Daily Capitalist

This is the year that Santa Barbara Bank & Trust (Pacific Capital Bancorp; Nasdaq:PCBC) celebrated its fiftieth anniversary. It also may be the year it goes out of business if a recent rescue deal isn't completed.

For almost 50 years, SBBT was a Santa Barbara institutions. Founded by civic leaders, it was one of the few local banks that thrived and survived over the years. There were a number of other local banks that started here which either went out of business or were acquired by a larger institution. Only one other local bank has survived long-term and thrives as an independent entity, the much smaller Montecito Bank & Trust founded in 1975. That bank is privately owned by a single local entrepreneur.

Since 1960 SBBT had built itself on a conservative business model that relied on lending to local individuals and businesses, using the connections and reputation of their founders and the knowledge they had of the community they served. After a few years it was clear that the bank was enjoying solid, but not spectacular, growth and paid regular dividends to its shareholders. The stock was closely held in that no one ever sold stock unless they had to or died. There was a standing list of people who wished to invest if stock became available. Many investors became very well off from their investment, especially the early investors who benefited from stock splits over the years. I know several that became wealthy and the stock comprised most of their asset base.

They hired bright people who took the firm's banking philosophy seriously. Many of the senior level executives were life-long employees of the bank and had acquired a great deal of wealth from their stock options and purchases over the years. I'm not going to portray the people who founded and ran the bank as geniuses or saints, or that they never made mistakes, but I will say they were honest, careful, concerned, and dedicated to the bank. I found it was not so easy to get a loan from them, as some of my real estate clients discovered.

Some of the senior loan officers, executives, and managers who had been with the bank for many years had the opportunity to retire well relatively young, relying on their bank stock sitting in their 401(k) plans. Some came away with very substantial amounts. The bank was generous to their retired employees, providing some health and dental care benefits.

Then things changed. They went for regional expansion starting in the late 1980s and started establishing branches out of the immediate Santa Barbara area. At that time, as now, the population on what is called the South Coast, the coastal towns including Santa Barbara, was was relatively small, about 200,000. They expanded south into Ventura and even Northern Los Angeles counties, and northward into San Luis Obispo, Monterey, San Benito, Santa Clara, and Santa Cruz counties. Much of their expansion was through acquisitions made from 1997 to 2005. Now it has 48 branches and has assets of $7.369 billion.

It seemed that SBBT went from the conservative local bank to a forward-looking and expanding regional bank. It seemed that the culture had changed with its size. Perhaps that is inevitable with growth. In order to compete with other regional players they had to be more aggressive in attracting deposits and borrowers as they entered new territories. They had to offer different products and services. They built up a trust department and engaged in wealth management. They completed about ten mergers over the years to acquire smaller banks in these areas.

Now they are struggling to stay in business.

Looking back with quite a bit of hindsight, there were basic flaws in its business model and some of the business choices it made that led to its downfall. To be fair, hindsight is a wonderful thing for a commentator looking on from the outside. Perhaps my observations are wrong, but here's how I see it.

1. In 2005 they implemented a new computer system for its banking business and added customer relations management programs. From what I heard on the street the implementation was a disaster and the bank had substantial problems which ultimately resulted in the replacement of the then current president. It's kind of interesting because their 10K in 2006 only said, "The Company has experienced some challenges with the installation that have caused inconvenience to customers." Having been on the lawyer side of securities issues I believe that statement is quite an understatement. What I think it says was that "We had a disaster but fixed it. Sorry."

It makes one wonder about management when something like that happens. While it had fine people at the top, perhaps they under-appreciated the complexity of the new world in which they operated. I see the computer fiasco as a symptom of that stress.

2. They had acquired a tax anticipation loan business (Refund Anticipation Loan “RAL” and Refund Transfer “RT”) that generated a lot of cash flow. Basically tax preparers submit loan applications to the bank for clients who want an immediate payment of their tax refunds and didn't want to wait around for the IRS to pay them. The interest charged on such loans is very high and the bank caught a lot of criticism from consumer advocate groups. According to their Q1 2006 10K, "In the first quarter of 2006, funds lent in RAL transactions totaled $6.0 billion compared to $4.8 billion in the first quarter of 2005. The funds processed through RT transactions totaled $12.1 billion in the first quarter of 2006..." They had revenues of $87,573,000 from these loans in Q1 but loan charge offs were rising. They borrowed the funds to make these loans by securitizing the loans.

They sold the business for $10 million in January of this year. While profitable, the securitization business had dried up making it difficult for them to raise capital to fund these loans. The need to raise additional capital to fund RALs compounded their problems since they needed a lot more capital just to maintain their Tier 1 capital ratio because of their growing problem with real estate loans. So, a significant amount of cash flow was lost to them which only compounded their problems.

3. They jumped big into the residential real estate development business, mainly through acquisitions of other banks. From their Q3 2006 10K, their president says,

From a core bank perspective, our business development efforts during the third quarter remained strong, particularly in the construction and residential real estate segments, which helped drive annualized loan growth of approximately 9% during the quarter. However, the competitive deposit pricing environment and higher borrowing costs continue to drive compression in our net interest margin and present challenges to generating earnings growth. We are pleased to have partially offset this through implementation of the expense management initiatives that we announced last quarter. Our operating efficiency ratio improved nearly 400 basis points from the second quarter of 2006, and we are focused on making continued progress in this area.

The management statement notes that much of the loan interest growth was driven by loans from a bank they acquired in San Luis Obispo county.

This is where the money train goes off the tracks. A growing portfolio of commercial real estate (CRE) and residential real estate loans, both for development and acquisition, were made throughout the boom, including loans made at the very top of the market.

No one saw it coming.

Loan Portfolio Analysis

As you can see their loan portfolio grew substantially during the boom years, especially loans to developers and for CRE. You can also see how their non-real estate commercial loans, consumer loans, and home equity loans increased along with real estate. This demonstrates the "wealth effect" of any boom where increasing asset values, in this crisis, housing, encourages people to take on more debt and spend.

As with most regional or local banks, SBBT was not caught with the toxic assets usually blamed for the crash. Their loans and assets were more traditional, and were heavily weighted to real estate, which at the height of the boom in 2006 constituted two-thirds of their loan portfolio (including home equity loans). As you can see from the below chart, these loans now account for 78% of their problem loans.

Allowance For Loan Losses

I don't think most people in Santa Barbara had a clue that SBBT was having problems until they announced that they took $180.6 million of TARP money in November, 2008. That knocked me off my stool. As a mere depositor and borrower, I had not realized that there had been fundamental changes to the bank, much less any substantial structural problems.

I think we can all guess what is happening to them now as loans for residential real estate construction are being written down or written off, as CRE continues to decline in value, and as home values decline. While Santa Barbara real estate is still relatively expensive when compared to the rest of the U.S., it is unfortunate that many of SBBT's loans are not confined to this area. As a result, the value of the bank's stock is almost zero ($1.60 per share at last look):

Their most recent 10Q report for Q1 2010 was not encouraging. They restated earnings, actually losses, to -$83 million to reflect a $3.1 million under reporting mistake. On May 11 the OCC and the San Francisco Fed imposed new harsher conditions on them, and which give the regulators greater oversight. Among the requirements: "to achieve and maintain thereafter a total capital at least equal to 12% of risk-weighted assets [now 10.1%] and Tier 1 capital at least equal to 9% [now 4.6%] of adjusted total assets (the “Minimum Capital Ratios”) by September 8, 2010."

Then came the following statement in the 10Q report:

If we fail to consummate the investment and the recapitalization or otherwise fail to raise sufficient capital, our ability to continue as a going concern would be in doubt and we may file for bankruptcy and/or the bank may be closed by the OCC and placed into FDIC receivership ...

The only thing that will keep the bank from the above consequences is a pending deal from an investor who is willing to invest up to $500 million in the bank. The investor, [not The] Gerald Ford, is an experienced banker who apparently sold his bank at the top of the market and is sitting on a pile of cash looking for good banking opportunities. The deal will give Mr. Ford and his company 80% control of the bank. The existing shareholders have a chance to buy up to 20% of new shares at the same price Mr. Ford is paying.

In either case it appears that the shareholders will be wiped out. It is not a pretty sight in a small community where many people had invested in the bank and the bank's stock represented a major (if not the major) portion of their assets. It is sad to see the many employees who spent their entire working lives with the bank, and who thought they had retired well, now find themselves considerably poorer, not able to earn it back at their later stage of life.

For what it's worth, this is the unfortunate side of capitalism's creative destruction that Austrian theory economist Joseph Schumpeter wrote about. This is the part where failed and unprofitable ventures go away so that capital may be directed to more productive enterprises. This is the process that corrects the mistakes of the business cycle and keeps the economy moving forward. It is necessary and unavoidable, but it leaves only the destruction part behind for those involved.

I think the big question on everyone's mind is: why did this happen to such a fine institution? Or, to be more specific, why did those running the bank put it in a position that left very little margin of error?

Let me restate that I knew several of the bank's founders, senior employees, and I bank with them. I also know several of the current board members who are rather stuck with the problem. I have the highest respect for them as professionals and business persons and I am well aware of their achievements and capabilities.

But for them, the crash was a Black Swan event. No one apparently saw it coming, or if they did, they were not able to sway opinion to their viewpoint. To be fair to SBBT and their executives, most of the financial world did not see the bust coming. Most people on Wall Street only saw the boom.

I further will disclose that I didn't see it coming either. I worked for a local developer at the time and didn't want to see it coming. I only saw piles of potential money. Mea culpa. But then that was before I had the leisure of unemployment and re-retirement which enabled me to resurrect my Austrian theory roots and become a famous blogger.

To those practitioners of Austrian theory economics, the event was not a Black Swan. In fact, Black Swan author, Nassim Taleb, says it was not a Black Swan event because the potential of a major crash was obvious. Taleb, I should point out, is of the Austrian School of economics for the most part. Many Austrian theory economists saw the boom, understood its causes, and predicted the inevitable bust.

The purpose of this article is not to chastise human behavior, but to criticize the state of economic knowledge in our world. Our current economics is now dominated by Keynesian or Monetarist econometricians. If one looks candidly at how our government has responded to this crisis, one can see that the same policies that caused the boom are being redeployed to rescue the economy from the bust. I am not going to discuss why these policies are wrong here because I have written extensively about the current state of the economy. I will say that propping up failed companies and banks is the wrong policy and that is why we, like Japan who tried these policies many times and failed each time, still suffer from a credit freeze, deflation, high unemployment, and stagnation.

I think a reflection on the plight of SBBT and the people who suffer from its downfall is a sad but valuable lesson in economics. We need to take a fresh look at economic theory. I'm not talking about egg-headed ivory tower-ism here, I'm talking about the practical effect of the policies our government uses. These Keynesian and Monetarist policies are directly responsible for the booms and busts we seem to be facing with increasing regularity. Unless we change our ideas of how the economy should run, the tragedy of SBBT will only be repeated.

 

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Wed, 06/09/2010 - 14:43 | 403817 seventree
seventree's picture

No one apparently saw it coming, or if they did, they were not able to sway opinion to their viewpoint.

I think this one sentence is critical to what happened here, and explains why booms never end until they bust. Not because it is impossible to recognize them in progress or project the path to eventual failure. The necessary information is as available during the boom as afterward.

If we must attach a a famous name to this phenomenon, I would suggest Darwin rather than Keynes. Nature will always produce a few clear-eyed realists who don't believe non-linear rewards from any strategy can rise forever. They are prone to saying things like "This is too easy, it is growing too fast, we should be thinking about how it might go wrong before it's too late." To say that this kind of gloomy gus is "not able to sway opinion" is putting it mildly. Business organizations have many ways of eliminating them from the gene pool, from peer pressure to termination for not being a "team player." The more survival oriented will turn their own thinking around, live harmoniously with the herd, and eventually die with it.

Wed, 06/09/2010 - 14:07 | 403783 Bolweevil
Bolweevil's picture

It is my understanding that Mr. Ford has run into resistance (from FDIC?). Do you have any knowledge regarding that?

Wed, 06/09/2010 - 12:59 | 403573 seventree
seventree's picture

A parable for our times. One need only read this post to see how America's future went off the rails.

Wed, 06/09/2010 - 04:03 | 403310 Nigaz
Nigaz's picture

Econ-

If you're not familiar with Marshall & Ilsley (NYSE: MI - regional bank), it's a remarkably similar story.  There were signs before 2008 in this case, but not 'widely' considered major trouble.  It has still yet to fully play out, and will make a great (sad) story when it's all done.

Tue, 06/08/2010 - 22:56 | 402949 Windemup
Windemup's picture

The most lucid explanation for the boom and bust cycle I've ever read was by Henry George in his book "The Science of Political Economy". A must read for anyone that thinks there is something amiss with our current crop of economists.

Tue, 06/08/2010 - 22:53 | 402945 Tapeworm
Tapeworm's picture

Thanks for the personal touch on the why of so many bank failures. My business and personal bank is not bust, but did have to take a wad of TARP in order to avoid BK. I warned the local business banker on just why they were going to get killed in the next three years. I am no banker, but all of the information that they needed was out there free of charge on the net.

 You are honest in saying that you didn't want to see the case for bust. That is what I saw there too in my bank. I was tinfoil then, but I get the "strange new respect" when their stock went from 80 to 4.

Tue, 06/08/2010 - 22:11 | 402885 brown_hornet
brown_hornet's picture

Econophile-

I think the words should be "INfamous blogger"

Wed, 06/09/2010 - 01:57 | 403177 Econophile
Econophile's picture

Now that is a compliment! Love it.

Tue, 06/08/2010 - 22:03 | 402873 Fred Hayek
Fred Hayek's picture

Everyone involved with real estate saw this coming.  I don't mean the exact outlines of it, the exact nature of the consequences, just how it would play out.  But everyone involved in real estate knew, deep down, that real estate could not rise in value forever.  Wages did not rise similarly. 

I'm an engineer working in land development in MA and everyone knew by the end of 2005 or early 2006 that the jig was up and that things were about to go downhill. 

I talked to a friend who was working for some kind of dot com company in '99 and 2000.  He said that everyone there knew what was coming, too. 

We have a client who had a condo project approved in late summer 2005 and who never moved a single shovelful of dirt.  It was bad market timing.  He could see it.  He's as greedy as anyone but it was, if not obvious, certainly no secret. 

How a bank could claim to be completely blindsided by this is beyond me.  Surprised by how far things went, sure, but blindsided?

 

Wed, 06/09/2010 - 01:56 | 403174 Econophile
Econophile's picture

Fred, I can tell you from my first hand experience that most folks didn't see it coming. In fact the vast majority of Wall St. players didn't see it coming. Ditto with Dot Bomb. I can recall a conversation pre-dot.bomb crash with a young president of an internet based company who told me that I didn't understand that we were in a new paradigm.

I like your name.

Tue, 06/08/2010 - 23:15 | 402964 Rebel
Rebel's picture

The thing that got me was around 2005 all of those Countrywide ads that had that dufus in a sports coat pitching Jumbo Loans, Combo Loans, No credit No Problem, You can have it all now, free money!!! Countrywide was just one example, and there were much worse on late night TV. Those Countrywide ads were playing on every channel, all the time. I did a rough calculation on how much air time costs, estimated how many times a day the ads were showing, and then estimated how many people must be falling for the pitch, and in over their head in debt. I would not say that I predicted the housing crash, but I had this knot in the pit of my stomach that things were not going to end well. The knot in my stomach was so large that I actually left a lucrative job in Silicon Valley, sold everything, and moved to a rednecky little place in the heartland. Traded the boardroom for feeding chickens and goats and gardening. Escaping California was very much of a "Hotel California" type experience, but have never looked back, and have never been happier.

Tue, 06/08/2010 - 21:49 | 402858 Mitchman
Mitchman's picture

It seems to me that the one event that changed the fortunes of the bank more than any other and that you failed to mention is that the bank went public and the chase for reported earnings was on.  That is why the bank went into goofy businesses about which t knew nothing like the tax refund business (and I question: how can yo have $10 million in charge-offs in that business?  All you are doing is bridging time to an IRS refund)  and let go of their conservative real estate lending policies (as your real estate clients had discovered) and got on the go-go band wagon.  

There is a huge difference between being privately held and being public.  The sad story of SBBT is just another example of it no matter how apparently well meaning the Board members may have been because the stock price became the measure of their performance.  

Tue, 06/08/2010 - 22:38 | 402920 jeff montanye
jeff montanye's picture

i agree with you and kevin b above.  this seems to have very little to do with "keynesianism" or "monetarism" and a lot to do with procyclical, short-term profit maximizing behavior suggestive of the change in culture at the great investment banks when they went from partnership to corporation.  

not that he was a blood relation or something, but this site generally plays very fast and loose with the term "keynesianism" (which its spellcheck doesn't even consider a word).  certainly the too big to fail, bail out the bank bondholders lunacy currently world central bank policy (with exceptions, e.g. scandinavia) owes nothing to keynes.  nor for that matter does deficit spending throughout a business cycle.  to repeat: keynes said run surpluses in expansion so as to be able to run deficits in contractions.  this is not, at all, what the advanced world has done.  for the most part it ran deficits throughout the cycle. in the u.s. this was most pronounced under republicans (nixon famously, but inaccurately, saying we're all keynesians now.  partisan politics gives me a pain and is not my point.  

imo the fed, in its current incarnation, is pernicious.  but business cycles, financial panics and multi-year depressions (1840's, 1870's & '80's) occurred prior to the establishment of the federal reserve.  certainly some of the problems of the u.s. fed are not generic to a central bank per se but to a central bank owned and operated by the banking industry. 

Wed, 06/09/2010 - 01:48 | 403161 Econophile
Econophile's picture

Jeff:

First, the bank was always publicly held. So, that didn't change their behavior. In fact most of their employees' compensation came in the form of stock options. I think this is the incentive we would like for most banks. If they sacrificed long-term survival for short-term gains, then their pensions are wiped out. Why would they consciously do that? So I think this point is misplaced.

Second, all major business cycles throughout history have been caused by a monetary authority, be it king, council, regional fractional reserve bank, or central bank. In every case monetary debasement was the cause of boom-bust cycles. It is a bit more complicated for this comment to get into here, but it was the Austrian School theorists who actually discovered the cause of the business cycle. And, it was not Keynes's "animal spirits."

Third, this boom-bust cycle had everything to do with the Fed. Years of cheap money post dot.bomb created the boom. Where the money flowed also was a result of government intervention into the housing market (Fannie, Freddie, FHA, etc.). Wall Street played a definite role by using bad risk models, but didn't cause the cycle. Greed is always present in the economy so it isn't the cause.

Fourth, not to nit pick but Keynesianism is a frequently used term in economics. 

Fifth, Keynes would not only have advocated the fiscal and monetary stimulus, all neo-Keynesians were the ones behind it. And most of them were emphatic about the bailouts. Recall that Keynes thought the problem with recessions was lack of consumer demand and it was the role of the government to spend and spend to create demand and cause a recovery. Yeah, I know the theory, liquidity trap, sticky wages, falling demand and all that. BTW what Keynes said in General Theory, and what he said later in life were quite different.

Sixth, unfortunately Keynesian theory has never worked when applied, ever in history. Japan tried every Keynesian trick in the book and they experienced 20 years of stagnation, deflation, and falling demand. Their average GDP growth in the past score of years has been 0.6%.

Lastly, I agree that Republicans are just as bad as Democrats.

Thanks for the comment.

Tue, 06/08/2010 - 21:51 | 402853 KevinB
KevinB's picture

You can also see how their non-real estate commercial loans, consumer loans, and home equity loans increased along with real estate.

Well, maybe you can, but I can't. From the freakin' table that was just above the quoted comment, I see:

For years:

(percent of total loans)

                          2009             2005

Commercial           18.9%           19.1%

Home equity           8.7%             6.5%

Consumer               3.1%             8.9%

What I see is commercial loans virtually unchanged (and actually lower, not higher, as a percent of total loans), and that total home equity/consumer loans drop from 15.4% to 11.8% of the portfolio. In absolute terms, the home equity/consumer loans dropped from $756 million to $609 million.

It's not often I see someone write something that is directly contradicted by the figures immediately above their assertion, but you've done it. Congratulations, sir.

Wed, 06/09/2010 - 01:24 | 403136 Econophile
Econophile's picture

Kevin, if you look at the growth in the dollar value of loans up to 2008, you can see the trend. Because the percentages remained relatively unchanged after the crash only tells you that loan volume dried up. What is really killing them is CRE and construction loans. Thanks for being a careful reader but please look more closely.

Wed, 06/09/2010 - 13:29 | 403655 KevinB
KevinB's picture

Actually, if you look closely, you'll see that home equity/consumer loans peaked in ABSOLUTE DOLLAR TERMS in 2006, and declined each and every year thereafter. The increase in commercial loans was about 6% compounded - good growth, to be sure, and I'm nowhere near enough an expert in SoCal real estate to decide whether this is excessive or not.

The big growth was in CRE and development, as is noted elsewhere in your piece, and I'm not disputing that. I'm disputing the single sentence I quoted in my earlier post, which is most definitely not supported by the evidence you present.

Lest you think I'm nitpicking, I'm so tired of being told that black is white, up is down, that the guy gunning down 16 people in Ft. Hood while shouting "Allahu Akbar" is not a Muslim terrorist, and that the oceans and temperatures are rising while it snows in Toronto in May, etc., etc., that I just feel honour-bound to call "Shenanigans" whenever I see them. Don't take it personally.

Wed, 06/09/2010 - 13:55 | 403743 Econophile
Econophile's picture

Kevin, if you recall, home prices peaked in 2006 and have declined ever since. This was the source of those consumer/home equity loans. My point was specific to real estate loans, not other loans, although I do mention the wealth effect. Nit picking the trees is ignoring the forest, Grasshopper. I get your general frustration, but I'm trying to make a point in the article and the numbers back me up. Thanks.

Wed, 06/09/2010 - 15:36 | 404104 KevinB
KevinB's picture

Last post on this, I promise. You wrote:

My point was specific to real estate loans, not other loans,

But the sentence I objected to, which I quoted in an earlier post, and will quote again here was:

You can also see how their non-real estate commercial loans, consumer loans, and home equity loans increased along with real estate.

So, which is it? Were you asserting the trio (non-CRE commercial/HE/consumer) were increasing, or not? If you were talking ONLY about real estate loans, why did you bring in the trio? Why do you present the increase in trio loans as "evidence" for your main point, when in point of fact, they were declining in both relative and absolute terms?

Personally, I think you carelessly pointed to this evidence without truly looking at it yourself. Nothing in the evidence you presented backs up your secondary assertion; as to your primary assertion that the bank got too involved with CRE and development loans - I already pointed out that I don't disagree with that.

Tue, 06/08/2010 - 21:40 | 402843 RobotTrader
RobotTrader's picture

Wow, what a wipeout.

As a commercial banker in Southern California, I can certainly relate.

Lots of guys who were supposedly "smart and conservative" got sucked into the Credit Bubble Vortex, and many ended up being "Enroned" out of existence.

A similar bank is Farmers & Merchants in Long Beach.

They are privately-held, but have been notorious for refusing to foreclose on properties held by long time customers, no matter how much heat they get from the OCC or FDIC.

Maybe this time, they will also get burned.

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