Wiping Out Community Banks

The most shocking line in this WSJ article has to be:

"Our bank has excellent earnings and a very clean loan portfolio," Mr. Allen says. "The only mistake we made was in owning U.S. government agencies."

The article is about small community banks who are seriously threatened by the government's failure to recognize the role GSE preferred stock played in the portfolios of organizations of all types and sizes. This particular piece was presaged by this Barron's piece from early September:

While most of the money-center banks continued to enjoy the benefits of a short-covering rally, shares of several regional names have suffered sharp losses in the session....In many cases, regional banks use the proceeds of the preferred dividends to maintain their required capital levels, meaning that the loss of that income stream could put their balance sheets at risk.

There are other problems as well. The WSJ piece discusses how the government has recognized an unfortunate scenario adding pain to the misery:

Banks also are seeking tax relief. Because of a quirk in tax law, the banks won't be able to deduct most of the losses on their Fannie and Freddie holdings on their federal taxes. The financial damages are considered "capital losses" for tax purposes -- meaning they can be used as a deduction only against capital gains earned by banks. But few community banks have meaningful capital gains to report. So, in the tentative agreement reached over the weekend in the massive financial bailout, Congress plans to let banks deduct the losses from ordinary income, cushioning the blow.

Roughly one month ago, this Financial Week article explored the risks posed to regional banks by the government's GSE takeover. The reality of failed banks of many shapes and sizes is now upon us. In fact, RGE Monitor reports:

Chris Whalen (RGE FinanceMonitor/IRA): number of US banks likely to fail by the year ended July 2009 (110) and total assets of said failed banks ($800 billion). Based on our work, four buckets seem to be visible: 1) large banks, 2) large regional banks, 3) specialized institutions and 4) community banks.

Certainly, organizations such as Lehman Brothers and a wide array of hedge funds are feeling pain for reasons other than owning GSE preferred stock, but there are many organizations that are suffering as a result of only this financial sin. A financial sin as unthinkable a sin one year ago as polygamy prior to the excommunication of Hyram Brown. For all of the talk about big risk takers and unwise lending, the vast majority of these small banks had extraordinarily conservative loan books and solid understanding of their clients and their clients' businesses. Yet, many will fail, be severly damaged, or be forced into the hands of others.