Banks failed over bad loans

Banks are now losing money and going broke the old-fashioned way: They made loans that will never be repaid.

As the number of banks closed by the Federal Deposit Insurance Corp. (FDIC) has grown rapidly this year, it has become clear that the vast majority of them had nothing to do with the strange financial products that seemed to dominate the news when the big banks were nearing collapse and being bailed out by the government.

There were no CDOs, or SIVs or AAA-rated "supersenior tranches" that turned out to have little value. Certainly there were no "CDO-squareds."

The severity of the string of bank failures shows that many of the proposed remedies batted about since the financial crisis erupted would have done nothing to stem this wave of closures.

These banks did not get in over their heads with derivatives or hide their bad assets in off-balance-sheet vehicles.

Nor did their traders make bad bets; they generally had no traders. They did not make loans that they expected to quickly sell, so they had plenty of reason to care that the loans would be repaid.

What they did do is see loans go bad, in some cases with stunning rapidity, in volumes that they never thought possible.

The fact that so many loans are souring is a testament to how bad the recession, and the collapse in property prices, has been.

But looking at some of the banks in detail shows that they were also victims of their own apparent success. Year after year, these banks grew and grew, and took more and more risks. Losses were minimal. Cautious bankers appeared to be missing opportunities.

As economist Hyman P. Minsky pointed out, stability eventually will be destabilizing.

The absence of problems in the middle of this decade was taken as proof that nothing very bad was likely to happen.

Any bank that did not lower its lending standards from 2005 through mid-2007 would have stopped growing, simply because its competitors were offering more and more generous terms.

Although the losses on current failures stem mostly from construction loans, it is possible that commercial real estate will be the next big problem area

During the credit boom, loans on those properties became easier and easier to get, on more and more liberal terms. Unlike residential mortgages, commercial real-estate loans typically must be refinanced every few years. With rents and values down in many areas, that will not be possible for a lot of buildings, and some owners are just walking away from their buildings.

Two years ago, when the subprime-mortgage problems began to surface, Washington, D.C., took great comfort from solid balance sheets. "Over all, the banking system is in very good shape," Sheila Bair, the FDIC chairwoman, said in an interview on CNBC. "They're very well-capitalized, well-diversified."

Last year, we learned the regulators, like the bankers, did not comprehend the risks of some of the exotic instruments dreamed up by financial engineers. This year we are learning that the regulators, like the bankers, also failed to understand the risks of the generous loans that the banks were making in the middle of this decade.