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From Wall Street to Main Street, What's going on with the banking industry?

This week we begin a series of articles featuring interviews with officials at local financial institutions to find out how their role in the community has changed in light of the financial crisis of the last 18 months.

As we have learned, what happened with financial institutions – local, national and global – is now affecting all of us.

Money and banking 101

Most of us have seen the film “It’s a Wonderful Life,” in which Jimmy Stewart plays the hero who is the owner of a small town savings and loan. There are some good economics lessons here.

Insured financial institutions take in money in the form of deposits and lend money to borrowers. As Gary Votopka, president of Mission Oaks Bank, explained, “We rent out money.”

In bank accounting, the balance sheet appears to the layman, to be reversed. The deposits are liabilities even though they are money in the bank. That is because they are owed to the depositors and interest is paid by the bank on these deposits.

On the asset side of a bank’s balance sheet are its loans. The money is rented out for an interest rate. The spread between the rate a bank pays its depositors and the rate it receives on its loans is a major source of income.

Other items on the asset side of a bank’s balance sheet are the cash on hand and securities it holds.

In all of finance there is a tradeoff between risk and reward. You can see I am segueing to the question of what went wrong with the financial system.

With federal insurance protecting depositors’ accounts up to $250,000 (may revert back in 2010 to older limit of $100,000), the depositor has no risk.

This insurance is so important because in risky economic times, without insurance, the default position of putting one’s money under the mattress seems far superior.

Without deposits and cash and secure security reserves, banks cannot lend. Their key function in the economy is to bring together borrowers and savers.

Financial services institutions depend on trust. They take in deposits and then lend out far more money than they keep as cash on hand.

Their “capital ratios” are regulated by the government even though different financial institutions such as national banks, state banks, savings and loans and credit unions are regulated and insured by different agencies. The trust element can be frayed in a crisis, causing a “run on the bank.”

In 2008 we saw pictures of depositors lining up at the failed IndyMac bank in California to get their money out. These deposits were all insured but customers were unsure when they would have access to their money.

The healthiest bank in the world has most of its money out working longer term and could not withstand a run like the kind seen often in the Great Depression: the situation Jimmy Stewart had to talk the local community down from in the film.

One last principle of banking is the concept of portfolio loans and selling loans to generate more lending capacity. Jimmy Stewart kept all his loans. He made money from the stream of interest payments.

However, deposits do not grow as rapidly as loan requests. So modern banking created mechanisms so that banks can sell their loans to institutions like Fanny Mae, Freddy Mac and the Small Business Administration (SBA).

This allows them to regenerate their lending capacity to make new loans.

What went wrong on Wall Street?

A Depression-era law called Glass-Seagal was repealed in the 1990s. It kept the securities industry and the banking industry apart.

It was deemed to be archaic and too restrictive to allow US banks to perform their function in the modern era of global banking and multi-national corporations.

This repeal allowed our largest banks to “play” in the far more risky markets issuing securities that, in hindsight, were high risk but earned high fees and offered sometimes naïve investors high returns.

More risk; more reward. In good times these investors and the banks that developed the products profited hugely.

Fanny Mae, a quasi-private company that has now been effectively nationalized, would buy conforming mortgage loans from banks.

Investment banks pooled hundreds, even thousands, of individual mortgages into derivative securities called Collateralized Debt Obligations (CDOs). These represented a stream of income from interest and principal mortgage payments.

Where it got really risky is when investment bank financial whizzes took these CDOs and sliced the income streams up – think of slicing a carrot – into various branches with greater and greater risk.

To make palatable what Warren Buffet calls “financial weapons of mass destruction,” they bought insurance from a company like AIG (credit default swaps). They also arranged for the rating agencies to give them very high ratings as securities.

Let’s go back to the carrot. The fat first slice on the top of the carrot got a very high credit rating; further slices toward the thin end of the carrot were rated lower, meaning they were higher risk, but if times were good, the returns would reward the risk.

The bubble bursts

Next, the housing bubble bursts.

When underwriting standards were loose, many people were given loans they could not afford. These loans were often variable rate loans that at some point would reset at much higher rates.

Most people want to hold on to their house and are still paying their loans. But when houses are losing value and people are losing jobs, a rising percentage of loans go bad.

However, the good mortgages and the sub prime mortgages are opaquely hiding somewhere in these derivative securities that were sold all over the world.

There are many kinds of credit markets beyond the residential mortgage market, but the result is that trust – the essential element in the financial world – has crumbled and it is now affecting all of us.

Strength and weakness in local financial institutions

The local and regional banks I will focus on in this series of articles do sell many of their loans. However, they have not been involved in exotic securities as the large banks have been.

Our local institutions portfolio many of their loans and are diversified. They concentrate on lending to local clients who need business loans, car loans, college and real estate loans.

An important principle and strength of smaller local institutions is that they try and know their clients. They are better able to gauge risk because they can drive by a construction project or drop in on a local business borrower.

Thus, the local bank has its deposits insured just like the national institutions but can concentrate on investing in the local community.

Yet local institutions must bear some risk to their shareholders (but not depositors). They are fish swimming in the sea of the local economy.

When the local economy experiences hard times some of their loans will go sour. Some of our regional institutions lent too much to developers and contractors.

The real estate crisis has claimed some victims. Downey Savings was seized and is now a unit of US Bank.

This past week, one of the banks I was going to interview but who never returned my calls, First Centennial Bank of Redlands with a branch in Temecula, was seized and is now a unit of First California Bank based in West Lake Village.

Support your local financial institutions

This is why this is a column and not a news/feature story. Most of us depend on credit, to some extent, to have the quality of life we dream about.

Our small businesses need loans for inventory and to make improvements and buy equipment. We want to remodel our homes and borrow to buy a car. We want to get a college loan.

Remember that you become a very attractive customer when you have money deposited in a checking account, savings account or CD at the local bank or bank branch.

If you have a good relationship with a banker at a local branch of a large national bank, keep that relationship.

But consider the advantages of your local community financial institutions. Your deposits, your CDs, are insured. Investments in the local community by homeowners, small business owners and stock investors will strengthen the community.

Margaret Singleton has a MBA in finance and 30 years experience as a business appraiser, bank appraiser and real estate appraiser with MAI and ASA designations.

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