The Banking Industry: Seven Years After the Crash

If one could travel back in time to March, 2008, the idea of a world-changing banking crisis right around the corner would be all but impossible to accept.

Granted, GDP growth was relatively modest, posting a 2.0% increase the prior year. The housing market — with average home prices reaching their peak in the second quarter of 2007 — had fallen six percent nationally.

The Dow Jones seemed to be in the middle of a correction, having declined about 15% from its all-time high of 14,164 set October 9, 2007. The labor market was still strong, with the U.S. unemployment rate just 5.1%.

Evidence was mounting that economic conditions were deteriorating, and whispers of a coming recession were getting louder. Still, a recession is a far cry from a financial crisis, and after nearly six years of growth, a downturn was arguably overdue. The Federal Reserve had already begun lowering interest rates months earlier in an effort to stave off a decline.

The Financial Crisis Exploded in September, 2008

Although Bear Stearns and other financial firms were already in trouble, the bankruptcy of the $639 billion financial behemoth Lehman Brothers in September, 2008 has generally been considered the beginning of the financial crisis.

Founded in 1850, Lehman became a major player in the securitization of Alt-A loans (“Liar Loans”) in the early 2000s and received rewards of record profits, peaking at $4.2 billion in 2007. Despite the healthy returns, Lehman was ailing, with its balance sheet highly concentrated in mortgage-backed securities. Of particular note were the billions of dollars in subprime mortgage pools it had assembled, a highly risky concentration which exploded in 2008 as the housing market spun out of control.

Over the next few months Lehman twice raised capital and at the 11th hour attempted to sell itself, but with a financial panic looming and suitors running for cover, it was too late. Lehman’s toxic mortgages eventually sunk the bank.

The Long, Painful Banking Crisis

Banks make the majority of their income from their net interest margin. A bank’s net interest margin (NIM) is the ratio of net interest income + non-interest income to earning assets, and is defined as follows:

A performance metric that examines how successful a firm’s investment decisions are compared to its debt situations. A negative value denotes that the firm did not make an optimal decision, because interest expenses were greater than the amount of returns generated by investments.

By formula, net interest margin is calculated as follows:

Loans are good investments for a bank if borrowers make their scheduled payments. A slowing economy negatively impacts a borrower’s ability to repay. Rising unemployment, which goes hand-in-hand with a weakening economy, also lowers the odds. Furthermore, a substantial decline in the value of collateral — the theoretical backstop of loan repayment — can turn a loan into a sizable loss.

What if all of those events occur at the same time? That’s exactly what happened to the banking industry as a net result of the implosion of the housing market. The U.S. economy was thrust into the worst recession since the Great Depression of the 1930s, and not only did the sharply declining economy and high unemployment rate (topping out at 10.0% in October, 2009) cause loans of all types to fall in record numbers, but the crashing values of real estate, equipment, and other collateral types made full recoveries of problem loans all but impossible.

Although the entire banking industry suffered, community banks were hit especially hard by the crisis. Smaller banks often placed more emphasis on perceived character and relationship factors in their loan underwriting. These intangible elements, although admirable, were all but worthless when borrowers stopped making their payments. Smaller community banks also had a hard time raising enough capital to offset their loan losses, making their demise more likely as the economy continued to struggle.

The steep decline in the economy and the frozen real estate market took a severe toll. The number of bank failures by year since the start of the financial crisis was as follows:

• 2008: 30
• 2009: 140
• 2010: 157
• 2011: 92
• 2012: 50
• 2013: 23
• 2014: 18

To date, four banks have gone under in 2015, a sign that despite the improved economy and the fact that the collapse began nearly seven years ago, the industry has still not fully healed. To put the numbers in perspective, just 40 banks failed in the ten years prior to the Great Recession.

The Banking Industry Today

Despite the severe losses suffered since 2008, the industry has rebounded in recent years. Bank stocks rose 33% in 2013, outperforming the S&P 500 in their strongest showing since 1997.  Return on assets rebounded to just over 1% in 2014, a figure well above the returns experienced during the financial crisis.

Consolidation has struck the banking industry, with the number of banks now well below 7,000 and continuing to fall. Although few would consider less choice as a good thing, a number of industry experts (not to mention a few regulators) were of the opinion that at its peak, there were simply too many banks in the United States. In point of fact, the trend line has headed downward for decades, with thousands of banks either closing or consolidating over the past 30 years.

For those that remain, the players are getting stronger and healthier as the economy continues to improve. The banking industry is back in full swing, making loans and helping individuals and businesses finance their needs.

If you notice your banker’s mustache twitching a bit more than it used to when you’re a day or two late on your payments, take pity. Sometimes seven years ago seems just like yesterday.