House Committee on Pensions, Investments & Financial Services Department of Banking Commissioner Charles G. Cooper April 2, 2009 Savings and Mortgage Lending Commissioner Douglas B. Foster

Topics of Discussion 2 Historical perspective on the banking crisis of the 80’s and early 90’s. Overview of current economic and regulatory environment for Texas banks. Effect of mark-to-market accounting on bank financial statements and capital adequacy. Legislative assistance for community institutions and communicating concerns to congressional delegation Role of community banks in strengthening their local economies through responsible lending. Current initiatives by the FDIC with regard to assessments that will impact bank earnings and thus capital Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Banking and S&L Crisis of the 80’s & 90’s 3  Deposit-interest rate ceilings phased out. Federal Reserve Bank restricted the growth rate of money supply and interest rates increased dramatically. Mortgage rates peaked at 15.5% in 1982 The prime rate peaked at 20.5% in 1981  Deregulation of S&L powers, allowing for increased risk taking. Savings and loans were given the capabilities of banks, without imposing the same regulations as banks. Removal of statutory restrictions on real estate lending. Regulatory relaxation permitted lending, directly and through equity participations.  Proliferation of state and federal bank charters in Texas between 1975 – 1990 totaled 802. Contributing Factors: Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Banking and S&L Crisis of the 80’s & 90’s 4  Raised deposit insurance limit from $40,000 to $100,000. Allowed the expansion of brokered deposits. (1980)  Regulatory agencies and regulatory systems not prepared to identify risk in era of deregulation. Staff experience declined and the understanding of risk in the industry was inadequate.  Changes in federal tax laws. Tax Reform Act of 1986 removed many tax shelters, especially for REITs. The Act reduced the value of these investments by limiting the extent to which losses associated with them could be deducted.  Volatility of oil prices. Prices plummeted from $70 (1981) to $20 per barrel (1986) Texas did not have a diverse economy and had an extreme dependence on oil. Contributing Factors (Continued): Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Historical Bank and S&L Failure Data 5 Results: Total Bank and S&L failures between : 168  Texas Banks and S&Ls accounted for 30 of these failures. Total Bank and S&L failures nationwide between : 1,600  Bailout of $160 billion– These funds were dedicated to the failure of the Federal Savings and Loan Insurance Corporation (FSLIC).  Texas banks and S&Ls accounted for 599 or 37% of these failures. Texas Bank and S&L failures as a percentage of U.S. total Legislative and Regulatory Response:  Branching restrictions lifted in Texas.  Southwest Plan. Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Recent and Current Economic Environment 6  Subprime Mortgage Lending Crisis. Credit enhancements like credit default swaps allowed mortgage loans to be securitized and sold in secondary market; off balance sheet liabilities increased highly leveraging many financial companies. Real estate bubble was created (pronounced in CA, NV, AZ, GA, FL). Losses were experienced by banks that originated, securitized or traded mortgage backed securities. Texas banks were not a major participant in the secondary market who generally maintained safe and sound underwriting standards. Texas home equity laws establish borrowing restrictions.  Created national recession which officially began in December  Current Texas economic status. The FRB’s Texas Business Cycle Index is trending downward. The change in the FRB’s Texas Leading Index is negative. Employment growth in the major metro areas is weakest in Dallas, Ft Worth and El Paso. Energy prices and the Texas rig count are down. Softening of commercial real estate is affecting the buying and selling of commercial properties. Residential real estate construction and sales are down dramatically. See Appendix for timeline of events A Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Concerns  Concentrations in: Interim Construction Land Development Commercial Real Estate  High level of volatile funding sources: Brokered deposits Internet deposits FHLB borrowings  Shortage of experienced bankers and regulatory examiners 7 Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009 Responses  Horizontal or targeted reviews  More frequent exams  Enhanced off-site monitoring  Increased use of enforcement  Expanded use of supervisor program  Requesting authorization to hire additional senior level examiners Regulatory Concerns and Responses

Federally Insured Depository Institutions Assets Under Supervision in Texas $725.2 Billion 8 See Appendix for market share information B Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Texas Faring Better Than Other States 9  While no longer robust, the Texas economy continues to show signs of stability and resiliency.  Texas banks and thrifts continue to be better capitalized than U.S. banks as a whole, and have been able to better absorb the impact of the financial market disruptions.  Maintaining prudent lending standards and benefiting from lessons learned from the bank and S&L crisis two decades ago, asset quality of Texas banks and thrifts continues to hold up comparatively well.  In February 2009, Sheshunoff and Co. Investment Banking, a bank advisory firm, released a report that states Texas banks carry fewer problem loans and have more capital than banks elsewhere in the nation.  Of the 25 bank failures in 2008, two were in Texas.  Of the 21 bank failures in 2009, none have been in Texas.  In March 2009, one Texas state-chartered bank acquired a failed Colorado financial institution. Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Commercial Bank Performance and Condition Ratio Comparison (State and Federal Charters) 10 Source: FDIC As of /31/ /31/1988 Number of Banks5947,0851,49213,123 Total Assets ($ in millions)$273,498$12,312,914$162,010$3,029,212 % of Unprofitable Institutions14.14%21.85%40.48%14.68% Net Interest Margin3.82%3.23%2.98%4.02% Return on Assets0.82%0.21%-1.28%0.82% Return on Equity7.85%2.11%-24.74%13.19% Net Charge-Offs to Loans0.50%1.31%2.84%1.00% Earnings Coverage of Net Loan Charge- Offs (x) Efficiency Ratio64.73%58.30%88.82%66.17% Texas Nation Texas Nation Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

11 Source: FDIC As of /31/ /31/1988 Loss Allowance to Loans1.31%2.28%3.47%2.41% % CRE to Total Loans25.03%14.00%NA Noncurrent Assets Plus ORE to Assets1.14%1.82%5.09%2.14% Noncurrent Loans to Loans1.43%2.90%6.18%2.92% Core Capital (leverage) Ratio8.94%7.42%4.63%6.16% Equity Capital to Assets10.40%9.45%4.71%6.28% Tier 1 Risk-Based Capital Ratio10.62%9.75%NA Total Risk-Based Capital Ratio12.67%12.75%NA Net Noncore Funding Dependence15.95%22.49%NA Total Bank Failures and Assistance Transactions Texas Nation Commercial Bank Performance and Condition Ratio Comparison (State and Federal Charters) Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Thrift Performance and Condition Ratio Comparison (State and Federal Charters) 12 Source: FDIC As of /31/ /31/1988 Number of Thrifts501,2201,69716,561 Total Assets ($ in millions)$91,561$1,534,369$269,563$4,569,456 % of Unprofitable Institutions38.00%32.46%44.25%16.78% Net Interest Margin2.25%2.77%1.69%3.29% Return on Assets-0.15%-0.57%-2.41%0.44% Return on Equity-1.96%-6.15%-98.68%7.87% Net Charge-Offs to Loans0.98%1.13%1.88%0.67% Earnings Coverage of Net Loan Charge- Offs (x) Efficiency Ratio68.37%66.21%113.76%68.82% Texas Nation Texas Nation Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

13 Source: FDIC As of /31/ /31/1988 Loss Allowance to Loans1.93%1.64%3.79%1.95% % CRE to Total Loans4.22%10.70%NA Noncurrent Assets Plus ORE to Assets1.87%2.38%NA Noncurrent Loans to Loans2.89%3.10%12.16%3.26% Core Capital (leverage) Ratio8.09% 4.63%6.21% Equity Capital to Assets7.66%9.04%1.41%5.54% Tier 1 Risk-Based Capital Ratio12.03%12.10%NA Total Risk-Based Capital Ratio13.60%13.34%NA Net Noncore Funding Dependence27.64%26.04%NA Total Thrift Failures and Assistance Transactions Texas Nation Thrift Performance and Condition Ratio Comparison (State and Federal Charters) Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Texas vs. Nation on Foreclosures 14 Source: Mortgage Bankers Association As a percentage of mortgage loans Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

15 A problem bank is defined as an institution with a safety and soundness CAMELS rating of 3, 4 or 5. Problem Texas State-Chartered Bank and Thrift Projections Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Accounting and Capital Treatment for Bank Assets 16  Mark-to-market or fair value accounting refers to the accounting standards of assigning a value to a position held in a financial instrument based on the current fair market price from the instrument or similar instruments.  Mark-to-market accounting has been a recent concern because of the unprecedented intersection of two factors – accounting guidance and market segment breakdowns.  The accounting guidance involved includes FASB 115 and FASB 157.  FASB 115 has (for over 15 years) directed that any temporary depreciation (or ‘impairment’) in investments be reflected as a deduction from book capital accounts but is added back for bank regulatory capital. This deduction does not affect earnings or regulatory capital adequacy.  However, FASB 115 also directs that any “other than temporary impairment” (OTTI) is to be written off through earnings, with a resulting reduction in regulatory capital.  FASB 157 (issued about 2 years ago) addressed the difficult valuation process for the many new types of investments which were often not widely traded with a 3-tiered pricing system. Level I securities were widely-traded securities (such as US Treasuries) with ready market quotes; prices were readily discernible from recent arms-length sales in the normal course of business. Level II securities are less widely-traded, and are valued by comparing them to recent market sales of ‘similar instruments’. Level III securities are often exotic, and are so thinly-traded that they are valued via models, from a set on internal assumptions. This is clearly a much more abstract approach, and difficult to validate in the market. Collateralized debt obligations (CDOs), backed with derivative collateral such as credit default swaps, are an example of this type.

Accounting and Capital Treatment for Bank Assets 17  The ‘market segment breakdown’ began about 18 months ago, when the markets for many of these new, more exotic securities began to freeze up due to general concerns about credit exposure and liquidity. The lack of ‘transparency’ in the valuation process also made potential buyers of these securities more cautious.  The usual ‘market valuation’ process for the great majority of more ‘traditional’ securities was not affected. These included US Treasury and Agency bonds, municipal bonds, bonds backed by Fannie Mae or Freddie Mac guaranteed mortgages, and corporate bonds.  But as arms-length transactions dried up for other types of bonds, more and more types of securities became nearly impossible to value via the traditional ‘market sales’ approach. In Texas banks, these types have most often been auction rate securities (ARS) and private-label collateralized mortgage obligations (PL CMOs).  The problem became acute when the valuation process, set forth by FASB 157, was issued in Under its direction, the ‘fire sale’ prices received by sellers under duress were being used as the only market sales available by which to set values. Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Accounting and Capital Treatment for Bank Assets 18  Then, per FASB 115, it appeared that in some of these securities there was loss that might in essence be permanent or ‘OTTI’. The depreciation in such cases was to be written off as a loss through earnings.  There was no accounting mechanism in place to differentiate between the probable credit losses (such as writing off some of the bad mortgages behind the PL CMOs) and the extraordinary liquidity depreciation that was present in the ‘frozen’ markets. Several Federal Home Loan Banks, for instance, took very large OTTI losses on their PL CMOs in late 2008 for this reason.  FASB’s proposed ‘fast-track’ revisions to both FASB 157 and FASB 115 are efforts to remedy the current situation. Securities whose markets have ‘frozen’ can now be valued as Level III, based on assumptions that presume non-distressed sales. The identified ‘credit loss’ portion of any OTTI is still to be charged off through earnings, but the ‘liquidity depreciation’ will be reflected as a deduction from book capital accounts but is added back for bank regulatory capital, without affecting earnings or regulatory capital adequacy.  FASB is meeting on April 2, 2009, to decide whether these revisions are to be enacted, so the situation is fluid, but moving very fast. Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Accounting and Capital Treatment for Bank Assets 19 Asset Type Balance Sheet Valuation Criteria Effect of Changes in Fair Value in Financial Reporting under GAAP Effect of Changes in Fair Value on Tier 1 Regulatory Capital Debt Investments TradingFair ValueChanges recognized in earnings Changes recognized in capital through earnings Available for SaleFair Value Changes reflected in other comprehensive income. No effect on earnings until sold or “other than temporary” impairment (OTTI). Changes not recognized until sold or OTTI Held to MaturityAmortized Cost Changes in fair value not recognized unless OTTI Changes not recognized unless OTTI Direct Investment in Loans Held for SaleLower-of-cost-or-fair-value Declines below cost recognized in earnings Declines below cost recognized in capital Held for InvestmentAmortized Cost Changes in fair value are not reflected. Impairment is recognized through earnings based on incurred credit losses. Changes in fair value are not reflected. Impairment is recognized in capital through earnings based on incurred credit losses. Source: Office of the Comptroller of the Currency Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

TARP – Capital Purchase Program 20 Participating State-Chartered Banks and Thrifts Total Number of State-Chartered Banks And Thrifts Applying: 67 Amount of Capital Requested:$3.2 Billion Number of State-Chartered Banks And Thrifts Receiving Capital To Date: 17 Amount of Capital Received To Date:$2.8 Billion Source: U.S. Department of Treasury Office of Financial Stability Information as of March 30, 2009 and Texas Savings and Mortgage Lending survey of Texas state-chartered thrifts. Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009 As of March 27, the Treasury Department had disbursed $303.4 billion of the $700 billion in Troubled Asset Relief Funds with about $199 billion going to purchase preferred shares of 532 financial institutions under the Capital Purchase Program, the General Accountability Office said in a report released on Tuesday, March 31, 2009.

Support for Financial Institutions and Agencies Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April  The Department of Banking and Department of Savings and Mortgage Lending (SML) need legislative support to: Ensure adequate long-term funding and personnel resources for the agencies that: oMaintain an experienced staff that can identify and respond to institutional weaknesses; oUnderstand, monitor and manage institutional operating patterns and risk exposures; and oSustain staff development and encourage qualified candidate recruitment.  Communicate with the congressional delegation about the importance of community financial institutions and the dual banking system.  The Texas Finance Commission adopted a resolution December 19, 2008, supporting the dual banking system (See Appendix ).  Commissioner Cooper and Commissioner Foster spoke at several trade association events, briefing participants (typically bankers) on events impacting the industry and offering their support.  SML held Thrift Industry Day, an opportunity for thrift executives to hear presentations from SML staff and to network with each other.  Several organizations provide support for regulators including: Conference of State Bank Supervisors (CSBS) - Promotes the preservation of the states’ authority in financial supervision (See Appendices and ). American Council of State Savings Supervisors C DE

Community Banks and Local Economy 22 Small businesses are the heart of the American economy. They are responsible for half of all private-sector jobs and they created approximately 70% of all new jobs in the past decade. Government initiatives to reduce or waive SBA loan fees and increase loan guarantee levels should allow community banks to help boost credit markets and small business lending. Source: White House press release  Meeting community lending needs through small business, home, commercial, and consumer loans;  Offering depository accounts and other products and services;  Purchasing debt obligations of local municipalities;  Providing community leadership and civic activities; and  Contributing to charitable organizations. State-chartered financial institutions are important to the economic viability of their local communities by: Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009 F See Appendix for state-chartered financial institution loan growth in 2008 and 2007

23 FDIC deposit insurance available per depositor up to $250,000 through the end of FDIC Deposit Insurance Increase Source: FDIC Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

24 Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009 Affects of New FDIC Assessment Analysis of the affect of the FDIC’s new and one-time assessments on all state-chartered banks and thrifts. bp= basis point In thousands

Affects of New FDIC Assessment 25 bp= basis point In thousands Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009 Analysis of the affect of the FDIC’s new and one-time assessments on a median state-chartered bank and thrift.

Appendices 2008 Timeline of Events Deposit Market Share in Texas Finance Commission Resolution Supporting the Dual Banking System CSBS Letter to Governor’s Association CSBS Letter to States to Send to Their Congressional Delegation State-Chartered Bank and Thrift Loan Growth for 2007 and 2008 A C D E F B

2008 Timeline of Events A Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

2008 Timeline of Events A Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

2008 Timeline of Events A Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

Deposit Market Share in Texas B Source: FDIC Offered by: Texas Department of Banking and Texas Savings and Mortgage Lending April 2009

C

D

E CSBS Letter for States to Send to Their Congressional Delegation

Texas State-Chartered Bank and Thrift Loan Growth F Adjusted for major mergers and acquisitions Source: FDIC Statistics on Depository Institutions