Bad loans burst bubble for local banks

The roadside signs advertise village life, a quiet hamlet painted in muted shades of gray, green and brown. The driveways slope down from two-car garages, and basketball hoops and satellite dishes show that people call this place home.

Just not enough people.

Cars crawl slowly down the streets as twilight creeps across trimmed lawns and tended flower beds. The drivers are home from work for the weekend; there’s no need to rush. The garage doors open, cars drive in. The doors shut. Lights turn on. All seems well at Tambark Village, a compact neighborhood built on a soggy stretch of land near the heart of Mill Creek.

Developments like this one brought the community banking sector to its knees.

At the edge of this quiet, sepia-toned village, there’s a piece of land that hasn’t entirely grown up — only part has spawned a rigid army of houses.

The other plots are vacant, marked by signs that yell “Available!” to anyone who takes a drive down the barren cul-de-sac.

This is Cottage Court. Except the cottages are three stories high, and the court — if that’s what the loops of roads comprise — is mostly empty.

Cottage Court is fodder for a polite but grim legal battle unfolding slowly in Snohomish County Superior Court between Frontier Financial Corp. and the property’s developer, the McNaughton Group. The Everett-based bank sued the McNaughton Group last fall for more than $40 million in loans and bank fees stemming from several construction projects around the county.

Lawsuits like that one are a sign of the times. Before the economy crashed, community banks all over the nation flourished by feeding off real estate.

Not anymore.

“Part of the problem is, banks aren’t healthy enough to fund (what we do),” said Kevin Ballard, general manager at the McNaughton Group.

That means development companies are looking for other ways to finish construction projects, including looking to private investors. But bad loans are still on the books at banks, giving regulators ample reason to constrain their lending ability.

The result? An economic stalemate that makes recession wounds slow to heal.

Banks in trouble

Seven banks across the nation failed in February. January hit the industry even harder, with 15 shut-downs.

Washington state alone has had a heaping helping of failures; seven banks landed on the Federal Deposit Insurance Corp.’s failed bank list within the last year, including Evergreen Bank in Seattle, Rainier Pacific Bank in Tacoma, and Horizon Bank in Bellingham.

Scott Jarvis, director of the state’s Department of Financial Institutions, said the root of the banks’ trouble grows from two sources: residential and commercial real estate. Housing developments gone awry are just one part of the equation; the vacant office buildings in downtown Seattle and going-out-of-business signs in small towns also play a part.

“If you go by the typical strip mall, you will see vacant stores where before there were occupancies,” Jarvis said.

Before banks fail, regulators crack down with warnings and directives. One of the biggest orders for community banks: diversify loan portfolios saturated with real-estate deals gone bad.

More than one third of nearly 90 banks in Washington are operating under some sort of regulatory reprimand.

And for two banks in Snohomish County, the situation became a little more dire last week.

City Bank of Lynnwood is scrambling to sell off foreclosed homes after the FDIC instructed it to get about $30 million from new investors and reduce its land base and other assets to $1 billion before the end of the month. The bank was also given an ultimatum: Raise more capital before April 10 or be sold to the highest bidder.

Everett-based Frontier Financial Corp. was labeled “critically undercapitalized” after the FDIC determined its fourth-quarter losses were more severe than initially reported. Frontier is appealing the FDIC’s assessment, but still risks government seizure if those appeals are denied.

Frontier now has until April 15 to raise capital or face the same type of sale as City Bank.

The orders signal that despite slight recoveries in the real estate market and an official end to recession, true recovery will take much longer.

“We’re not out of the woods yet,” Jarvis said. “And from my standpoint, it’s going to be another long year.”

The new Frontier

Everything looks like business as usual inside the Frontier Bank branch on Colby Avenue in Everett.

A teller counts out cash behind the counter. A loan representative in a blue tie meets with a woman about “your options.” And the new-accounts desk is vacant during a lunch break.

Those are the day-to-day signs of life that mask an institution fighting for survival.

Frontier’s stock was worth $2.75 a share at closing Tuesday. On the same date in 2007, it closed at $26.39. In between, the bank engineered a reverse stock split that lowered the number of available shares to increase their value.

When Frontier Chief Executive Pat Fahey came out of retirement in 2008 to run the bank, the community banking industry was in the early stages of upheaval. Though construction meant big returns for years, it was a boom-or-bust investment.

And most bank officials across the country weren’t betting that a near-depression would flip the construction industry upside down.

“It was just … a house of cards,” Fahey said. “I think people were perhaps deluded by the fact that it was going so well. And it was very profitable.”

But only for a while, he added. “Yield and risk go together.”

Now, Frontier is seeking an investor to take over the bank with a fresh supply of cash. The bank found a buyer last year, but the pending sale didn’t pass muster with regulators in time to meet deadlines.

The FDIC’s recent move to classify the bank as “critically undercapitalized” hasn’t changed that goal. Bank officials continue to meet with potential investors, many from the Puget Sound area.

The region is “coming out of its darkest hour,” Fahey said. Still it’s a tough time to raise capital.

If Frontier does emerge from the worst recession in recent history unscathed, it’ll mean a more conservative approach to real-estate lending.

“We will continue to be in that business, but we’ll be in it for appropriate levels of concentration,” Fahey said. “That was what brought about the problem in the first place.”

In the spotlight

Community banks were dealt a punishing blow by recession in 2008, but that blow was overshadowed by government seizure and bailouts of financial giants.

Now, the spotlight has shifted.

Politicians are looking for an injection that will unfreeze the country’s credit market, and they think it might be buried underneath the rubble of the shaky small-scale banking industry.

Small businesses need to hire workers to cure the nation’s high unemployment rates. And banks need to lend in order for hiring to happen.

That’s the assumption made in Washington, D.C., where directives regarding community lending come rolling out of the Capitol building and White House every few weeks.

But being part of the solution means making loans. And the constraints regulators placed on troubled community banks make that a tough prospect.

It’s a cycle that needs to break, said Sen. Patty Murray, the sponsor of a bill that would direct $30 billion from the Troubled Asset Relief Program to community banks. “The FDIC is saying to them, ‘You have too much on the expense side,’ ” Murray said. “Well, they can’t fix that.”

Her goal for community banking legislation? “Get these toxic assets off their books, which is what we did for the big banks.”

Read Amy Rolph’s small-business blog at www.heraldnet.com/TheStorefront. Contact her at 425-339-3029 or arolph@heraldnet.com.

Part one of a two-part series. Check back tomorrow to read about how problems at community banks have affected the region’s small-businesses.

Regulators have given Frontier Bank until April 15 to raise more money or be sold. Page D1.