Local Banks Feeling Pinched
Fed Rate Cuts Squeeze Lending Margins

By Alejandro Lazo
Washington Post Staff Writer
Monday, April 7, 2008

The Federal Reserve's aggressive moves to reduce interest rates are posing new problems for regional and local banks already suffering setbacks from the housing slump.

The Fed has cut the federal funds rate, the key interest rate it controls, six times since September in an attempt to ward off a financial crisis. And with each cut, the rate banks can charge a variety of businesses and consumers has often fallen as well.

Community banks, in particular, are seeing their profits decline because they tend to rely on small-business and real estate development loans that adjust almost immediately to a rate cut by the central bank.

These smaller banks are also more reliant on certificate of deposit accounts, which pay out fixed interest rates to their customers over set time periods, meaning in a time of rapid rate reductions they are locked into paying higher rates until the term expires.

The housing slump is bringing other worries. Most community banks have avoided the losses from the subprime mortgage crisis that has plagued some of the bigger national banks and Wall Street investment firms.

But smaller community banks are not immune to the secondary affects of the housing market's downturn. Developers can default on construction loans if real estate prices plunge and projects fail.

"This is going to be a pretty interesting time over the next 12 months," said Bryce W. Rowe, an analyst with Robert W. Baird & Co. who covers several of the publicly traded banks in the Washington area. "I have a hard time thinking [community banks] are going to get through it without a major event."

So far that hasn't happened, but investors are nervous.

By the end of 2007, construction loans accounted for about 28 percent of Arlington-based Virginia Commerce Bancorp's loan portfolio, analysts said. Shares for the Virginia bank are well off their 52-week high of $20.32 as the banking environment has weakened. The stock closed at $12.12 Friday. Bank executives did not return calls seeking comment.

"Virginia Commerce historically has been one of the best performing banks in the country and it has really been growing at a blistering pace over the last five to 10 years," said Mark Muth, an analyst with FTN Midwest. "With the real estate slowdown, obviously that growth has also slowed down and they have hit a wall."

The number of troubled loans at both Reston-based Millennium Bankshares and Chantilly-based Alliance Bankshares have ticked up as well over the last year. Investors have reacted and their shares have fallen.

Richard I. Linhart, the chief executive of Millennium who was installed last year to turn the company around, said it will take time to pick through the loans that were made during the real estate boom. Acquisition and development loans used to finance the first stage of construction projects made up a sizable portion of the loans the bank cannot collect on.

"What happens is when the real estate market implodes, those appraisal values start going down," Linhart said. "To me, it's just a period of time where you hunker down and weather it, but it will certainly impact bank earnings in the short term."

Even those banks that have largely avoided losses from loans related to the real estate downturn are getting hit by a compression of their net interest margins -- the difference between what they earn on loans and pay out on deposits -- because of the central bank's rate-cut campaign.

The Fed has cut the federal funds rate to 2.25 percent, from 5.25 percent, since September.

"In January alone, the Fed cut 125 [basis] points in eight days -- which is huge," said Muth of FTN Midwest. A basis point is 0.01 of a percentage point. "There is no way that banks can keep up with that kind of decrease."

Competition for deposits has also kept the interest rates banks pay to their customers higher.

Local banks' troubles have not been exclusive to Northern Virginia, nor strictly tied to that region's real estate market. Sandy Spring Bancorp, headquartered in Olney, has seen its nonperforming loan portfolio surge to $34.4 million at the end of 2007 from $3.7 million a year earlier. The company attributes a sizable portion of that increase to a troubled development loan in Delaware, analysts said.

Chevy Chase Bank, of Bethesda, the area's largest locally headquartered bank, announced late last year that it was laying off about 300 employees as it reduced banking hours and mortgage operations. Chevy Chase underwrites billions of dollars in home loans throughout the country, many in California.

Cardinal Financial has weathered the turbulent credit markets and had essentially no nonperforming loans on its books at year's end. The McLean company's mortgage-banking subsidiary, George Mason, also remained profitable last year, though profits declined.

Bernard H. Clineburg, chief executive of the company, said Northern Virginia will remain a difficult place for community banks for at least the rest of the year.

"I think there is a bomb waiting to blow," Clineburg said. "I can feel it. I can smell it. I just don't know where it is going to be."