This recession and its accompanying financial crises started with large financial institutions making headlines with bad loans, liquidity problems, and in many cases insolvency. The driving factors at that point were the toxic residential-real-estate-based securities filtering their way through the financial system. Many large financial institutions were highly exposed to securitized packages of residential mortgages whose underlying fundamentals deteriorated very quickly.

We’ve seen a lot of Bank failures since September 2008. By Friday October 23 there have been 106 bank failures thus far in 2009, the most since 1992. However, the composition of the failures has been changing from large financial institutions to small banks. A key factor driving the compositional change is commercial real estate, which remained relatively healthy through the first three quarters of 2008, but has gradually been pulled into decline by the rest of the economy. The weight of joblessness, falling retail sales, and unwanted office space has driven commercial real estate to historically high vacancy rates and depressingly low net absorption rates.

While small banks were not highly exposed to securitized residential mortgage risk, they appear to be more exposed to commercial real estate and business loans secured by commercial real estate. Given that commercial foreclosures have not yet peaked we expect that more bank failures will occur during the next 12 months, with small banks leading the parade. As this market evolves, it will likely contribute to weak credit availability on Main Street.