When the stock of Sterling Financial Corp. plunged recently, it was pushed down in part by short selling allowed under new federal regulations, asserts Harold Gilkey, chairman and CEO of the Spokane-based financial holding company.


Short selling of stock, or agreeing to provide shares at a certain price at a later date, involves betting that the price of a stock will go downand that the short seller will be able to profit by buying the stock at a lower price before having to deliver it. It can raise suspicions if its believed a short seller is trying to drive down a stocks price before buying it.


The SEC changed the rules on short sellers, Gilkey says. It used to be that you could sell short only on an uptick in the market. Also, he says,You had to borrow the stock.


Now, he says, You can sell short anytime. You dont have to borrow the stock; you just have to identify where youd get it.


Gilkey adds, They clearly increased the volatility in the stock market. They gave the hedge fund managers a new way to make money.


In Sterlings case, the rumors were that we needed capital, Gilkey says. He dismisses that notion, saying, We have $1.2 billion in capital.


Also, it was rumored that Sterling had suffered $800 million in losses, he says. On July 22, Sterling posted second-quarter net of $11.7 million.


The Spokane bank holding companys stock, which has been as high as $29.28 a share in the previous year, was driven down to a low of $2.36 a share on July 15 as the stocks of Washington state banks fell.


Sterling is powerless to do anything about rumors, Gilkey says, adding, How do you prove a negative? I can only control the things I can control. I cant control Wall Street.


Still, he says, Sterling was affected more than others, because were a liquid stock, versus shares for which theres little demand.


The national mortgage crisis that has hurt financial institutions had its roots in the repeal of the Glass-Steagall Act, which separated the activities of investment bankers, such as those on Wall Street, from the activities of commercial bankers, asserts Gilkey.


The interplay between investment bankers and community bankers helped create the violent swings in the Depressionand deepened the nations current financial crisis, Gilkey says.


That occurred when Wall Street and major U.S. banks sold mortgage-backed securities and made billions of dollars available for mortgage lending, he says.


They formed the genesis of subprime lending, and as demand for loans mushroomed, it became a matter of how much product could you provide, Gilkey says.


Greed overcame fear, and it was for minor dollars, he says. At one point, Gilkey met in Seattle with a group of CFOs, including one who had made an enormous investment in a product he didnt understand because it would earn 1/16th of a percentage point in additional interest, Gilkey says. In this case, Hell get his money back, but its illogical, Gilkey says.


In such an environment, mortgage lenders relaxed their lending standards until it got so bad all you had to do was sign a paper and you got a mortgage, Gilkey says. The excesses resulted in a surplus of buyers, leading to a bubble in the housing market, he says.


In the worst example hes familiar with, a 29-year-old house-flipping resident of the Boise area who made $34,000 a year in his job claimed falsely that he had annual income of $1 millionand obtained mortgages on nine houses at once, Gilkey says. Those loans, made to a non-Sterling customer, were sold to Countrywide, a national mortgage lender whose financial collapse and purchase by Bank of America has become synonymous with the excesses of subprime lending.


I know a lot of people who are 29 years old. I dont know any who have an income of $1 million a year, Gilkey says. This kid couldnt pay for one house, much less nine.


When the housing market collapsed, all of a sudden these major money-center banks, New York City banks, got caught with an inventory (of mortgages) that was surplus, Gilkey says. They recorded huge losses, and so did Wall Street brokerages, and financial stocks have been punished as a result, he says.


The big banks that participated in the fiasco had softened their underwriting standards even though the primary responsibility of a commercial banker is to protect depositors money, Gilkey says.


Sterling and other banks that didnt do subprime lending still are burdened with the remnants of a credit crisis that was not of our own making, Gilkey says.


At the end of the second quarter, Sterlings nonperforming assets, mostly loans on which borrowers are at least 90 days delinquent, had climbed to $303.4 million, up from just $33.4 million a year earlier, while classified assets, or assets that are problematical because markets have deteriorated or borrowers businesses have changed, had risen to $497.5 million, up from $95 million.


The mistake we made is we expanded with our developers, which occurred in part because of changing relationships between bankers and developers, Gilkey says.


A builder who has made a lot of money buys real estate to make more money, and developers were making money while homes were selling well, he says. Historically, if you banked a developer, you had all of his business, and a banker who thought a developer might be getting overextended could say, Gee, we think you have enough (loans) out, Gilkey says.


Yet, in the overheated lending market that preceded the mortgage crisis, a developer could get more money simply by talking to another banker, he says. Consequently, there was significant leverage that wasnt historically there.


Sterling already had expanded to Boise, then had bought First Bank NW Corp., of Clarkston, Wash., which had a portfolio of loans there, adding to Sterlings problems when the market soured, Gilkey says.


We wanted to have x amount of the construction activity in the Boise market; we ended up with x plus y, he says.


Because good numbers of new jobs are being created in the Boise market, and job seekers are buying homes there, Sterlings nonperforming assets in the market have fallen to 12 percent of all such assets, down from 17 percent at the end of the first quarter, Gilkey says. Also, things have improved for Sterling in Vancouver, Wash., and Bend, Ore., and the Puget Sound and Southern California markets have remained on an even keel, although Portland and Utah have worsened.


Spokane, he says, has some excess housing supply, but doesnt have the kind of excess inventory built up elsewhere in part by loose lending practices and resulting heightened liquidity in the market.


Sterling has been served well during the crisis by the geographic dispersion of its business, which is another form of diversification, Gilkey says. Also, it wrote a lot of business in the second quarter, with loan originations of $1.06 billion, just under the $1.08 billion in new loans it originated in the year-earlier quarter.


About $8.5 billion of our $9 billion portfolio is operating extremely well, Gilkey says.


He predicts that Sterlings nonperforming assets likely will peak sometime in the third or fourth quarters this year, and Sterling and other Pacific Northwest banks will work through their problems during 2009.


Its been a year now; it takes some time to get your arms around (the problem), he says. The problem came on suddenly. While nobody can clearly call the bottom, were probably bouncing off the bottom now. It will take a couple of years to fix.


Asked whether Congress should reinstate the firewalls between investment bankers and commercial bankers that long were provided by the Glass-Steagall Act, Gilkey says, Im not a politician, although he believes the act should have been left in place. He says the Federal Housing Administration has done a marvelous job of identifying the problem, and fixing it, and he supports the compromise reached in Congress to provide support for Freddie Mac and Fannie Mae. Without that, we could have had much more serious problems, Gilkey says.


From its low point of $2.36 a share on July 15, Sterling had rebounded to trade as high as $8.15 on Aug. 5, the day Gilkey was interviewed for this story. He said he had bought 20,000 shares on Friday, Aug. 1, the first day he, as a corporate officer, was eligible to buy the companys stock after Sterlings recent earnings release.


Contact Richard Ripley at (509) 344-1261 or via e-mail at editor@spokanejournal.com.