David Payne has grown accustomed to disappointing people. The chairman and chief executive at the $4.7 billion-asset Westamerica Bancorp in San Rafael, Calif., has weathered the worst of the financial crisis better than most peers, yet finds himself saying "no" to prospective borrowers more often than he'd like. He's also spending more time counseling loan officers discouraged by the number of applications that get shot down in the underwriting process.

"Our declination rate right now is in excess of 90 percent of applications," Payne says. "It's all on the commercial side-people who can't qualify because their credit is damaged. They had a bankruptcy, they can't support the cash flows needed for the loan, they don't have enough collateral, their net worths are inverted.

"It's very hard to watch. You feel terrible, but you can't do something that's unsafe to your bank."

With 37 million residents and a $1.9 trillion economy that, on its own, would rank seventh in the world, California has a history of leading the country out of recessions. But that doesn't appear likely to materialize this time around.

Following a real estate crash that was as severe as any state's, its economy is in shambles. The unemployment rate stood at 12.5 percent in August, among the highest in the nation, and lawmakers haven't been able to close a $19 billion state budget shortfall. Perhaps most significantly, real estate prices, which have fallen by as much as two-thirds, have continued to drop in some areas, and remain pretty much stalled out elsewhere. In August, California recorded 69,143 foreclosures, or 20 percent of all filings in the nation, according to RealtyTrac, an Irvine, Calif., tracking firm.

"There's always been a California recovery story," says Richard Hartnack, vice chairman of consumer banking for U.S. Bancorp. "But we have such an overhang of excess residential real estate today, it's still a ways off."

Commercial real estate isn't in much better shape. According to SNL Financial LC, CRE delinquencies in California during the second quarter were 5.14 percent, up from 4.61 percent in 2009 and above the national average of 4.56 percent.

Double-digit office vacancy rates are the rule across the state; some markets, including Sacramento and Riverside, are at or above 20 percent. And with retail sales slumping, malls are under pressure, too.

Banks, of course, are feeling the pain. More than 30 banks have failed in the state since mid-2008-fourth-most in the nation in that span-and observers say another 20 could go down. Meanwhile, many of the survivors are struggling just to stay profitable. The median return on equity for publicly held banks with less than $10 billion of assets was 1.46 percent in California, according to SNL, versus 5.81 percent for the nation; return on assets was 0.18 percent compared to 0.62 percent nationally.

"In my career, I've never seen a recession anywhere near as deep as this one, or an environment that's been more difficult to bank in," says Steven Buster, the CEO at the $3 billion-asset Mechanics Bank in Richmond.

What California needs to shake the doldrums is a good dose of job creation-something the state legislature is trying to do in budgeting $300 million to assist small businesses in that effort.

Policymakers are also counting on investments in green technology, government stimulus spending and increased trade activity flowing through its ports to make a dent in an unemployment rate that's expected to linger in the double digits at least through 2012, according to the UCLA Anderson Forecast.

The challenge is that real estate is the state's biggest industry, accounting for one in eight jobs before the market went bust. In 2005, new-housing construction alone generated 487,000 jobs and $67.7 billion of economic activity in the state, according to the California Homebuilding Foundation. In 2009, the tally was 77,000 jobs and $13.8 billion.

"It's the most important segment of the economy," says Sung Won Sohn, an economics and finance professor at California State University-Channel Islands, and a former chief economist at Wells Fargo & Co. "When the boom went bust, people lost their jobs, and they haven't come back."

"It's a vicious circle," says Joseph Otting, Los Angeles-based vice chairman of commercial banking for U.S. Bancorp. "Until the building industry can come back-or a suitable replacement industry emerges-it's going to be very difficult to get back to full employment."

Banks could give the industry a boost by easing credit standards, says Richard DeKaser, a noted real estate economist and president of Woodley Park Research in Washington, D.C. But they've been burned by real estate already and are under pressure from regulators to be exceedingly cautious. "They'll only [finance real estate transactions] if they perceive price improvements. That will happen gradually, not overnight," he says.

California was perhaps the primary incubator for the financial crisis, and paid among the heaviest tolls.

Many of the most toxic mortgage products-the subprime, no-doc, low-doc, option-ARM, all with little-or-no-money-down-were created there, and employed with fervor across the state. Underwriting was slipshod, and fraud, often in the form of misstated incomes, became commonplace. Regulators issued warnings and advisories on real estate exposures, but offered little in the way of tough oversight.

The central valley and Inland Empire, running vertically through the center of the state from Sacramento down to Bakersfield, soared the highest and took the most precipitous fall. In Merced, the median price of a house rocketed from $167,700 in 2003 to $305,700 three years later, according to figures from Woodley Park Research. In the second quarter of this year, it stood at $101,900-a 66 percent drop from its peak.

Other markets have witnessed similar drops. Median prices in Stockton and Modesto are off 60 percent from their highs; Bakersfield, Madera, Salinas and Vallejo all have seen values more than halved. Tonier burgs, such as Santa Barbara and Napa, have witnessed price drops of more than 40 percent from their highs.

As happened elsewhere, banks that had nothing to do with the exotic products got caught up in the free fall. With mortgages so easy to get-and a belief that housing prices could never fall-developers found willing lending partners in many banks.

Richard Smith, the CEO of Trico Bancshares in Chico, Calif., tells of a borrower who approached Trico's main subsidiary, the $2.2 billion-asset Tri-Counties Bank, in 2007 with what, at the time, seemed like a can't-miss deal: the opportunity to pay $10 million for a commercial property appraised at $15 million. The customer put down $5 million and borrowed the rest.

"We thought we had made a $5 million loan against $15 million, but three years later the appraised value was $3.2 million," Smith explains. The loan is now in workout, and Trico has booked a loss. "You would have thought we would be in good shape with that kind of loan. ... It shows just how difficult it is to judge things in a declining real estate market."

To be sure, it's not all gloom and doom. Bankers and analysts agree that things aren't as dire as they were even a year ago. Delinquency rates on multi-family housing have dropped sharply, to 2.74 percent in the first half, from 3.70 percent in 2009-well below the national average, and an indication that the worst may be over.

The housing market is showing some nascent signs of stabilization. While median prices continued to decline in many inland markets during the second quarter, the drops were slighter than they've been in the past. Prices in some of the biggest cities-including Los Angeles, San Francisco and San Jose-jumped in the second quarter to levels not seen since late 2008.

"Historically, price appreciation starts along the coast, then moves like a wave through the Inland Empire area and the mountains," Otting explains.

Bankers and analysts are quick to offer up anecdotal evidence that suggests the California economy is poised to turn a corner. Lisa Stevens, a Los Angeles-based executive vice president and regional president for California retail banking at Wells Fargo, tells of a big housing development in Irvine, east of Los Angeles, that had been halted for two-and-a-half years due to the slowdown.

Wells opened a new branch nearby, anticipating business that didn't materialize. A recent surge in buying has changed all that. "Now, every house is sold and the project will be completed in six months," Stevens says. "We're seeing pockets of good recovery. Customers feel like they're coming out of the most difficult times."

Aaron Deer, a San Francisco-based analyst at Sandler O'Neill & Partners LP, talks about ferry rides and coffee shops around town that seem more crowded than they were a year ago. Recently, he attended a conference in Los Angeles for buyers of distressed assets.

The vultures "were frustrated. The deals that are coming up this year, there's so much competition that prices are getting bid up," he explains.

"We have money coming back into the market," Deer says-something that's showing up in lower losses for banks on sales of foreclosed properties.

It takes a while for the impact of such anecdotes to trickle into the official statistics. A few of the strongest banks, including U.S. Bancorp and Umpqua Holdings, are positioning themselves for a rebound through FDIC-assisted deals, deeply discounted mergers or de novo openings.

"I tell people, 'Keep your eyes up. The opportunities that are passing you by right now will never come again,'" Davis says. Umpqua has 71 branches in California, and recently opened branches in Santa Rosa and San Francisco to capitalize on the disruption. "But you've got to have a very strong balance sheet to take advantage of the situation."

Still, with property values so depressed, it's hard to imagine real estate driving California's recovery. And if not real estate, then what?

The state's economy is diverse; the high-tech, agriculture, tourism and entertainment industries are all big enough to lift the state's prospects.

Perhaps California's biggest ace-in-the-hole is its ties to Asia, which provides a healthy base of immigrants, as well as flows of investment capital and trade. Eighty percent of international goods that come through the West Coast of the U.S. come through the ports of Los Angeles and Long Beach. The import-export business has picked up from its 2009 lows, with the region's trade traffic expected to grow more than 11 percent this year, according to a report in May by the Los Angeles County Economic Development Corp.

Buster of Mechanics Bank invests in rail cars on the side, and says carrying volumes are "way up. That's commerce. Freight levels are improving; inventories are building. Something is happening, and it could be contagious."

It could be a while before job growth catches up, however. Firms began shedding jobs as the economy soured, and a report from the Los Angeles County Economic Development Corp. projects that trade-based employment won't return to its 2007 peak until 2015.

California is also a hub of green-technology investment. The nonprofit research firm Next 10 has tracked more than $11.6 billion in clean-energy venture capital since 2006.

But the $452 million in green-company investments attracted in the third quarter this year was down 61 percent from a year ago, according to San Francisco-based consulting firm Cleantech Group-a possible fallout from the planned November ballot initiative that could suspend the state's global warming law requiring more use of clean energy resources by utility companies.

Many bankers would like to make more commercial and industrial loans to fill the void left by real estate. Ray Davis, the CEO of Umpqua Holdings Corp. in Portland, Ore., estimates the market for small and midsize business loans in the state at $80 billion.

Deposits in the state have surged by an average of 5 percent in the past year, but loan demand through the first half of 2010 was off 10 percent from a year ago, leaving banks no place to effectively deploy the funding.

The problem is that many would-be borrowers are less interested in expansion than survival, and are viewed as not worth the risk.

Conversely, clients viewed as more bankable are hunkered down, the economy too sluggish and uncertain to justify much expansion or hiring.

"Demand for good loans isn't just down, it's absent," says Sandler O'Neill's Deer. "Consumers and businesses are de-leveraging, hanging onto more cash, paying down their debts. It's arguably a good thing for the long-term economy, but it's very painful for the banks."

The tough times have taken a toll on frontline morale.

Recently, a manager asked Payne to call one loan officer who had four straight big loans denied. "He said, 'Can you call this guy and pump him up? He's been working very hard, then the appraisals come in and they can't support the loan,'" Payne recalls. "Keeping the relationship people in the field propped up is a full-time effort."

With so few bankable borrowers out there, and competition for good loans so fierce, Payne says some banks are getting desperate. He has heard stories of banks offering attractive customers "sub-6 percent, seven-year fixed loans" on commercial loans-a dicey proposition in the present low-rate environment.

"We're seeing a return of the same irrational pricing that got us into trouble in the first place," Payne says.

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