Commercial Deals Abound, but Loans are Scarce

The Wall Street Journal

 

Real-estate prices are enticingly low in many areas of the country, prompting business owners to pursue sweet deals on storefronts, manufacturing facilities and other commercial properties. But because banks remain wary of commercial real-estate loans, landing financing to make such a purchase can be time consuming and tedious.

Compared to peak prices in October 2007, commercial property values are down 42%, according to Moody's Investors Service Inc. Price index reports compiled by Moody's and Real Capital Analytics Inc. show that as of March 2010, the cost of industrial and office space fell 32% in the last two years. Retail space also plummeted 28%.

"There is excess space, which opens an opportunity for small firms," says Bill Dunkelberg, chief economist at National Federation of Independent Business, a Washington advocacy group. "You won't see prices like these for a long time."

Some owners are heeding the call. Randy Scheidt, who heads the legislative subcommittee of the National Association of Realtor's commercial division, says that he is noticing business owners "feeling more comfortable with the future" and weighing whether "such an acquisition would be fiscally prudent."

But the tight credit environment is making it difficult for entrepreneurs to secure those loans. "What is so different today versus 2006 is the underwriting scrutiny," says Mr. Scheidt. "It's not unusual for [the loan process] to take an additional 30 to 60 days."

Eliot Boyle, owner of U.S. Metals LLC in Denver, decided last year to move his sheet-metal roofing and siding business to a new facility. Lease rates in the area were steady, but commercial spaces for sale on the market were falling. "We thought this was a good time to take advantage of how well we were doing and how poorly the real-estate environment was doing," he says.

After preparing his business plan, he visited five banks and was turned down by four. The remaining lender, Bank of the West, which had previously worked with Mr. Boyle, issued him a Small Business Administration loan to buy a $680,000 building. The price for the space —a 50%-larger facility—had dropped 40%.

The process took longer than anticipated and closed one day before the scheduled move. The delays, says Mr. Boyle, stemmed from the bank's requirement of additional environmental reports and other due diligence.

"All those appraisals showed that…if the bank needs to move fast and has to liquidate the building quickly, it can do that," says Mr. Boyle.

"The approval timelines are really not that different than they were in the past," says Jim Cole, spokesperson for the San Francisco-based Bank of the West. "Appraisals take the same amount of time and, as always, environmental reports can take longer than expected."

Many banks taking extra precaution before issuing commercial mortgages are reeling from those kinds of losses and are wary of putting more of those loans on their books. According to a Real Capital Analytics' study of Federal Deposit Insurance Corp. and bank data, the default rate for commercial real-estate mortgages rose to 4.2%, amounting to $45.5 billion, for the first quarter of 2010. That's the highest default rate since 1992.

Commercial real estate loans have really hurt community and regional banks, which are key lenders to small businesses. They hold just more than half of bank-issued commercial mortgages and their portfolios are likely to hurt for some time. The default trend is expected to continue through 2011, when it may hit 5.4%, before abating, according to Real Capital Analytics.

Although the commercial real estate market has shown some tentative signs of life in the early months of 2010, there is little transparency about the value of many properties, says Sam Chandan, chief economist at Real Capital Analytics. Appraisals help determine price, he explains, but commercial property values are supported by other transactions in the area.

To overcome the credit challenge, experts say entrepreneurs can make themselves more attractive by submitting sound financial plans that back up their income projections and intent to repay the loan. Borrowers with solid credit histories and established bank relationships are more likely to get a loan.

Mr. Chandan says newer businesses can still land financing if they can bring equity to the table, especially if the borrower wants to purchase a vacant property that the bank is holding. But, he cautions, "lending standards have tightened considerably, so it will be challenging."

SW Florida Banks, Builders In Bind Over Loans

News-Press

Lloyd Mandel developed the Shoppes at the Forest center on U.S. 41. 

Now he and SunTrust Bank are on a battle over a mortgage for the property.

Lloyd Mandel says he fulfilled his part of a bargain with SunTrust Bank: He built a strip mall in south Fort Myers, and leased out most of it.

Now Mandel, of Mandel & Simms Real Estate, wants to convert his construction loan to a mortgage at the rate agreed upon two years ago when the project got started.

But, he says, SunTrust won't honor the deal, citing various "outs" in the contract such as a drop in the value of the property.

"We're not going to comment on a particular client," said SunTrust spokesman Mike McCoy. But, he noted, "we obviously are in the business to make loans to creditworthy borrowers."

If banks start exercising their rights on a large scale to get out of agreements to lend, Mandel said, "no piece of commercial property in Lee County is safe if it's got a mortgage on it."

Whatever the future holds, experts say, it's clear in the past few months more builders are facing a troublesome combination of plummeting commercial values and cash-strapped bankers who can't — or won't — make the loans.

Now, with their back to the wall, some builders are fighting back. Tactics include filing to reorganize in bankruptcy court in an attempt to get a judge's intervention.

Mandel said he's considering taking that course, noting the bankruptcy judge has power to write down a commercial loan or otherwise change the terms.

"Since mid-November, I bet I've had a dozen people call recounting similar fact patterns across the Southeast," said Jack Williams, resident scholar at the American Bankruptcy Institute and a bankruptcy professor at Georgia State University. "The story unfortunately isn't new to me. I think it's an indication of things to come."

Commercial Mortgage Defaults Next Problem For Insurers

Investment News

Potential losses from mortgage-backed securities, direct loans could top $22B through 2011, rating agency Fitch predicts

Already under pressure from credit rating agencies, U.S. life insurers are about to be rocked again — by defaults on their investments in commercial real estate and mortgages, according to a report from Fitch Ratings Ltd.

Unless the commercial real estate market recovers, Fitch estimates that commercial-mortgage-backed securities of recent vintages will suffer losses that average out to about 9%. The ratings firm expects pressure on the securities and other non-AAA rated bundles of commercial mortgages to rise sharply next year.

Fitch projects the potential losses from commercial-mortgage-backed securities owned by life carriers to be between $13.1 billion and $16.0 billion. Directly-placed mortgages will generate $5.4 billion to $6.6 billion in losses through 2011, under Fitch’s core stress scenario.

As of the end of 2008, Fitch’s universe of life carriers had about $308 billion or 12% of invested assets in directly-placed mortgage loans. Exposure to commercial mortgage-backed securities, including collateralized-debt obligations comprised of commercial real estate, topped $150 billion or 5.8% of total invested assets at the end of last year, according to Fitch.

However, most of the securities were investment-grade, as less than 2% of invested assets were in high-yield securities at the end of 2008, according to Fitch.

Fitch also notes that the steep declines in statutory capital over the last 18 months have hobbled the insurers’ ability to get through an extended downturn.

To date, the life insurers have not recognized material impairments or losses on investments related to commercial real estate, according to Fitch.

Why The Commercial Real Estate Bust Is Different

from Business Week

Unrealistic assumptions, layers of investors, sky-high prices, and possible fraud will make it hard to clean up the mess in commercial real estate

When Goldman Sachs (GS) sold complex bonds backed by the Arizona Grand Resort and other commercial properties in 2006, it suggested the returns would be strong. The 164-acre luxury Arizona Grand, set against the Sonoran Desert in Phoenix, boasted an award-winning golf course, deluxe spa, and several swank restaurants. The on-site water park was named one of the best in the country by the Travel Channel. With the resort's new owners planning to refurbish hotel rooms and common areas, Goldman told investors that the renovations would help boost cash flow.

As was so often the case during the real estate boom, the lofty projections didn't pan out. When the economy softened and business travel slumped, Arizona Grand's bookings slipped to 67%, from 80%. The resort defaulted on the $190 million underlying loan in 2009—a hit that alone could largely wipe out investors who bought the riskier pieces of the Goldman mortgage-backed securities deal.

"It's one of the largest losses we have forecasted for an individual loan," says Steve Kuritz, a senior vice-president at Realpoint, an independent credit-rating agency. The property, once valued at $246 million, is now worth just $93 million. A spokesman for Goldman says the pricing on the bonds was in line with market levels at the time and not above what investors could get on similar securities. Grossman Co. Properties, which owns Arizona Grand, didn't return calls for comment.

It would be easy to write off this blowup as just another casualty in the regular boom-and-bust cycle of the $6.4 trillion commercial real estate market. But the Goldman deal, with its unrealistic assumptions, multiple layers of investors, and stratospheric prices, helps illustrate why this downturn is more complicated than previous ones—and will turn out to be far costlier. Already, prices have plunged 41% from the peak in 2007, according to Moody's/REAL Commercial Property Price Index—worse than the 30.5% fall in the housing market from its 2006 apex. "We've never seen this extreme a correction as far back as the data go, which is the late 1960s," says Neal Elkin, president of Real Estate Analytics, the research firm that created the index. Adds billionaire investor Wilbur Ross: "Commercial real estate has gone from being highly liquid at sky-high prices to being extremely illiquid at distressed prices."

To appreciate why this bust is like no other, first consider the typical commercial real estate downturns that used to crop up every 5 or 10 years. The pattern was predictable: When prices for apartment complexes, office buildings, shopping malls, and other properties began to rise, developers sped up their projects to cash in on the bull market. Eventually, some of those developers, unable to fill all the new space, began to default on their loans, and lenders were stuck with the buildings they'd financed. The slump lasted no longer than the time it took for the property glut to be worked down.

TURNING A BLIND EYE

But overbuilding isn't the culprit in this bust. An oversupply of money is what pushed commercial real estate over the edge.

It turns out the same excesses that drove the housing market's crazy rise and fall were present in commercial real estate, too—but they have largely gone unnoticed until now. Bankers, in their haste to make more and bigger loans, blindly accepted borrowers' wildest growth assumptions and readily overlooked other shortcomings on loan applications. They did so in part because they could easily sell their dubious loans to investors in the form of commercial mortgage-backed securities. As the market overheated, it became a breeding ground for fraud: A flurry of new court cases reveals the disturbing extent to which commercial mortgage borrowers may have doctored loan documents.

While the housing crisis seems to be easing, the commercial storm is still gathering strength. Between now and 2012, more than $1.4 trillion worth of commercial real estate loans will come due, according to real estate investment firm ING Clarion Partners. Analysts at Deutsche Bank (DB) estimate that borrowers will have trouble rolling over as many as three-quarters of the loans they took out in 2007, the most toxic vintage.

For the banks and investors whose money fuels the economy, this presents major problems. Their losses will likely cast a shadow over lending—and, by extension, the overall economy—for years. The market won't fully recover until 2020, says Kenneth P. Riggs Jr., CEO of Real Estate Research, and in cases where "values were over the top...maybe never."

In the short term, toxic securities are creating a new problem weighing on the market: a tangle of interconnected investors fighting over the remains of the properties they own. In the past the damage was limited to a handful of lenders who invested directly in any given project. Now there can be dozens of groups of investors, each with its own agenda. The April bankruptcy of shopping mall owner General Growth, one of the largest real-estate-related bankruptcies ever, affected hundreds of parties—an unprecedented slicing and dicing of assets. These investors won't soon forget the bust and aren't likely to dive back into the market as aggressively as they once did.

And yet the securities are only a secondary problem. The main driver of the commercial real estate bust is the underlying loans. How frothy did the market get? In one notable example, New York investment fund Sterling American Property and real estate company Hines paid $281 million in 2007 for the 42-floor office building at 333 Bush St. in San Francisco. That worked out to $518 a square foot, far higher than today's price, according to Real Capital Analytics, a research firm. Less than two years later, the building's primary tenant, law firm Heller Ehrman, filed for bankruptcy and stopped making rent payments. According to Real Capital Analytics, the building's owners did not make a recent loan payment, and the lender is expected to begin foreclosure proceedings. Says a spokesman for Sterling and Hines: "[We] continue to own and operate the property."

What's striking is how quickly some big commercial deals have gone south. In April 2007, Charney FPG, a New York real estate partnership, paid about $180 million to buy a 22-story office building in Manhattan's Times Square district. It borrowed $202 million to pay for the purchase, renovations, and incidentals—111% financing. Because the rental income didn't cover the debt payments, Comfort's lenders, Wachovia and RBS Greenwich Capital, required the firm to set aside $10 million in reserves to keep the project afloat until it got more paying tenants. Those occupants never materialized, and by July the owners had exhausted 95% of their reserves. The building is now in jeopardy of being seized by the bankers, says Real Capital Analytics' head of research, Dan Fasulo. "Everyone knows Judgment Day is coming." Says a Charney spokesman: "The owners are in the midst of restructuring the debt." Wachovia and RBS declined to comment.

Commercial lending mirrored mortgage lending in another way: Loans were made based on an unshakable belief that the market would never go down. An analysis by research firm REIS of mortgage securities created between 2005 and 2008 found that income projections for properties exceeded their historical performances by an average of 15%. "It was all based on assumption of cash flow," says Howard S. Landsberg of New York-based consultant Weiser Realty Advisors. "If you couldn't afford to pay the bank back now, in three years you could count on another $20 a square foot" in rent. When the numbers didn't add up, some lenders got imaginative. Says a banker at a large Wall Street firm: "If the cash flow wasn't there, you had to ignore it or find ways to create it."

Some lenders may have drummed up business for themselves, enticing borrowers with more money than they needed. Consider Credit Suisse's (CS) $375 million loan to the Yellowstone Club in Big Sky, Mont., one of the starkest examples of poor underwriting in recent memory. Opened in 1999 by Timothy L. Blixseth, a welfare kid turned timber magnate, the private ski and golf club catered to the ultra-wealthy crowd. Microsoft (MSFT) founder Bill Gates and Tour de France champion Greg LeMond built multimillion-dollar vacation homes there. In 2005 a Credit Suisse banker approached Blixseth about a loan, which the banker compared to "a home equity loan," according to bankruptcy court documents. Blixseth initially turned down the offer. But after several calls and a personal visit to Blixseth's home near Palm Springs, Calif., the banker persuaded Blixseth to borrow $375 million in the name of the club. According to court papers, the two decided the transaction fee by coin flip; Blixseth won, agreeing to pay 2%.

"WILD, OUT-OF-CONTROL SPENDING"

But not all of the funds were earmarked for the club. The deal allowed Blixseth to use up to $209 million of the proceeds "for his own personal benefit," according to the bankruptcy court papers. In a civil lawsuit filed by Yellowstone investors and homeowners, the plaintiffs say Blixseth used some of that money to fund a lavish lifestyle, including the purchases of a 20-seat Gulfstream corporate jet, two Rolls-Royce Phantoms, and three Land Rovers. His ex-wife, Edra Denise Blixseth, may have benefited from Credit Suisse's largesse, too. In a legal declaration filed in a Montana court, Timothy Blixseth notes her "wild, out-of-control spending." Among her extravagances, he alleges, was a "divorce celebration party" with "a voodoo doll game whereby the guests could poke pins in a life-size doll in my image to inflict pain on my various body parts." Timothy Blixseth's attorney says his client used the "vast majority" of the funds for business purposes. Blixseth, the attorney says, plowed money into an international expansion plan, including the purchase of "golf and resort properties in Mexico, the Caribbean, and elsewhere," as well as the Gulfstream jet. Edra Blixseth could not be reached for comment.

While Blixseth was busy spending the money, Yellowstone was struggling under the weight of its debt. Vendors often went unpaid for three months or longer, according to bankruptcy court testimony. In November 2008, Yellowstone filed for bankruptcy protection. "The only plausible explanation for Credit Suisse's action is that it was simply driven by the fees it was extracting from the loans it was selling and letting the chips fall where they may," said Ralph B. Kirscher, a federal bankruptcy judge in Helena, in a May court decision. Timothy Blixseth's attorney says the bankruptcy was prompted by his client's divorce proceedings. A spokesman for Credit Suisse says: "We worked on behalf of the institutions that held this loan." (The judge vacated his decision after the bank agreed to settle with Yellowstone's new owners, which include money manager Cross Harbor Capital Partners.)

RED FLAGS GALORE

The banks were hardly the only freewheeling players during the credit boom. The fast-and-easy lending environment was fertile territory for alleged fraudsters. In 2007 Prudential Financial lent $13.9 million to Namir A. Faidi, a Houston developer who planned to use the money to pay off construction loans on Piazza Blanca, a Mediterranean-themed shopping complex in Galveston, Tex. Faidi dipped into the project's reserve fund to make the first loan payment but failed to make any more. After that, Prudential concluded that some of the leases he'd submitted weren't legitimate. According to a civil suit filed in federal court by Prudential, Faidi's loan papers included a signed lease from time-share giant Bluegreen, a purported tenant that would occupy 26% of the space. But when Prudential contacted Bluegreen after the default, it learned it had backed out of talks and never signed a rental agreement.

In court proceedings, a Bluegreen employee said the signatures on the documents weren't his. Another supposed tenant, Mia Group, said in court filings that the lease on file for the restaurant company was invalid because it was signed by a business associate who didn't have authority to do so. "He was a few leases short of what he needed to get the loan," says Andrew F. Spalding, a Houston attorney who is representing Prudential. "I'm sure his thinking was just like that of most other developers: Even if the tenants were fake, he figured he could still fill that space in no time with someone else."

An attorney for Faidi, Robert A. Axelrad, says the disputed lease for Bluegreen was arranged by an outside broker. He acknowledges that the loan application included future rent payments from Bluegreen, but he says the figures were meant to be "pro forma" estimates based on the possibility of Bluegreen occupying the space. "My client says he never saw the lease and never represented there was a lease," says Axelrad. Faidi filed for personal bankruptcy in September. The civil case is ongoing.

Glaring problems that normally would have raised red flags seemed to be in plain sight of loan officers during the credit boom. Phoenix entrepreneur John J. Wanek appeared to have the right credentials when he applied for a $6.5 million loan from Merrill Lynch to buy the Ashberry Village Apartments in 2002. The sprawling ranch-style complex in Columbus, Ohio, would be the latest addition to his small, Midwestern real estate empire. He had never missed a payment on a half-dozen similar properties. And the rent rolls Wanek provided showed that more than 90% of Ashberry's units were occupied. After Wanek defaulted within six months, Merrill concluded that it had been duped. It claimed in a civil suit filed in a Franklin County (Ohio) court that Wanek had altered the rent-roll numbers to make the complex look more profitable. Merrill, which is now owned by Bank of America (BAC), contends that the complex was nearly one-third vacant at the time, and that Wanek had "grossly understated" the operating expenses. According to the suit, Wanek had inflated the numbers to get a bigger-than-necessary loan and used the extra money to cover back payments on other apartment buildings.

Even if the allegations are true, Merrill should have seen the warning signs. According to the suit, after applying for the loan, Wanek told Merrill he would transcribe data from the previous owner's supposedly illegible rent rolls into easier-to-read spreadsheets. In the process, he boosted many figures to suspiciously round numbers. Wanek also overstated his equity in the real estate he posted as collateral and listed some of his parents' assets as his own.

An attorney for Wanek, Mark C. Collins, says his client recreated the rent rolls—with Merrill's approval—only because his office had been burglarized and many records stolen 10 days before closing. "He prepared those numbers as best he could off the top of his memory," says Collins. "The proper due diligence wasn't done by anyone, but they want to make the buyer the scapegoat." Wanek, who filed for bankruptcy shortly before he lost the civil case in January 2006, now faces criminal fraud charges from the Franklin County prosecutor.

All told, Merrill and the lenders on Wanek's other properties have lost $38 million. His parents, two retired schoolteachers, had to file for bankruptcy as well. "Lenders were willing to underwrite on his record and the revenue stream of the property," says David D. Ferguson, an attorney who represented Merrill. "But it was a scheme doomed for failure."

Administration Issues Guidlines For Commercial Loan Restructuring

DS News

Federal banking regulators issued guidelines Friday to encourage “prudent commercial real estate (CRE) loan workouts.”

In a statement from the FDIC, officials acknowledged that CRE borrowers are dealing with diminished cash flows, depreciated collateral values, and prolonged delays in selling or renting commercial properties – all factors to that some fear could ignite another economic tailspin.

The new rules offer explicit details on how banks should address commercial loan restructuring, as was promised in mid-October by the regulators, which include the FDIC, Federal Reserve, and the Office of the Comptroller of the Currency, among others. According to the Wall Street Journal, banks in recent months have inundated the agencies with questions about commercial loan modifications as the number of problem loans has soared.

The newly issued 33-page guidance for commercial loan restructuring essentially sanctions extending troubled CRE mortgages upon maturity. Regulators said renewing and restructuring CRE loans should be consistent with safe and sound lending practices and should include a thorough analysis of the borrower’s ability to repay, overall financial condition, operational cash flow, and any market conditions that could hamper repayment potential. The guidelines include several examples of hypothetical modifications, that regulators said “illustrate a prudent workout process.”

According to a recent study by the global commercial real estate firm Jones Lang LaSalle, 55 percent of the lenders surveyed said they plan to offer borrowers one- to six-month extensions on their maturing commercial real estate loans. Forty-five percent said the biggest factor in determining loan extensions was a requirement for borrowers to pay down some of the principal, and nearly 30 percent said they have begun offering forbearances to commercial borrowers ranging from six to 12 months.

Some economists and cautionary market watchers have criticized such actions – so-called “extend and pretend” agreements – as simply delaying the inevitable commercial real estate crash. In their statement outlining loan restructurings, federal regulators warned lenders about being too lenient and only deferring recognition of ensuing losses. Nevertheless, government officials are encouraging banks to rework troubled CRE mortgages rather than foreclose – a sentiment reminiscent of the government’s push for the industry to retool problem residential mortgages.

The demise of many of the 100-plus banks to go under since the financial crisis began has been the result of portfolios with large concentrations of commercial property loans – namely troublesome construction and development loans.

FDIC data shows that commercial mortgages totaled almost $1.1 trillion at the end of June, representing 14 percent of all loans and leases, and recent projections put expected commercial real estate losses as high as $300 billion.

“Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers’ financial conditions will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classifications,” the FDIC said upon issuance of its workout guidelines.

Watchdog Says FDIC Failed On Commercial Loans

Bloomberg

The Federal Deposit Insurance Corp. failed to enforce its own guidelines to rein in excessive commercial real estate lending by at least 20 banks that later collapsed, reports by the agency’s watchdog show.

The FDIC’s Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency’s examiners didn’t identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed. The findings are in separate reports posted this year on the inspector general’s Web site.

“It’s often we’ll see in our reports that the FDIC detected problems in the bank in a timely fashion, but in some cases forceful corrective action wasn’t required by the FDIC to be taken quickly enough,” Jon Rymer, the FDIC’s inspector general, said in a telephone interview.

The failure to follow up on the 2006 recommendation, that banks avoid letting commercial real-estate holdings exceed 300 percent of capital, has emerged as FDIC Chairman Sheila Bair steps up her effort to expand the agency’s role in regulating the financial-services industry.

Bair, a 55-year-old appointed by President George W. Bush, is lobbying the Democratic-led Congress to give the FDIC the authority to unwind any failing bank holding companies. The FDIC’s powers are limited to disassembling commercial banks and thrifts, and it lacks authority to unwind Federal Reserve- regulated holding companies such as New York-based Citigroup Inc. and Bank of America Corp. in Charlotte, North Carolina, that have businesses beyond taking deposits and making loans.

‘Stopped It’

“We should ask the prudential regulators why they did not do more to push banks to pay attention to their guidance,” Representative Brad Miller, a Democrat from North Carolina, said in an interview. “If they thought their conduct was unsafe, it’s unsound, they certainly should have stopped it.”

Miller sits on the House Financial Services Committee, which oversees the FDIC and the banking industry.

“We are in process of addressing any existing gaps in supervisory policy with respect to commercial real estate lending,” FDIC spokesman Andrew Gray said in a prepared statement. “The FDIC has also stepped up our off-site surveillance program to assist our examiners in targeting those institutions with elevated risk profiles so that corrective action programs are instituted in a timely and constructive manner.”

Fed, OCC, OTS

The Federal Reserve, Office of the Comptroller of the Currency and Office of Thrift Supervision have been faulted this year by their watchdogs for not reining in commercial real estate lending in reports issued on failed banks they supervised. Inspector generals for the regulators released 12 reports, about half the number completed by the FDIC’s watchdog.

Regulators have closed 99 financial institutions this year, the most since the 179 in 1992 during the savings-and-loan crisis. Matthew Anderson, a partner with Oakland, California- based Foresight Analytics LLC, a real-estate market consulting firm, said the number of failed banks will climb rapidly in part because delinquency rates on commercial real estate mortgages are “rising substantially.”

Defaults on commercial real estate loans totaled $110 billion, or 6 percent of all such loans, in the second quarter. That’s about 11 times the level in the fourth quarter of 2006 when the guidelines were released. Defaults may rise to $170 billion by the fourth quarter of 2010, Foresight Analytics said.

Community Banks

The risks are greater for community banks with assets of $10 billion or less, Anderson said, because commercial real estate loans make up a bigger percentage of their business. Smaller banks don’t have the capital to compete with large banks for mortgages and consumer loans, so they turn to local-market lending, where they have an advantage.

Commercial real estate loans will pose the biggest risk to banks for several quarters, Bair told Congress on Oct. 14.

Declining real-estate values caused by rising vacancies, falling rental rates and weak sales are contributing to losses, Comptroller of the Currency John Dugan, the regulator of national banks, said at the same congressional hearing.

Along with Dugan and the Federal Reserve, the FDIC in 2006 set a threshold -- 300 percent of a bank’s capital -- for safe levels of commercial real estate loans. The guidance was aimed at helping regulators identify banks with high loan concentrations that warranted greater supervisory scrutiny.

At the time, smaller and mid-sized banks opposed the guidelines. Bankers said they feared federal examiners would treat the thresholds as absolute limits, threatening a lucrative business for community lenders.

‘Boom Times’

The regulators said the thresholds were not limits and that federal bank examiners would use the guidelines to identify lenders with risky levels of such loans.

“The guidance was put out in boom times,” said Kevin Petrasic, a lawyer at Paul, Hastings, Janofsky & Walker LLP in Washington and former special counsel at the Office of Thrift Supervision. “Profits were very high. There wasn’t a full realization of what we were staring at.”

The FDIC reiterated the importance of strong capital and risk-management practices for banks with high concentrations of commercial real-estate loans in a March 2008 letter.

By September 2008, commercial real-estate loans represented 1,329 percent of total capital at Security Pacific Bank in Los Angeles, a bank that collapsed two months later. The level “far exceeded the capital criteria thresholds for additional supervisory oversight,” according to a review in May by the FDIC inspector general.

The bank’s failure cost the FDIC fund about $210 million.

FirstBank Financial

In December 2007, FirstBank Financial Services of McDonough, Georgia, had concentrations of 645 percent, more than double the recommendation.

The FDIC didn’t take any enforcement action until 2008 “when there were significant and quantifiable losses in the bank’s loan portfolio,” the inspector general found. The bank failed in February, costing the FDIC fund about $111 million.

The FDIC and state regulators were slow resolving banks with other issues. It took almost two years to shut New Frontier Bank, the largest lender in northern Colorado with $2 billion in assets, after agencies identified in mid-2007 a rise in soured loans, increased reliance on volatile funding and weak management. State regulators shut the bank April 10.

Bair, Dugan and Timothy Ward, the Office of Thrift Supervision’s deputy director of examinations, supervision and consumer protection, said last week they are planning to issue guidelines on how to modify troubled commercial real-estate loans to reduce defaults.

$1.8 Trillion

U.S. banks held $1.8 trillion in commercial real-estate loans as of the second quarter, representing 24 percent of outstanding bank loans, according to Foresight Analytics. Commercial real estate loans represent 39 percent of the $4.7 trillion in total real-estate loans.

Of 95 U.S. bank failures before September, 71 were caused by non-performing commercial real-estate loans, said Chip MacDonald, a partner specializing in financial services at Atlanta-based law firm Jones Day.

“The supervisory process has to have more consistency in the good times and not just in the bad times,” said John Bovenzi, a partner at Oliver Wyman, a New York-based management consulting firm, and FDIC chief operating officer until this year. “It’s historically been harder to show effectively that changes need to be made when times are good.”

Deposit Fund

A surge in bank closings pushed the FDIC deposit insurance fund, which pays the cost of unwinding failed institutions, into a deficit, requiring the FDIC to replenish the reserve without overburdening hobbled banks. Last month, it proposed that banks prepay three years of premiums to raise $45 billion.

Bair told a Senate subcommittee on Oct. 14 that bank failures will continue to rise, reaching a peak next year, while costing the fund $100 billion through 2013.

Some analysts are more pessimistic. Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, California, firm that evaluates banks for investors, said the deposit fund will run a deficit of $300 billion to $400 billion and about 1,000 banks will fail or be merged through 2012.

The FDIC supervised 5,039 banks of the 8,195 commercial banks and savings institutions as of June 30, according to the agency. The FDIC and state regulators share oversight, and each sends examiners to the banks on average every other year.

“We should have been more strict,” Joseph Smith, North Carolina’s bank commissioner and chairman of the Conference of State Bank Supervisors, said in a telephone interview. Two banks have failed in Smith’s state this year.

“Had we required the reduction of CRE lending, it would have been thought of as an intrusion by regulators into the businesses of banks and to the operations of local economies,” Smith said. “Yes, it would have been the right thing to do. It would have caused a firestorm then. That might have been better than a firestorm now.”

Regulators Encouraging Commercial Real Estate Loan Modification

Reuters

U.S. regulators are encouraging banks to restructure commercial real estate loans, which they view as one of the greatest challenges that could compromise the industry's recovery.

Officials are close to finalizing guidance that would encourage banks to recognize potential losses in their commercial real estate portfolios and not simply renew troubled loans to delay loss recognition, regulators told a Senate banking subcommittee.

"While there have been some positive signals of late, the financial system remains fragile and key trouble spots remain," such as commercial real estate, U.S. Federal Reserve Board Governor Daniel Tarullo said.

Other regulators echoed his concerns, including Federal Deposit Insurance Corp. Chairman Sheila Bair and Comptroller of the Currency John Dugan.

Dugan characterized commercial real estate as the "greatest challenge" facing banks while Bair targeted it as a prominent area of risk for the next several quarters.

COMMERCIAL LOSSES SOARING

As of June, commercial real estate loans totaled more than $1 trillion, or 14.2 percent of all loans and leases in the bank industry, Bair said.

Regulators struck a cautious note on the health of the banking system, notwithstanding that JPMorgan Chase & Co, one of the top Wall Street banks, reported on Wednesday that its quarterly profit rocketed to a much-high-than-expected $3.6 billion. [ID:nN13183184]

Tarullo zeroed in on potential losses the banking system faces on soured commercial real estate loans and said some were slow to even acknowledge the weakening sector.

Prices for existing commercial properties have fallen 35 to 40 percent since peaking in 2007 and more declines are anticipated. Rising job losses and high vacancy rates also are weakening demand for commercial property, Tarullo said.

At the end of the second quarter, about 9 percent of commercial real estate loans were delinquent, nearly double the level a year earlier.

Dugan said credit quality is deteriorating across almost all classes of banking assets, in nearly all sizes of banks.

 He said national banks must set aside more capital and reserves to absorb these potential losses, which could cause more small institutions to fail.

Bair said the number of so-called "problem banks" and bank failures will remain high for the next several quarters. So far this year 98 U.S. banks have failed, compared to 25 last year and 3 in all of 2007.

As of the end of the second quarter, 416 banks with about $300 billion in assets were on the problem bank list. The FDIC estimates that bank failures will come with a price tag of $100 billion from 2009 through 2013.

SLOW ECONOMIC RECOVERY

Regulators were wary about celebrating signs of tentative recovery.

Tarullo said the economy appears to have resumed growing but warned that it will take time to rebound from the serious financial crisis it endured and jobs won't come back quickly.

"The unemployment rate has continued to rise, reaching 9.8 percent in September, and is unlikely to improve materially for some time," he said.

U.S. economic activity turned up in the third quarter as investors waded gingerly back into riskier waters and businesses began to restock depleted inventories. U.S. housing prices rose for the third straight month in July, raising hopes the market is stabilizing.

But because of distressed labor markets, consumer spending and credit availability could remain weak.

Bair said the scope of losses in household wealth during the severe downturn over the past two years has been so great that the economy will need time to repair and recover.

"While we are encouraged by recent indications of the beginnings of an economic recovery, growth may still lag behind historical norms," Bair said.