Tighter Lending Rules Needed: FDIC's Bair

CNBC

Regulators should tighten lending rules for home mortgages in the US and the government is taking on a lot of risk by guaranteeing risky loans, Federal Deposit Insurance Corporation Chairman Shelia Bair warned.

"I think we should all be concerned about the type of exposure that the government is taking on through guaranteeing so many mortgages right now, and make sure that we do have some prudent underwriting standards, and especially documented ability to repay," Bair told CNBC Wednesday.

Bair called for a new set of "common sense" rules that would apply to both bank and nonbank mortgage sellers, ensuring the borrower has the capacity to repay a mortgage and makes a larger down payment than is currently required.

"Clearly there is a strong correlation between the amount of skin in the game a borrower puts in up front and how that loan performs," she said. "And it's only common sense. Do you put 20 percent down? You're committed to that house. You walk away from that house, you're going to lose a lot of the money that you put in up front."

Policymakers were trying to balance the need for prudent underwriting with a need to support what is still a very distressed housing market, she said.

"Going forward, the standard as we emerge from this crisis should be very robust income documentation, ability to repay standards, and some significant down payment," Bair said.

The housing market, which in 2009 suffered its worst downturn since the Great Depression, had stabilized somewhat and credit standards were improving, Bair said, but it was unclear what a double-dip recession might do to house prices.

The likelihood of a renewed economic slump had increased somewhat, Bair said, but FDIC economists were not forecasting a double-dip scenario.

“Banks are in a better position now because loan quality has improved considerably over the last few years, and so I think they're in a better position to withstand it if we have another downturn,” she said.

Toxic CDOs Beset FDIC as Banks Fail

The Wall Street Journal

The FDIC has inherited hundreds of potentially worthless bonds that have come back to haunt the Wall Street firms that sold them, the credit-rating firms that graded them and the hundreds of small banks that bought them.

The Federal Deposit Insurance Corp., and by extension the U.S. taxpayer, owns more than 250 collateralized debt obligations that were purchased by small institutions that later failed. Although the bonds have a book value of more than $400 million, they are a headache for the agency as it grapples with the toxic assets flowing from many banks around the country.

"We're getting more of [the CDOs] all the time," said Miguel Browne, an assistant director in the FDIC's division of resolutions and receiverships. The agency has inherited such securities from about two dozen banks that have failed in the current crisis, including Omni National Bank in Atlanta, Venture Bank in Lacey, Wash., and San Diego National Bank.

The FDIC's mountain of bad securities has grown even bigger in recent weeks following the failure of Riverside National Bank of Florida, a small firm that had stuffed its investment portfolio with 27 CDOs known as trust preferred securities. Although it was a community bank with 58 branches in Florida, its pile of CDOs has almost doubled the notional value of bonds owned by the federal agency.

Now, in an unusual move, the FDIC may be preparing battle back directly. It has asked a New York court for permission to replace Riverside as plaintiff in a six-month-old lawsuit in which the bank accused more than a dozen financial firms of misrepresenting the value of the CDOs.

The FDIC's focus on CDOs comes at a time when the financial instruments are being scrutinized by regulators and prosecutors. Several Wall Street firms, including Goldman Sachs Group Inc. and Morgan Stanley, have attracted particular attention in recent weeks for what they told investors about the nature of the CDOs when the initially sold them.

The problem is that it is difficult to pin down the value of something for which there may be no market. According to FDIC estimates, that the book value of the CDOs that the agency now holds is more than $400 million. But "a lot of these things will have little or no market value," Mr. Browne said.

The agency hopes to auction off any CDOs that have value this summer. If it can't unload them, the FDIC could be forced to write off their value, saddling taxpayers with the losses.

Many of the 200 bank failures since the beginning of 2009 have been accelerated by losses in trust preferred securities, which are a hybrid between debt and equity. More than 1,500 banks issued such securities between 2000 and 2008 after regulators ruled that they could be counted as capital, making their balance sheets appear healthier.

Wall Street brokerage firms then bought the securities from individual banks that had issued them and packaged them into CDOs. The brokerage firms then sold slices of the CDOs to other small banks. Community banks bought roughly $12 billion of these trust preferred CDOs between 2000 and 2008, according to Red Pine Advisors LLC, a New York firm that values illiquid investments.

Riverside, based in Fort Pierce, Fla., bought 27 trust preferred CDOs with a book value of $211 million between 2005 and 2007. Only two of those CDOs revealed the underlying collateral the investments relied upon, according to a lawsuit that Riverside filed last year in New York Supreme Court. It bought the securities from Wall Street firms, including Merrill Lynch, which is now owned by Bank of America Corp., FTN Financial, a unit of First Horizon National Corp., and boutique financial-services firm Keefe, Bruyette & Woods Inc. Defendants also include McGraw-Hill Cos., which owns credit-ratings firm Standard & Poor's, and Moody's Corp.'s Moody's Investor Service; the suit says that the credit raters determined the CDOs to be investment grade when they weren't.

When the financial crisis struck, the banks that issued CDOs couldn't afford to make interest payments on them. Credit-rating firms then downgraded the securities, battering their value.

That dealt a blow to Riverside, which was already stumbling under the weight of soured loans. Its CDOs dropped an average of 11 rating levels within four years. Its portfolio of trust preferred securities dropped more than 60% to $79 million by the end of 2009, according to the lawsuit.

Riverside has sued more than a dozen firms that sold it the trust preferred securities, saying they were "based on inflated investment-grade ratings, undisclosed material conflicts of interest," among other misrepresentations, according to the lawsuit.

"We believe we have meritorious defenses in this matter and intend to defend ourselves vigorously," said a spokesman for First Horizon. Representatives of KBW and Merrill declined to comment.

"We believe the claim has no legal or factual merit," said an S&P spokesman. A Moody's representative declined to comment.

But in a motion to dismiss the case, the defendants said Riverside's losses "result from the risks it knowingly assumed and from the unprecedented market cataclysm, rather than any flaw in the specific CDOs at issue here."

When Riverside failed last month, Toronto-Dominion Bank of Canada acquired the most valuable pieces, including its branches, $2.76 billion in deposits and most of its $3.42 billion of assets. The Canadian bank left the trust preferred securities to the FDIC, which also inherited Riverside's lawsuit.

Earlier this month, the FDIC filed a motion to replace Riverside as plaintiff in the case. The agency also is seeking a 90-day stay in the case as it tries to determine what the CDOs are worth.

Lennar buys distressed loans from FDIC

Builder bets on recovery by purchasing stake in loan portfolios at a discount;

Home builder Lennar Corp. has struck a deal with the Federal Deposit Insurance Corp. that could help the firm replay its success investing in troubled loans during the last major real estate crisis.
 

Market Watch
 

Investors bid up the company's shares Thursday but some experts cautioned it may be harder to make the numbers work in the current downturn.

Lennar has positioned itself to benefit further from a real estate recovery through a distressed-land transaction with the FDIC to purchase a 40% stake in bank loans with a combined unpaid balance of about $3 billion.

Late Wednesday, the Miami-based company said it closed transactions with the FDIC to buy two portfolios of loans for $243 million.

Lennar subsidiary Rialto Capital Advisors will conduct the daily management and workout of the portfolios, the company said.

Lennar has purchased a 40% interest in the loan portfolios, while the FDIC is keeping the remaining 60% equity interest. The FDIC provided $627 million of financing at no interest for seven years.

With FDIC kicking in about $365 million in equity, Wall Street analysts pegged the portfolios' overall purchase price at $1.22 billion, or 40 cents on the dollar.

The portfolios include about 5,500 distressed residential and commercial real estate loans from 22 failed bank receiverships.

"Acquiring and working out distressed real estate loans was a large and extremely profitable part of our business during the last major real estate down cycle in the early 1990s," said Lennar Chief Executive Stuart Miller in a prepared statement.

The builder has been preparing to invest in distressed loans for two years, and it takes "great pride in understanding market cycles and identifying the opportune point of entry," Miller said.

"Our strong cash position and proven track record in this area enables us to capitalize on this market cycle and create long-term value for our shareholders," said the CEO, adding the company expects the deal will be accretive to 2010 earnings.

Deutsche Bank analyst Nishu Sood said Lennar is the first builder to do a major distressed land deal in the housing bust.

"Given Lennar's history of timely strategic decision making, we think investors will give management the benefit of the doubt," the analyst wrote in a note Thursday. "This is appropriate, but at the same time we think there are long-term risks given the unusually severe nature of this cycle."

Shares of Lennar, which in recent years has faced investor worries over its exposure to joint ventures, were up about 8% in afternoon trading Thursday.

"Comparisons abound among both investors and builders between the current period of distress and the early 1990s," Sood said. "If the recovery path of the housing market is similar to the mid- to late-1990s current distressed deals like Lennar/FDIC will look brilliant in hindsight."

However, the analyst worried that the comparison may not be so easy.

"The early 1990s downturn was more typical historically speaking (i.e. V-shaped) and led into an unprecedented 14-year mortgage credit driven upturn," Sood wrote. "This housing downturn by contrast has done nothing but bust historical paradigms. We think this elevates the risk of large distressed deals relative to the early 1990s."

Lennar has purchased a stake in acquisition, development and construction loans, about 70% of which are residential, and the remaining commercial. They are mostly concentrated in Georgia, Nevada and Arizona. In late January, Lennar announced plans to enter the Atlanta market.

J.P. Morgan analyst Michael Rehaut said while 90% of the portfolio is nonperforming, "we believe experience of Lennar's Rialto team managing the portfolio, and the extensive due diligence performed, should result in value creation."

Lennar can achieve this in several ways, "including a discounted payoff, where the borrower pays off the loan balance at a discount but above Lennar's purchase price; foreclosure and liquidation, where Lennar takes back the asset and then sells to a third party; or value add, where Lennar develops or leases the asset and sells at a later date."

Last month, Lennar said it swung to a fourth-quarter profit as the builder was helped by a tax benefit.

In late 2007, the firm sold 11,000 properties to a joint venture with a Morgan Stanley affiliate for $525 million, or a 40% discount to book value. See archived story on the land deal.

Last year, Lennar bought a stake in a joint venture called LandSource. The builder had sold most of its investment in LandSource to Calpers in 2007 at the height of the real estate bubble, before LandSource went bankrupt.

Amerca's New Land Baron: FDIC

Wall Street Journal

ATLANTA -- In the waning days of the Great Recession, the federal government is still jumpstarting the economy and propping up financial markets.

It is also trying to sell Dresden Heights, a failed condo development on a noisy freeway ramp next to a Motel 6, a Waffle House and a Do-It-Yourself Pest Control.

For more than a year, the Federal Deposit Insurance Corp. has been seeking a buyer for 36 partially built condos it inherited from a high-flying, short-lived Atlanta bank. The agency has been fending off vandals, haggling with architects and uncovering the developer's blunders, all in a bid to dispose of this condo project, just one of the 2,554 foreclosed assets dumped onto its books. "These are properties with a bad story," says Jim Gallagher, a senior official in the FDIC's Division of Resolutions and Receiverships. "What we're trying to sell is something that is rundown or not completed or has some property damage."

Click Image to View Interactive Graphic

The financial crisis started with Americans buying homes they couldn't afford. It is ending with the government struggling to sell buildings it never wanted.

In the past two years, the FDIC has taken over 150 failed banks. In the process, it has seized more than 5,000 houses, subdivisions, buildings, parcels and other foreclosed assets. The current backlog of property stuck on the agency's books, with an appraised value of $1.8 billion, ranges from an $18,700 clapboard home with stained carpets in Birmingham, Ala., to a $1.7 million mountainside lodge with a heated driveway in Steamboat Springs, Colo.

Taxpayers will be grappling with this flotsam for years to come, one example of how the crisis will linger long after the economy begins to revive. At a recent FDIC auction in Atlanta, the agency offered a four-unit condo building it had already sold once before -- after the savings-and-loan crisis two decades ago.

These days, it takes the FDIC on average six to eight months to sell a property. Dresden Heights, tied up with unpaid bills, a lawsuit and complex right-of-way questions, is among its toughest prospects.

The project was the brainchild of Quantum Homes and its chief executive, Ramsey "Jim" Salahat. In March 2006, just as Atlanta's housing market was peaking, Mr. Salahat took out a $3.78 million, 18-month loan from Main Street Bank in Covington, Ga., to purchase and prepare 5.3 acres abutting an interstate entrance ramp.

The developers brought in a crane, knocked down soaring oak trees, installed sewers and laid out two short roads, Heights Way and Quantum Lane. They planned 80 residential units and seven buildings.

At the groundbreaking in May 2007, Mr. Salahat and Quantum President Eyal Livnat posed for photos, wearing white hardhats and digging red Georgia soil with shovels festooned in blue ribbons. They threw a cocktail party, serving wine, roast beef, quiche and cookies.

Quantum Homes and its owners defaulted on some $10 million in bank loans when the Dresden Heights condo development in Atlanta failed. In 2008, Alpha Bank & Trust foreclosed on the collateral -- three partially built buildings and the land directly beneath them -- and soon failed itself. The Federal Deposit Insurance Corp. took over both the bank and its assets, only to discover that at Dresden Heights its property was completely surrounded by land owned by BB&T Corp., which had foreclosed on another loan to the developers. The uncertain right-of-way made it difficult for FDIC to sell the property; buyers couldn't be certain that they'd be able to reach the buildings without trespassing. Above, a blueprint. The three buildings are outlined.

"Future homebuyers are quickly reserving space at Dresden Heights...so interested homebuyers should act fast to ensure they have a home at this great community," Mr. Salahat said in a news release afterwards.

The release quoted Deanna Helie, a "prospective home buyer" who attended the event, as saying: "When this area begins to grow, I want to be in on that growth at an early point."

Ms. Helie, who lives adjacent to the Dresden Heights property, said she was talking about the neighborhood only, and stopped by out of curiosity, not to shop. She wondered about the wisdom of building homes next to a pest-control outlet. "I was thinking, 'This isn't going to fly,'" said Ms. Helie, a computer programmer.

A few days after the groundbreaking, Mr. Livnat signed a two-year, $6.75 million loan from Alpha Bank & Trust, a startup bank in nearby Alpharetta, Ga., to finance construction of the first three buildings. Two dozen customers, most of them first-time home buyers, put down $500 to $1,000 deposits on the condos, which started at $194,900. The developers told the early buyers they would likely be able to move in within a year, according to Kristy Jeffries, who at the time was Quantum's saleswoman.

In early 2008, work on the project slowed, Ms. Jeffries recalls. People started asking for their money back, "and the builders weren't giving it to them," she says. In her office, located in the basement of a model home, she started receiving calls from disgruntled subcontractors complaining they hadn't been paid. She says one unhappy supplier repossessed Quantum's construction trailer, which still contained file cabinets with records of potential buyers.

That spring, Mr. Salahat closed Quantum's headquarters in a lavish Atlanta office complex. He moved the company into a cramped, low-budget space behind a chiropractor's office outside of town, where Ms. Jeffries says she went for her paychecks.

The last time Ms. Jeffries saw Mr. Salahat was over a Tex-Mex meal in May 2008, when the developer told her the company was going bankrupt. Former associates say he has moved to Jordan. Neither they nor the FDIC could provide contact information. Mr. Salahat's listed phone numbers in the Atlanta area have been disconnected.

During a brief interview on his stoop, Mr. Livnat, Quantum's former president, declined to discuss details of the Dresden Heights project. "It was an unfortunate time to start a company," Mr. Livnat said. "Things were at a peak, and it went down quick." Mr. Livnat was skittish about answering the door, and he said he is worried the FDIC or creditors might come after him.

Alpha Bank foreclosed on the three partly finished buildings a year after Messrs. Salahat and Livnat broke ground. On May 6, 2008, a bank representative stood outside the Dekalb County courthouse and offered the property for sale. No one was willing to beat the bank's $4.692 million minimum. Alpha Bank now owned Dresden Heights.

The buildings sat exposed to rain, sun and wind through the summer of 2008, prompting bank officials to sign an agreement with McGuire Properties Inc., of Kennesaw, Ga., to finish construction. The company is run by George F. Nemchik, Jr., who was also an Alpha Bank shareholder, according to his attorney and Ms. Jeffries. Mr. Nemchik didn't return calls seeking comment.

Alpha Bank retained Ms. Jeffries to sell units. When she went to pick up her paycheck one day in October, a bank executive told her the lender was on the brink of collapse. He suggested the FDIC might want to keep her on as a sales agent for Dresden Heights. She demurred. "I think that property is cursed," she says now.

The American government came to own Dresden Heights on Friday, Oct. 24, 2008, about six weeks after the collapse of Lehman Bros. Georgia regulators closed Alpha Bank and turned it over to the FDIC. That weekend, Stearns Bank of St. Cloud, Minn., took over Alpha's branches. It acquired just $39 million of the $354 million in assets. The FDIC took possession of the rest, including Dresden Heights.

The FDIC inspector general's post-mortem blamed Alpha Bank's failure on "management's aggressive pursuit of asset growth concentrated in high risk" residential real-estate development and construction loans. Former Alpha Bank chief executive Joe Briner, now a consultant with a corporate-turnaround firm in Atlanta, didn't return calls seeking comment.

The FDIC wanted the property sold quickly, despite a series of obstacles, including hundreds of thousands of dollars in liens filed against Dresden Heights by building-material suppliers and McGuire Properties, the company that was finishing construction. If enforced by a court, any potential buyer would have to cover those bills before taking possession.

In January, the FDIC's outside property-management firm gave the listing to Atlanta real-estate broker Rob Jordan, a 40-year-old who had spent 10 years as a commercial banker before joining his father in the family firm. These days, Jordan Co. does virtually all of its business selling foreclosed commercial properties.

Mr. Jordan and his colleague, David Walmsley, pulled the county records on Alpha's construction loan, a routine step. They stopped cold at the surveyor's description of the property put up as collateral. "Said tract of land contains 6,776 square feet," the documents said of the first parcel. The other two parcels were similarly small.

Messrs. Jordan and Walmsley realized that Alpha Bank and now the federal government owned the three buildings and the land immediately beneath them -- but not an inch more. "What about the sidewalks? The stairs? The stoops?" asks Mr. Jordan. "They're all on someone else's property." The brokers checked with the county and confirmed that even the two small streets running through the subdivision belonged to someone else.

That someone else was BB&T Corp., a Winston-Salem, N.C., bank. BB&T had bought Main Street Bank, which made the original loan to Quantum that allowed the developer to buy the Dresden Heights land. When Quantum went bust, BB&T foreclosed on that land and put it up for sale for $1 million.

Rifling through court records, Messrs. Jordan and Walmsley discovered that Quantum had signed an easement allowing passage between the two properties. But it wasn't clear if the agreement would be legally binding on future owners.

The murky right-of-way made the sales job far more difficult. The FDIC would have to inform potential buyers there was no guarantee they could gain access to their property without trespassing. The brokers next sought to obtain the building plans, vital documents for anyone hoping to finish the development. In January, Mr. Jordan called Bill vonHedemann of Niles Bolton Associates, the principal architect on the project, to ask for copies. Mr. vonHedemann declined, politely. The developers, he said, owed his firm more than $60,000 in fees.

Anyone who wants the 85 or so computerized drawings will have to pay for them, he told Mr. Jordan. "We don't give the plans away," Mr. vonHedemann said in an interview.

Mr. Jordan didn't worry, initially. Alpha Bank should have had plans on file and regularly sent an agent to the site to check progress. But the brokers found no evidence Alpha had kept such records.

Meantime, the property was beginning to deteriorate. Over the winter, the outside pipes froze. In March, thieves broke into a model unit and stole the refrigerator, the range and the dishwasher. The FDIC boarded up the ground-floor windows on all of the townhouses, changed the locks, stowed the air conditioners in the garages and hired a full-time security service.

Messrs. Jordan and Walmsley fielded nearly a dozen offers, but none was close to the $2.8 million asking price. By May, the brokers worried the FDIC was shooting too high.

The FDIC ordered two new appraisals, a process that took almost five months. The brokers put off would-be bidders by saying the FDIC was undertaking "internal adjustments," an intentionally vague phrase intended to keep shoppers interested without responding to offers.

McGuire Properties, the company that had agreed to finish the Dresden Heights construction on behalf of Alpha Bank, dropped its liens on Aug. 17 in the face of a federal law making the FDIC immune to such claims. Instead, McGuire sued the FDIC in federal district court. McGuire contended that after seizing Alpha, the agency had directed the builder to continue work on the condos, and reneged on a promise to pay. The company demanded $653,014 plus interest.

In court filings, the FDIC denied the main allegations and asked the court to force McGuire to cover the government's legal costs. The two sides are in settlement talks. In September, the agency cut Dresden Heights's asking price 25%, to $2.1 million, and the brokers called the serious prospects.

One repeat bidder was 39-year-old Ho Hyun Chung. Mr. Chung moved from Seoul to the U.S. in 1996 to study business. He stayed to work for the U.S. cell-phone unit of LG Group, a South Korean conglomerate. Frequently up late on conference calls with headquarters, Mr. Chung became hooked on TV infomercials touting DVDs and books that promised riches through foreclosed real-estate. "I bought most of them," he says.

In 2007, as the real-estate market was tanking, Mr. Chung quit LG and started a business with his wife. Their niche: Buying unfinished foreclosed townhouses and completing them. He says he owns 42 units in 11 properties around the Atlanta area, including five townhouses he bought from the FDIC in December. He says he makes money on some, and loses on others.

Mr. Chung spotted Dresden Heights on the FDIC Web site. He liked that it was inside the perimeter beltway and near two universities.

He figured he could make a good return if he put no more than $1.5 million into finishing the project and then sold the units for $130,000 to $145,000 each, generating almost $5 million in gross revenue. It's a plan, he says, that depends heavily on the federal government's $8,000 first-time homebuyer tax credit. The credit, just extended by Congress, expires at the end of April. "If that goes, I don't know how the market will react," he says.

In October, almost a year after the FDIC seized Dresden Heights, the FDIC and Mr. Chung signed a sales contract giving him 30 days to conduct due diligence. Neither side would disclose the price.

Only then did Mr. Chung's lawyer notice that the FDIC's buildings were islands surrounded by BB&T's land. Mr. Chung acknowledges the FDIC disclosed the information, but says he "didn't quite understand" the problem until his lawyer raised it.

"I need to clean that up first," he says. He also wanted to make sure the person who buys the BB&T land signs an agreement that allows for the development and sale of the three buildings.

This month, he asked the FDIC for an extension on his 30-day contingency period. The FDIC turned him down, and the agreement expired.

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.”