Small Banks at Greater Risk from CRE mortgages (from September at globest.com)

FROM SEPTEMBER 2009...globeSt.com (ALM)

This past September, it was becoming increasingly clear that smaller banks would suffer greater hardship as more commercial real estate mortgages started coming home to roost...

by Cody Lyon
NEW YORK CITY-Commercial mortgage defaults, which are projected to reach unprecedented levels in 2011, pose an even greater risk for smaller, regional lenders than the nation’s more high-profile large banks. So says Dr. Sam Chandan, president of Real Estate Econometrics.

"If you look across the banking system, commercial mortgage loans represent about 14% of banks’ net loans and leases," Chandan tells GlobeSt.com. However, he says, banks that have assets of $10 billion or more typically see a less than 10% exposure rate to commercial real estate. On the other hand, smaller institutions with assets between $100 million and $1 billion see exposures as high as 30%.

And therein lies a very big problem and more pressing calls for policy interventions. "Some of these smaller institutions that have not been the direct focus of policy interventions are seeing a tremendous deterioration of commercial mortgage performance," says Chandan. "If default rates continue to rise in the way current trends suggest, and if low rates of recovery on exposures worsen, some institutions will be impacted in terms of their viability, not only in their terms of their capacity to lend for commercial real estate, but also in their capacity to participate in the market."

The handwriting is on the wall, according to data from federal bank regulators. During the second quarter of 2009, the FDIC issued 151 regulatory orders. Nearly half of those orders were "cease and desist," which often precede a bank’s closure. Already this year, the FDIC says there have been 89 bank failures with assets totaling $91.6 billion.

A spokesman tells GlobeSt.com that the FDIC is looking closely at commercial real estate, but adds, "we do not have any projections to make regarding its future impact."

But the alarm bells were ringing in July testimony before the Joint Economic Committee of Congress from Jon D. Greenlee, associate director of the Federal Reserve’s Division of Banking and Regulation. Greenlee told that committee, "A high proportion of small- and medium-sized institutions continue to have sizable exposure to commercial real estate, including land development and construction loans, built up earlier this decade, with some having concentrations equal to several multiples of their capital."

Those would be the banks with names like Platinum Community Bank of Rolling Meadows, IL; First Bank of Kansas in Kansas City, KS; and First Coweta Bank of Newnan, GA, to name three of the casualties in the past two months, according to FDIC data. According to local news reports, each had bet heavily in the commercial real estate market.

The now defunct First Coweta Bank’s web page read, "Let First Coweta be your business partner! For construction and real estate purchases, call one of our commercial loan officers today for rates!" Another regional bank, United Bank Corp. of Barnesville, GA, has assumed First Coweta’s deposits and loans.

"The difference is, we’re not talking about the biggest banks right now," Chandan says. "It’s not the TARP recipients: the JPMorgans and Citibanks. Instead, it’s the hundreds, perhaps thousands of smaller, community and regional banks that provide liquidity to people in smaller markets across the nation."

He says "the failure of any one of these smaller banks will not impact financial stability on a national level. Individually, the failures do not get the same degree of attention as the large institutions, whose failure would present systemic risk for the entire financial system and economy."

Chandan says policy makers have paid significant attention to conditions in the CMBS markets. But, he says, there has been little in the way of support for banks struggling with a deterioration of mortgage performance. The outstanding pool of commercial real estate mortgages on the balance sheets of banks is "much larger than the CMBS universe," Chandan notes.

And, he says, REEcon’s view is that the banking system will play the dominant role in the commercial real estate marketplace, as it has historically. Ultimately, Chandan says, "there can’t be a normalization of credit conditions without a healthy banking system."

As the latest Federal Reserve Bank Senior Loan Officer Opinion survey noted, 40% of lending institutions indicated that standards for investment-grade commercial real estate lending would remain tighter than their longer-term average levels for the foreseeable future. About 55% expected this outcome for non-investment-grade loans.

Chandan says that so far, there does not seem to be consensus on how policy makers and banks themselves will alleviate some of the strain on smaller and regional banks. He says banks are being encouraged to modify balances, so that loans can become performing again. But, he says, modification of loans implies significant cost to banks.

Ultimately, Chandan says, the costs to capital reserves are where policy needs to be focused. He says that to achieve that goal, there should be some sharing of the costs associated with writedowns.