Commercial Property Is Biggest Risk, U.S. Bank Examiners Find

By Craig Torres
Jan. 6 (Bloomberg) -- Losses on commercial real estate loans pose the biggest risk to U.S. banks this year, troubling smaller lenders while unlikely to threaten the entire financial system, U.S. bank examiners concluded during a review.
“Losses from commercial real estate will be quite high by historic standards,” said Eugene Ludwig, former Comptroller of the Currency who is now chairman of Promontory Financial Group, a Washington-based consulting firm to financial institutions. “Hundreds of banks will fail or will be resolved over the course of the cycle.”
Federal Reserve Governor Elizabeth Duke said in a Jan. 4 speech that credit conditions in commercial real estate “are particularly strained.” Fed Governor Daniel Tarullo cited commercial real estate as one of the “key trouble spots” in congressional testimony in October after the Fed stepped up a review of banks’ exposure to such loans.
The failure of loans backing malls, hotels and apartments may impede the U.S. recovery as small- and medium-sized banks reduce lending and conserve capital to absorb losses, analysts said. Tight credit could slow the cycle of investment and hiring that is critical for sustained growth, they said.
Fed Chairman Ben S. Bernanke, in a Dec. 7 speech, cited tight credit among “formidable headwinds” likely to hinder growth. Total loans and leases by banks in the U.S. fell to $6.79 trillion in November from $7.23 trillion in the same month a year earlier, according to Fed data.
More Than Doubled
The default rate on commercial mortgages held by U.S. banks more than doubled to 3.4 percent in the third quarter, according to Real Estate Econometrics LLC, a property research firm in New York. Default rates in the first three quarters of 2009 have been the highest since 1993, according to the firm.
Losses on the debt will “place continued pressure on banks’ earnings” because collateral values have fallen, Jon Greenlee, associate director of the Fed’s bank supervision division, said in Nov. 2 testimony to the domestic policy subcommittee of the House Committee on Oversight and Government Reform.
Banks and investors held about $3.5 trillion of commercial real estate debt in June 2009, with about $1.7 trillion of that total on the books of banks and thrifts, according to Fed data. About $500 billion of the loans will mature each year over the next few years, Fed officials say.
Regional banks are almost four times more concentrated in commercial property loans than the nation’s biggest lenders, according to data compiled by Bloomberg on bailout recipients.
Vulnerability of Banks
Investors have recognized the comparative vulnerability of smaller banks. The KBW Regional Banking Index, which includes shares of Old National Bancorp of Evansville, Indiana and Glacier Bancorp Inc. of Kalispell, Montana, fell 24 percent last year compared with a 3.6 percent decline for the KBW Bank Index, which includes shares of JPMorgan Chase & Co. and Citigroup Inc.
“The strong get stronger and the weak get weaker,” said Joel Conn, president of Lakeshore Capital LLC in Birmingham, Alabama, which specializes in financial stocks. “It is very difficult to come up with a scenario where earnings get anywhere back to normal for small banks with large commercial real estate exposures.”
Fed officials stepped up reviews of commercial real estate loans at banks last year. The Fed is focusing on banks smaller than the 19 largest lenders examined in May. Those institutions held assets exceeding $100 billion.
Defaults among prime borrowers for residential mortgages will probably accelerate this year, according to Robert Shiller and Karl Case, the economists who created the S&P/Case-Shiller Home Price Index.
Hold to Plans
Still, the Fed will probably hold to its plans to finish the purchase of $1.43 trillion in mortgage-backed securities and housing-finance debt by March 31, barring a reversal in the economy or big rise in mortgage rates, Fed watchers said.
“Clearly, the market would react quite negatively if the Fed said, ‘We are changing our mind,’” said Stephen Stanley, chief economist at RBS Securities Inc. in Stamford, Connecticut, and a former Richmond Fed researcher.
Bernanke has said the purchases have helped lower mortgage rates and stabilize the economy. The Fed, which began in September to slow down the purchases, still has about $139 billion of mortgage-backed securities left to buy out of $1.25 trillion, and $15 billion of federal agency debt out of $175 billion.
Chris Rupkey, chief financial economist at Bank of Tokyo- Mitsubishi UFJ, Ltd. in New York, said Fed officials will monitor mortgage rates and the difference in yields between mortgage-backed securities and Treasuries.
‘Opposite Direction’
“They will not extend it without seeing a bad outcome,” Rupkey said. “Everything seems to be moving in the opposite direction” of increasing purchases of the securities, he said.
St. Louis Fed President James Bullard said in November that the central bank should retain the flexibility to respond to any weakening in the economy by extending beyond March its authority to buy mortgage-backed securities and agency bonds.
Mortgage rates in the U.S. rose last week to 5.14 percent, the highest since August, Freddie Mac said Dec. 31. That’s still close to the record low of 4.71 percent reached in the week ended Dec. 3 and the average 5.04 percent for 2009. Rates averaged 6.05 percent in 2008 and 6.34 percent in 2007.
An increase in rates to 6 percent may prompt the Fed to reconsider ending purchases of mortgage-backed securities, Rupkey said.