Small Banks Face Hits on Commercial Real Estate

Small Banks Face Hits on Commercial Real Estate

By LINGLING WEI, Wall Street Journal

Thursday's "stress-test" results will bring fresh scrutiny to the nation's biggest banks. They also are likely to highlight the woes from commercial real-estate loans that are piling up at large and small banks alike.

In the worst-case scenario, federal regulators examining the 19 largest U.S. banks are projecting losses of up to 12% on commercial real-estate loans over two years, according to a document viewed by The Wall Street Journal. The regulators are likely to cite commercial-property debt problems as a major reason why at least some of the large banks need additional capital.

Such losses likely would cause even deeper misery, and risk of failure, at small and medium banks because they tend to have disproportionally more exposure to commercial real-estate loans than giant institutions. While regulators have indicated they won't allow the 19 stress-tested banks to fail, that group doesn't include more than 500 banks with assets of less than $1 billion that have too much exposure to commercial real estate and are at the most risk of failing, according to an analysis by Foresight Analytics LLC.

During the housing boom, small and regional banks doubled down on lending to home builders and commercial-property developers and investors as they were largely squeezed out of the home mortgage market by large banks and Wall Street firms. Now many of those loans are going bad as vacancies rise, rents fall and developments open to anemic demand.

Analysts already had been forecasting hundreds of bank closures in the next five years. The stress-test assumptions, including a 10.3% jobless rate at the end of 2010, raise the specter that some of the failures could occur sooner.

The 12% loss rate being used by regulators to scrutinize commercial real-estate loans surprised some analysts because default rates on such debt remain lower than those on home mortgages. The loss rate implies that the nation's banks and thrifts, which hold $1.8 trillion of commercial real-estate debt on their books, would incur $216 billion in losses by the end of 2010.
[KeyCorp] Bloomberg News

KeyCorp is among 19 stress-tested banks with a large exposure to commercial real estate. Here, a KeyCorp branch in Upper Arlington, Ohio, in 2006.

With that loss rate, "you're talking about a depression in the U.S. economy and a major crisis in the banking system," says Richard Bove, an analyst at brokerage firm Rochdale Securities LLC.

In addition to the commercial real-estate loans clogging bank balance sheets, an additional $700 billion of those loans were packaged as securities and sold to investors. In light of plummeting property values and surging defaults, credit-rating firms have imposed downgrades on those securities. On Monday, Moody's Investors Service said it downgraded $52.9 billion in so-called collateralized debt obligations stuffed with commercial real-estate debt as part of its review of $83.1 billion in such CDOs amid worsening market conditions.

While bank regulators aren't immediately applying the stress-test criteria to small and midsize institutions, banks with high commercial real-estate exposures are drawing greater scrutiny from regulators. Nearly 3,000 banks and thrifts are estimated to have commercial real-estate loan portfolios that exceeded 300% of their total risk-based capital, according to Foresight. Regulators consider the 300% threshold as a red flag, although it doesn't necessarily mean all those banks are in danger of failing. Risk-based capital is a cushion that banks can dig into to cover losses.

While the failure of a single small bank is unlikely to cause systemic damage to the nation's financial system, such institutions could have a big impact as a whole. Banks with commercial real-estate loan portfolios exceeding 300% of their total risk-based capital have total assets of about $2 trillion, compared with $2.3 trillion in assets at Bank of America Corp.

Stress-tested banks that had a large exposure to commercial real-estate as of the end of 2008 include Regions Financial Corp., BB&T Corp., Fifth Third Bancorp and KeyCorp. "We are experiencing deterioration in other [commercial real-estate segments] such as the retail property group, which is dependent upon consumer spending to generally support rents," KeyCorp finance chief Jeffrey B. Weeden said in a conference call last month.

Commercial real-estate debt represented about 119% of the bank's total capital as of Dec. 31. "We remain well capitalized by any regulatory measure," Mr. Weeden said.

To be sure, banks wouldn't get hit as hard from commercial real-estate under rosier scenarios or if government programs succeed in pulling the U.S. economy out of its funk. The Federal Reserve, for example, announced on Friday new terms on one of its lending programs that officials hope will help revive the commercial real-estate market.

Since late 2007, 58 banks and savings institutions have failed, with assets totaling about $400 billion.

About a dozen of the failed banks, including Great Basin Bank of Nevada and First Bank of Idaho, had unusually high commercial-mortgage exposure, according to Foresight.

A bank currently on the ropes because of commercial real estate is Corus Bankshares Inc., a big condominium-construction lender. In a securities filing Friday, the Chicago-based lender said it was "undercapitalized" as of March 31. Regulators might place the bank "into conservatorship or receivership," according to the filing.

So far, banks have been generally reluctant to sell their troubled commercial-property loans partly because they would be insolvent if they sell at bargain prices being sought by investors. That might change if regulators put more pressure on banks to clean up their books.

From January 2008 to the end of February, the Federal Deposit Insurance Corp. sold about $1.16 billion of distressed real-estate and other types of commercial loans from failed banks for about 59 cents on the dollar, according to industry data.
—Damian Paletta and Nick Timiraos contributed to this article.

Write to Lingling Wei at lingling.wei@dowjones.com
Printed in The Wall Street Journal, page C1