Continuing Commercial Loan Problems

July 7, 2010

Many opportunistic investors have turned their attention to the bundles of securitized loans known as commercial mortgage-backed securities, or CMBS. They believe that in commercial real estate these loans stand ready for a day of reckoning.

These loans, as their residential cousins, were compartmentalized (or tranched) into many pieces. While the highest-rated tranches, rated triple-A may not be in danger, the tranches most likely to be hurt are those with the worst ratings – the triple Bs. These were the biggest victims of lax underwriting standards.

According to Commercial Mortgage Alert, the boom years of 2005 through 2007 saw a total of $602 billion in CMBS issuance. (The CMBS written during those three years account for a total of 49% of all CMBS written over the past 20 years.)

CMBS, however, accounts for only about 20% of the total loan market, according to an article in which quotes Jones Lang LaSalle (JLL). According to JLL, the bigger danger to the capital markets — and to banks — are speculative commercial loans, like those in construction and land loans. Those aren’t backed by firm assets and are a key part of the reason that many smaller banks have failed in recent years. For many, it is these loans and not the CMBS loans that are worrisome and could yet bring a day of reckoning to commercial real estate.

To illustrate this point, on June 21st, the Federal Deposit Insurance Corporation (FDIC) closed its 83rd bank this year –Nevada Security Bank (NSB).

The FDIC’s loss sharing agreement with the takeover bank, Umpqua Bank will cost the Deposit Insurance Fund an estimated $80.9 million.

Nevada Security Bank had net loans and leases of $330 million. Of that total, almost two-thirds, $204 million, was in commercial real estate. Commercial real estate, multifamily, and construction loans combined totaled $275 million, just over 83% of the bank’s lending balance sheet. The default rate on its commercial real estate loans was 10.6%  in the first quarter, more than double the national average. Similarly, the default rate on its construction loans was 25.8%.

Globest recently published a study conducted by Dr. Sam Chandan, Global Chief Economist at Real Capital Analytics.

The study notes the continued deterioration in the performance of commercial real estate and construction loans as the key driver of strains in the regional and community bank sectors. However, while the default and loss experience in banks’ commercial real estate portfolios varies substantially, smaller lenders’ average exposure to real estate is clearly higher than at their largest peers.

Dr. Chandan studied 56 bank failures since 2008. In each of these cases, the resolution of the failure resulted in a loss to the FDIC’s Deposit Insurance Fund (DIF).

Across the thirty-six bank failures where commercial real estate was cited the average default rate on commercial mortgages was 11.4% in the last quarter during which the bank was active – three times the average bank commercial real estate default rate of 3.8% in the fourth quarter 2009. Surpassing commercial defaults, the default rate for multifamily mortgages across the same subset of failed banks was 17.9%; the construction loan default rate, 29.7%.

The exceedingly high default rates in the commercial, multifamily, and construction loan pools weighed on the failing banks because these loan pools represented a large share of each bank’s total lending. On average, the sum of commercial, multifamily, and construction loans represented 75% of net loans and leases at failed banks cited for commercial real estate exposures. 45% of the combined balances were in commercial real estate specifically. By way of comparison, the average commercial real estate concentration across all active banks at year-end 2009 was 15%.

The most interesting part of the study was that 7,721 banks – roughly 97% of all active banks in the first quarter – have at least some exposure to commercial real estate. Of these, 565 currently report commercial real estate default rates of at least 10%. Even when employing the higher benchmark of an 11.4% default rate (the average commercial real estate default rate for failed banks), 440 banks report higher default rates in their legacy commercial portfolios. These banks represent more than 5% of all FDIC-insured institutions and 3% of the system’s total assets.

In the second quarter of 2010, there were 45 bank failures in the U.S., generating a loss of nearly $11.1 billion for the FDIC. The failed banks had assets of $50.1 billion, and deposits of $40.5 billion. 

In Florida, regulators seized eight banks with combined assets of $6.3 billion, generating a loss of nearly $1 billion for the FDIC’s insurance recovery fund.  The second quarter seizures means 14 Florida banks with combined assets of $8.6 billion have failed in the first six months of 2010. This year’s closings match all of 2009 when 14 Florida bank failed.

Florida now has the most bank failures of any state in the nation for 2010. In fact, only one other state – Illinois with 12 failures – has experienced a double digit number of bank seizures this year,

Banks have failed in 24 states ranging from Arizona to Nebraska, Oregon to South Carolina. Rounding out the top five states for the most bank failures after Florida and Illinois are Georgia with nine failures, Washington with seven failures, and California and Minnesota with six failures each.

Posted by Scott R. Lodde


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