Bankers in parts of California hurt most by the housing slowdown said they worry about the potential for a ripple effect in their commercial real estate portfolios, so they are working to minimize their risk.
But if housing woes continue to affect the economy for long, such trouble might be unavoidable, they said.
"If the residential problems last into mid-2009 or later, then that's going to have an impact on the commercial side of things because consumers may not want to keep spending," said Thomas J. Hawker, the chief executive of the $1.9 billion-asset Capital Corp. of the West in Merced, Calif.
Analysts said they expect that the credit ripples from the housing sector could be felt even sooner.
"I think the next shoe to drop will be commercial real estate," said Brett Rabatin of First Horizon National Corp.'s FTN Midwest Research Securities Corp.
The Inland Empire region east of Los Angeles and the San Joaquin and Sacramento valleys near Sacramento have some of the fastest-growing counties in the country, and companies like Capital Corp. flourished with double-digit loan growth during the past decade. As people gave up on the more expensive coastal areas, the population in many inland counties has grown 20% or more this decade, about triple the 6.4% growth rate for the country overall, according to data from the U.S. Census Bureau.
However, the once-booming residential construction market in these areas has slowed significantly, and deteriorating credit quality hit the third-quarter earnings of many banks in these areas.
California — and these two regions in particular — is more vulnerable to the housing crisis than other parts of the country because the Golden State's economy depends so heavily on residential construction, analysts said.
Problems could very well spill over into commercial real estate if home sales fail to pick up and businesses suffer, analysts and bankers agreed.
Mr. Rabatin said lending on retail properties — particularly those built to serve new housing developments — would be most affected. "Some banks are curtailing their exposure to shopping centers and strip malls in case the economy softens within the next six months," he added, citing Capital Corp. as an example.
Mr. Hawker said his company has tried to diversify its lending away from commercial real estate to mitigate the impact should conditions worsen in the San Joaquin and Sacramento valleys.
Commercial and industrial loans — a less-risky business line, Mr. Hawker said — make up about 27% of Capital Corp.'s $1.3 billion loan portfolio, and the company last month bought a factoring business, Bay View Funding.
His company also has expanded its commercial real estate portfolio geographically, to the San Francisco Bay area, particularly Silicon Valley, where the housing slowdown is less severe, he said.
Still, a slow recovery in the housing sector could undermine consumer spending and take a toll on commercial real estate, Mr. Hawker said. "That could have an impact on us booking new loans as well as incurring problem loans."
Capital Corp.'s third-quarter net income rose 2.9% from a year earlier, to $6 million. Though the company beat analysts' consensus by 2 cents, it had a $407,000 charge related to a $9.39 million nonperforming residential construction loan in Rocklin, Calif.
The company's second-quarter profit was nearly wiped out by a $3.73 million provision for the same loan. It earned $642,000 in the second quarter, down from $6.25 million a year earlier.
Jeffrey A. Rulis, an analyst at D.A. Davidson & Co. in Portland, Ore., said that other Sacramento-area banking companies, including the $567 million-asset American River Bankshares in Rancho Cordova, have told him that the commercial real estate sector has been holding up well so far.
But he said this could change in coming quarters. "Central Valley markets like Sacramento, Stockton, and Modesto have some of the highest residential foreclosure stats in the state, and whether that leads into the commercial projects, I think that's the next logical step," Mr. Rulis said.
In the Inland Empire region, which includes Riverside and San Bernardino counties, two banking companies that would probably be affected by any slowdown in commercial real estate lending are the $4.4 billion-asset PFF Bancorp Inc. in Rancho Cucamonga, and the $2.5 billion-asset Vineyard National Bancorp in Corona, according to Mr. Rabatin.
PFF already has been hit hard by the housing slowdown. The company swung to a $7.5 million loss in the third quarter, from a profit of $14 million a year earlier, due mainly to a $34 million provision for loan losses in its residential construction portfolio.
Robert Bohlen, an analyst at KBW Inc.'s Keefe, Bruyette & Woods Inc., said that PFF would probably experience more credit-quality problems in its construction portfolio as the housing slowdown continues.
However, he disagreed with Mr. Rabatin about PFF's potential commercial real estate risk, saying it does not have major exposure to a decline in that sector. About 15% of PFF's $4 billion loan portfolio is in commercial real estate, far below the typical 35% to 40% for California community banks, he said.
Vineyard National said in its third-quarter earnings release that it hopes to increase its commercial real estate lending but intends to focus on "borrowers with substantial holdings, liquidity, and strength, and expansive operations seeking to reposition mature properties."
Its third-quarter net income rose 18%, to $5.5 million, buoyed in part by lending tied to the luxury home construction market in Southern California coastal areas, which have been relatively immune to the slowdown.
Though Vineyard National's loan-loss provision remained unchanged at $1 million from a year earlier, the company said problem loans might increase should "borrower capacity erode and markets sustain further duress."
The company charged off $400,000 during the quarter, all related to Small Business Administration loans.
Neither PFF nor Vineyard returned calls seeking comment.
Stephen H. Wacknitz, the CEO of the $1.3 billion-asset Temecula Valley Bancorp Inc. in the southernmost Inland Empire city of Temecula, said that, if the housing slowdown continues, it "has to have some spillover" into commercial real estate. "The longer this goes on, the amount of impact will be anybody's guess," he said. "But for now we don't anticipate any real serious problems at this point, and we are on top of things and managing things very well."
Temecula's third-quarter earnings fell 35.4%, to $2.6 million, due mainly to a discounting of assets under Financial Accounting Statement 156. Though the company's nonperforming assets doubled from a year earlier, to $32 million, or 1.39% of total assets, its net chargeoffs remained low, at 0.07% of total loans.
