For going on a year now, bankers have been characterizing commercial real estate as the next shoe to drop.
Certainly for some institutions, such as the recently failed Corus Bank, it has felt more like a jackboot. But for most, the shoe is falling at a pace slow enough to suggest a controlled landing instead of a resounding thud.
How is this possible in the wake of price declines that have knocked commercial property values down about 35% from their peak two years ago?
Some credit a strategy known as "extend and pretend" or "delay and pray," the poetic but arguably reckless practice of amending loans to give down-on-their-luck borrowers a longer or easier path to repayment.
But even as banks stop pretending and praying and instead face up to their problems — a trend real estate experts say they finally are starting to observe in markets around the country — there is reason to believe that the industry will avoid the cataclysmic crisis seen last year in home mortgages and other credit markets.
For starters, the CRE lending business is smaller than the residential business, accounting for 43% of banks' real estate loans as measured by the Federal Deposit Insurance Corp. Moreover, many of the riskiest CRE loans were funneled through the securitization market, while others got written down when banks with heavy concentrations of bad loans, such as Wachovia, were absorbed by stronger institutions.
Also in banks' favor: accounting rules. Because CRE loans typically are held to maturity rather than classified as available for sale, they are relatively insulated from the type of market volatility that led to massive writedowns last year on tradeable securities. That protection might not always be there, with accounting standard setters considering a drastic expansion in the application of mark-to-market accounting.
But for now, the safety net is in place, reducing the likelihood that the CRE market experiences a triggering event like Merrill Lynch & Co.'s sale of collateralized debt obligations last July, which netted 22 cents on the dollar and moved up the day of reckoning for other holders of similarly toxic securities.
"Probably the saving grace for bankers is that most CRE loans are not in held-for-sale, so they don't have to take marks like they did on their CDO portfolios last year," said Christopher Wolfe, a financial institutions analyst with Fitch Ratings. "You can assume that the defaults will continue to escalate … but the nonperforming-asset figures might not be as high you'd presume otherwise. It will just continue to be a slow burn in terms of the losses and the defaults that will occur."
Banking regulators presumably are on high alert. Examiners learning about emerging risks in the industry were warned in a recent presentation from the Federal Reserve Bank of Atlanta that banks may be slow to take losses, as they were with residential loans. The Atlanta Fed would not provide a copy of the presentation.
And investors no doubt will be scouring banks' third-quarter results this week and next for further evidence of the dribs and drabs by which the CRE problem is making itself known.
But given that commercial real estate values tend to lag the economy, and given that the loans made in 2005 and 2006 — when credit requirements generally were at their loosest — have yet to mature, it could be several years before the full extent of CRE losses is measured.
As refinancings come up over the next three years, "this is where the stress points begin to build," said Keith Leggett, senior economist at the American Bankers Association. "What makes it worse is that because the value of the collateral is dropping, the loan-to-value ratio is rising, and that means that the people who are going to be refinancing are going to have to come up with a substantial amount of equity to roll over the credit or to get new credit."
At that point, Leggett said, "banks aren't going to be able to pretend" anymore that delinquent payments will somehow materialize.
"They will be required to start recognizing these losses," he said. "What hopefully has taken place is that there had been enough warning signs out there about CRE that banks had taken the necessary steps to begin to prepare."
Increasingly, there are signs that these preparations are under way.
Mike Mounts, a managing director with the real estate investment banking team at Jones Lang LaSalle Inc. in Chicago, said he has observed some banks farming out collections work and offering contingency payments equal to one-third of the recoveries, illustrating a newfound willingness among banks to take up-front hits on the loans. He has seen other banks get more aggressive with foreclosures, under the assumption that it is better to be at the front of the line when a borrower with competing creditors falls into distress.
"After a year of denial and pulling out all the stops, banks are coming to grips with this stuff and doing what they have to do," said Mounts, who formerly worked in the structured real estate product group at Bank of America Corp. "The consensus now is that they really need to start doing something, because whatever deal they can cut now will be better than whatever deal they can cut six months from now."
In addition to lower property values, borrowers are contending with rising vacancies and falling rents, which is cutting into their cash flow. But while Mounts expects more deterioration in CRE, he said the government is doing a good job of hemming in the problem. Bank regulators are working closely with companies to make sure their CRE exposures are recognized, and government agencies are "taking steps to make sure we don't have triggering events that lead to wholesale liquidation," Mounts said, citing a recent relaxation in Internal Revenue Service rules making it easier for real estate mortgage investment conduits to make loan modifications.
The IRS rules relate more to securitized loans than to loans held by banks. But the fate of the different segments of the business are intertwined in many respects.
That said, some general distinctions that can be made between CRE loans that were securitized and those that were not. W. Kendall Chalk, interim chief executive of the Risk Management Association and a former chief risk officer of BB&T Corp., said the real estate crisis of the early 1990s prompted many banks to show restraint during the most recent development boom, which had the effect of steering borrowers with weaker credit profiles to the securitized market, where the lure of fee income frequently translated into deals with lower credit standards.
"In spite of the fact that bankers sometimes have a hard time learning lessons, I think we did learn something that time, and banks were not taking as much CRE risk," Chalk said. "I'm sure there are a few smaller institutions that have risk concentrated in one product area or one geographic area, but in terms of an industrywide cataclysmic event, I just don't see it happening."