Glut of Maturing Realty Credits May Stall Lenders
A close look at bank real estate portfolios shows why credit for future economic expansion may founder on past mistakes.
The chief culprit is a glut of bank lonas coming due at a time when nonbank lenders - the traditional refinancers - are unwilling to step forward.
The bank loans, originated during the boom years of the 1980s, include traditional construction loans and the formerly trendy medium-term loans known as miniperms that banks developed in hope of getting a bigger share of the market.
That leaves bankers with a hard choice: either foreclose and go into the moribund real estate development business or extend additional capital to sustain vacant office buildings and shopping malls until the climate improves.
Few banks can take further hits to their balance sheets. But extending credit may pose even worse ramifications. It means siphoning off capital that ought to be helping bank clients to meet payrolls and other expenses that are supposed to fuel an economic recovery.
A Big Rollover Is Due
The tab for a rollover of these loans comes to $66 billion for the year that ends next June, according to the National Realty Committee, a lobbying group based in Washington. Another $115 billion could come due soon after that.
More lenient rules on real estate loans could ease the problem but would not change the need for banks to shoulder real estate debt left over from the boom years - and at a time when bank strength is sorely needed in other sectors of the economy.
Indeed, the persistence of the recession so far suggests bank capital may already have been diverted from the expansion-minded small businesses that economists now count on to provide that lift. "They're the ones that get squeezed when the banks get squeezed," said Robert J. Brusca, the economist at Nikko Securities.
Hangover from the 1980s
And banks are being squeezed hard.
They are in the midst of an agonizing process of rolling over $400 billion of real estate loans, most of them to projects that broke ground in the late 1980s.
This requires no additional outlay of money. Nor, by any means, are they all bad loans.
But because the insurance companies and others who provide permanent finance have fled the risky, overbuilt real estate markets, banks will have to keep most of these loans on their own books for a while longer. And these loans must be capitalized - at 8% of book value under a standard being phased in by the end of 1992 - with money that could have been held against new loans.
In addition, the banks are under regulatory pressure to adjust the value of real estate assets downward to today's values. This results in an additional drain on capital, as banks increase loss reserves.
In New England alone, according to one group of lenders, at least 100,000 jobs will be lost if appraisal standards for real estate aren't eased by the time the demand for new credit returns. This group, the real estate finance division of the Greater Boston Real Estate Board, estimates that every dollar of bank capital translates into $10 to $15 of lending capacity.
Overbuilding a Factor
That an overhang of debt left over from the go-go 1980s might flatten the economy has been part of the conventional wisdom for several years. And that is not only because corporations are pouring money into debt service instead of expansion.
The current recession is different from those past, because of "the extreme speculation in commercial real estate and higher-income" investment by banks, Harvard professor John Kenneth Galbraith said. "That's where the whole credit system is focused.
"The further effect of real estate [overbuilding]," he added, "is unemployment in the construction sector."
What caught many people by surprise, though, was the size of the wave of refinancing demand that reared up just when nobody was willing to lend on real estate.
Timely Payoffs Uncommon
The National Realty Committee, a lobbying group, cited a recent Federal Reserve survey of loan officers that showed only one-third of the miniperm and construction loans that came due in the last 12 months were paid off as originally scheduled. Most of those loans have been temporarily extended by the banks, in a trend that affects big domestic banks more than small banks or the domestic branches of foreign banks, according to the survey.
Large-bank problems are more likely to spill over into the national economy, impeding a recovery, the committee said.
Bankers told the Fed another two-fifths of the construction and miniperm loans on their books was due to mature in the next year, and 80% had no permanent financing arranged.
One banker, speaking on condition of anonymity, said the general policy at his bank is to extend the loans for two to three years - rather than provide a 10-year permanant loan - in hopes that the permanent-financing market will rebound by then.
Improvement Less Likely
But prospects of a rebound seem to be getting worse.
The seizure of Mutual Life Insurance Co. this summer accelerated a flight to liquidity on the part of run-sensitive insurance companies, said David Shulman, managing director and real estate expert at Salomon Brothers. Although their flight caused a sharp drop in the yield on seven-year Treasury securities, making it cheaper to refinance real estate with loans of similar maturity, the bottom line is that the market got "more illiguid," he said.
Illiquidity cuts banks in two ways. Not only does it force them to pick up more of the credit burden, it knocks the legs out from under the current market price of real estate collateral.
Leniency in valuing real estate is the measure most often proposed by bankers and developers, who complain examiners are forcing them to value loans based on today's liquidation value, rather than on a fair market price. The Office of the Comptroller of the Currency has conceded the need to recognize the future value of real estate, but bankers say the leniency is not yet in practice.
In a study commissioned by the Greater Boston Real Estate Board, appraiser Richard E. Bonz said that has to change, or-banks will be caught in a vicious cycle of declining value.
Not for the Losers
"This approach will not obscure the problems of permanently impaired real estate for which there is no reasonable demand," he said, advocating projecting future economic conditions in evaluating the probable demand for real estate.
To contrast his approach to the current practice, Mr. Bonz used the example of a commercial property loan of $12 million, in which the value of the collateral was temporarily impaired by the bankruptcy of a tenant and a temporary oversupply of office space in the market.
In the example, a recent appraisal valued the property at $11 million, and an estimate of fair value from a current sale of came in at $9.5 million.
According to Mr. Bonz, the regulators today would force a writeoff and reserve of $3.45 million, and $41.4 million of credit would be "erased from the system," assuming a 12-1 ratio of lending capacity to bank capital.
A Different Result
Using an appraisal method that allows the bank to recognize a $12.1 million market value - based on a 10% improvement when conditions stabilize - a $2.4 million loss reserve would be required, and only $28.8 million of credit would be lost.
Anthony Downs, real estate expert at the Brookings Institution agreed, saying the current practice amounted to telling banks to foreclose and sell as soon as possible.
"It's bad advice," Mr. Downs said. "It's like telling everyone in a fire you ought to be the first one out of the room."