Losses on commercial real estate loans pose the biggest risk to U.S. banks this year, troubling smaller lenders while unlikely to threaten the entire financial system.

"Losses from commercial real estate will be quite high by historic standards," said Eugene Ludwig, a former comptroller of the currency who is now chairman of Promontory Financial Group, a Washington consulting firm to financial institutions. "Hundreds of banks will fail or will be resolved over the course of the cycle."

Federal Reserve Gov. Elizabeth Duke said in a Jan. 4 speech that credit conditions in commercial real estate "are particularly strained." Fed Gov. Daniel Tarullo cited commercial real estate as one of the "key trouble spots" in congressional testimony in October after the Fed stepped up a review of banks' exposure to such loans.

The failure of loans backing malls, hotels and apartments may impede the U.S. recovery as small and midsize banks reduce lending and conserve capital to absorb losses, analysts said. Tight credit could slow the cycle of investment and hiring that is critical for sustained growth, they said.

In a Dec. 7 speech Fed Chairman Ben Bernanke cited tight credit among "formidable headwinds" likely to hinder growth. Total loans and leases by banks in the U.S. fell to $6.79 trillion in November from $7.23 trillion in November 2008, according to Fed data.

The default rate on commercial mortgages held by U.S. banks more than doubled, to 3.4%, in the third quarter, according to Real Estate Econometrics LLC, a property research firm in New York. Default rates in the first three quarters of 2009 were the highest since 1993, the firm said.

Losses will "place continued pressure on banks' earnings" because collateral values have fallen, Jon Greenlee, associate director of the Fed's bank supervision division, said in Nov. 2 testimony to the domestic policy subcommittee of the House Committee on Oversight and Government Reform.

Banks and investors held about $3.5 trillion of commercial real estate debt in June 2009, with about $1.7 trillion of that total on the books of banks and thrifts, according to Fed data.

About $500 billion of the loans will mature each year over the next few years, Fed officials say.

Regional banks are almost four times more concentrated in commercial property loans than the nation's biggest lenders, according to data compiled by Bloomberg on bailout recipients.

Investors have recognized the comparative vulnerability of smaller banks. The KBW Regional Banking Index, which includes shares of Old National Bancorp in Evansville, Ind.. and Glacier Bancorp Inc. in Kalispell, Mont., fell 24% last year, compared with a 3.6% decline for the KBW Bank Index, which includes shares of JPMorgan Chase & Co. and Citigroup Inc.

"The strong get stronger and the weak get weaker," said Joel Conn, president of Lakeshore Capital LLC in Birmingham, Ala., which specializes in financial stocks. "It is very difficult to come up with a scenario where earnings get anywhere back to normal for small banks with large commercial real estate exposures."

Fed officials stepped up reviews of commercial real estate loans at banks last year. The Fed is focusing on banks smaller than the 19 largest lenders examined in May. Those institutions held assets exceeding $100 billion.

Defaults among prime borrowers for residential mortgages will probably accelerate this year, according to Robert Shiller and Karl Case, the economists who created the S&P/Case-Shiller Home Price Index.

Still, the Fed will probably hold to its plans to finish the purchase of $1.43 trillion of mortgage-backed securities and housing-finance debt by March 31, barring a reversal in the economy or big rise in mortgage rates, Fed watchers said.

"Clearly, the market would react quite negatively if the Fed said, 'We are changing our mind,' " said Stephen Stanley, chief economist at RBS Securities Inc. in Stamford, Conn., and a former researcher with the Richmond Fed.

Bernanke has said the purchases have helped lower mortgage rates. The Fed, which started slowing down the purchases in September, still has about $139 billion of mortgage-backed securities left to buy out of $1.25 trillion.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.