The increasing concentration of construction loans in community bank portfolios is raising regulators' eyebrows.

Last week the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., and the Office of Thrift Supervision all expressed concern about the rapid pace of construction lending at community banks and thrifts. Though none urged community banks to scale back, each cautioned about the risks in a line of business that even many large banks have curtailed.

"Real estate is like an old friend you keep at arm's length … because every once in a while it comes back to burn you," said David D. Gibbons, the deputy comptroller for credit risk at the OCC.

Big banks have historically been the main providers of construction financing, and they still have a bigger share of the market. Yet in recent years community banks have expanded such lending fast as the number of development projects has risen.

In 1997, for example, construction loan portfolios at small banks and thrifts grew only half as fast as at those with more than $10 billion of assets - 8.3% versus 16.8%. But two years later the smaller institutions' holdings were growing three-quarters as fast as the bigger ones' - 18% versus 23.5%.

Construction loans are about 5% of the loan portfolio at community banks, compared with 3% at larger banks. And community banks had a big role in last year's 27.2% increase in construction loan portfolios for all banks, according to the OCC.

Why are smaller banks turning to construction loans? The obvious answer is that in the robust economy, there is simply more development. Moreover, despite the risks, construction lending can be very profitable.

Robert Glickman, the president and chief executive of Corus Bankshares in Chicago, said that his $2.5 billion-asset company decided to focus on construction lending because of the strong demand. "We've developed an expertise in it," Mr. Glickman said.

Of the bank's $1.8 billion of loans outstanding, construction loans make up about 25% - up from less than 15% two years ago and 5% for the average community bank.

Mark Fitzgibbon, an analyst at Sandler O'Neill & Partners in New York, also said the commoditization of the home mortgage market may have contributed to the rise in construction lending by small banks and thrifts.

"In effect, many thrift and community banks that have traditionally made a lot of residential mortgage loans have de-emphasized that business" and stepped up their pursuit of higher-yield loans, he said.

Thrifts and smaller banks have also become more proactive about procuring construction loans and are taking away business from bigger banks that have focused more on acquisitions and other larger credits, Mr. Fitzgibbon added.

Still, evidence of the growing credit risks is easy to find.

Mr. Gibbons said that the number of problem loans as defined by the OCC increased by 70% from yearend 1998 to yearend 1999. And in its in a semiannual report issued last week, the FDIC warned that the frequency of two risky underwriting practices in construction lending have increased slightly compared with the six months that ended Sept. 30.

The proportion of banks deferring interest payments during the loan term "as standard procedure" rose to 6% from 3%. Although this practice is not unusual in construction lending, the increase in frequency indicates that it should be watched, the report said.

A drive for earnings growth is also cited as a reason for a slight rise in the number of banks making speculative construction loans, which regulators view as particularly risky. The FDIC reported that the percentage of banks doing so either "frequently enough to warrant notice" or "as standard procedure" rose by 1% to 25%.

And OTS Director Ellen Seidman told reporters after her quarterly "state of the thrift industry" speech last week that her agency is seeing a lot of speculative construction lending in places like Atlanta by thrifts outside their home markets.

This, she said, "can be very dangerous."

Because real estate recessions tend to be regional, examiners are particularly leery of institutions with lending concentrations in one geographic area. Strong growth in the South, the Southwest, and the Northwest has led banks there to increase concentration in construction lending, leaving them overexposed should a downturn occur, regulators said.

The OCC is concerned about what a recession would do to banks highly concentrated in construction. But Corus' Mr. Glickman says his company is prepared.

"We anticipate a downturn" and expect to have defaulted loans as a result of it, he said. Corus' reserves provide an adequate cushion, he added.

Still, Mr. Gibbons of the OCC said there has never been more of a need for improvement in credit-risk management.

"Bankers should really raise their own standards," he said. If they do not, "the examiners will do it for them."

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