When examiners from the OCC arrived in February to begin going over the books at the First National Bank of Artesia (NM), they bee-lined almost immediately for a portfolio of construction and development loans—many of them in the hot Las Cruces market—that CEO W. Everett Crawford views as his $532 million-asset institution’s bread-and-butter. More than four months later, after numerous squabbles, the exam ended, leaving Crawford with a sour taste in his mouth.

Never mind that property prices in Las Cruces have declined only modestly over the past year, or that First National’s loans had gone mostly to contractors with long-established relationships with the bank. Stricter underwriting standards and third-party loan reviews, added since the market began heading south in 2007, didn’t seem to matter much, either. What concerned the examiners was that First National’s book of commercial real estate loans totaled more than 300 percent of capital—a big no-no in an environment that has regulatory agencies worried about bank failures.

The examiners went over each and every one of Crawford’s loans, digging into borrower credentials, challenging appraisal values and threatening to downgrade the credits, he says. Before it was over, Crawford got into several heated conversations with folks at the OCC’s regional office in Denver and wound up adding $150,000 to his loan-loss reserves. “I said, ‘I’m a banker. We look at cash flows and equity, and if those things aren’t there, we downgrade the loan ourselves. ...You’re not letting me do my job,’” says a still-irked Crawford. “But it didn’t seem to matter.”

Crawford’s lament is being echoed often these days across the nation’s banking landscape. Chris Cole, regulatory counsel for the Independent Community Bankers of America, says he’s hearing loads of complaints that examiners are “acting unfairly and over-reaching in terms of caution.” But while the regulators’ tactics might be open to debate, their motivations are understandable because they’re based on one irrefutable fact: Sharp declines in housing prices, sparked by the subprime mortgage crisis, are spreading into the commercial real estate arena, meshing with a stuttering economy to create a perfect storm of credit problems that could yet batter the industry in ways not seen in nearly two decades.

The fallout promises to be far more devastating than the subprime crisis, because CRE is so much more pervasive — a linchpin business for so many institutions, including most community banks. “The subprime lending business probably touches one in 25 banks, and look at the trouble it’s caused,” says Mark Fitzgibbon, a managing director with Sandler O’Neill & Partners. “CRE touches 25 of 25 banks.” And that means that troubles thus far limited primarily to big names on Wall Street could come home to roost on Main Streets across the country.

Trying to predict how bad things might get is dicey business. It’s even possible—but not probable—that the tempest could blow over without causing much damage. Most analysts believe that we’re on the cusp of a period that, before it is over, could lead to perhaps hundreds of failed banks and many more that are forced to boost reserves and absorb CRE-related losses big enough to leave them teetering.

“It’s a huge, huge concern,” says Gerard Cassidy, an analyst with RBC Capital Markets, who predicts that as many as 300 banks could go under during the next two years. “Some banks are going to go out of business, others will be wounded and survive.”

At the end of the first quarter, CRE loans accounted for more than $1.6 trillion of bank assets, or more than 20 percent of the industry’s $7.97 trillion loan total, according to the FDIC. That included $632 billion in construction and development loans, and some $989 billion in other “nonfarm non-residential” offerings, including office buildings, retail malls, hotels, industrial warehouses and the like.

Large-bank CRE exposures are generally manageable, a May report by Fitch Ratings concluded, although weakness is evident. Wachovia recorded $1.1 trillion of “market valuation losses” on commercial mortgage-backed securities in the six months ended in March. National City Corp. has cautioned that a $225 billion portfolio of Florida construction loans could see losses of 35 percent as borrowers run out of money. In early July, Marshall & Ilsley CEO Mark Furlong warned that the Milwaukee banking company could see a net loss of $1.60 per-share in the second quarter, due mostly to “exposure embedded in our housing-related construction and development portfolio.”

Other big players, including SunTrust Banks, BB&T Corp., KeyCorp, also are struggling with CRE. “It’s very conceivable to me that we could see some larger banks fail,” says Fitzgibbon. He cites $330 billion-asset Washington Mutual as a potential candidate, because of its “heavy exposure to subprime and construction lending.”

For all that, community banks face a grimmer picture. In recent years, smaller institutions have been disintermediated by bigger banks and nonbank players in key consumer lines, such as credit cards and even mortgages. They’ve responded by putting pedal to the metal on CRE, where they’ve remained very competitive. In December 2006, rising concentration levels prompted the OCC and other regulatory bodies to issue a joint communiqué warning that those whose exposures exceeded 300 percent of capital in total CRE—and 100 percent in C&D and land loans —would face increased scrutiny.

Many bankers ignored that counsel, arguing their local markets could support higher levels. In reality, many say privately, they had nowhere else to turn. “It’s been the only game in town for most small banks this decade,” says Patrick Frye, svp for Summit Financial Group, a $1.5 billion-asset bank in Moorefield, WV. “If you weren’t in CRE, then you had no growth prospects.”

Growth and record profits came during the boom. Now many banks must face up to the risks. According to Comptroller of the Currency John Dugan, the average community bank boasted CRE loans equal to 285 percent of capital at the end of 2007—double where it was only six years earlier. More than one-third of all community banks had ratios of more than 300 percent. For comparison’s sake, Cassidy says that the ratio of CRE loans to the industry’s tangible capital-plus-reserves is about 69 percent today; in 1988, at the onset of the last big real estate bust, the figure was 53 percent.

The primary focus is on land and residential C&D loans—an area that banks piled into like lemmings during the housing boom. In some parts of the country, entire condo developments and suburban subdivisions sit empty, leaving builders unable to keep up with loan payments. The problem is most acute in erstwhile boom states, including Florida, California, Arizona and Nevada, and in rust belt locales, such as Michigan and Ohio, where the economy is struggling mightily. A recent Sandler O’Neill analysis found that 20 of the 25 banks with the largest concentrations of C&D loans were in either the West or Southeast.

But trouble isn’t isolated to those areas. Sharon Haas, the sector head for North American commercial banks at Fitch Ratings, says there are pockets of severe residential construction weakness around the country, and that virtually all banks are being touched in one way or another. Indeed, according to SNL Financial, community banks with C&D loans accounting for more than 60 percent of all loans can be found in places as diverse as Georgia, Illinois, Oregon, Utah and Kansas. “We’re finding weakness at the ZIP code level,” Haas explains.

Overall, 4.71 percent of the industry’s C&D loans were classified as non-current at the end of the first quarter, with another 2.47 percent less than 90 days delinquent, according to the FDIC. Charge-offs on those loans were just 1.1 percent, or about $70 million. Given the dynamics, all of those figures look bound to rise precipitously.

Ivy Zelman, CEO of Zelman Associates, a housing research firm, predicts that over the next five years banks will need to charge-off a minimum of about $65 billion, and as much as $165 billion, or 26 percent of all C&D and land loans. She bases that on projections that “aggregate land prices” will deflate more than 50 percent, (they’ve already fallen 40 percent in some places), exceeding the historical high of 37 percent in the early ’90s. “If you do the math, it’s not hard to believe that we’ll have at least 10 percent charge-offs,” she says. “It would almost be stupid to believe otherwise.”

The effects already are playing out in higher reserve levels, dented earnings and valuations, and CEO job losses. Four banks failed in the first half of the year, including ANB Bancshares, a $1.9 billion-asset Bentonville, AR company that had 78 percent of its loan book in C&D—much of it out-of-footprint—and was running with a 27 percent delinquency rate on those loans. Others have been forced to sell, including $4.4 billion-asset PFF Bancorp of Rancho Cucamonga, CA, which in June agreed to be acquired by FBOP Corp., after projecting a $204 million quarterly loss due to its exposure to central California homebuilders. The price: $1.35 per-share, down from $30 a year earlier. (Overall, the Keefe Bruyette & Woods Bank Stock Index plunged 35 percent in the first half of the year, reflecting investor unease.)

Spillover into the broader CRE market could come next, FDIC chairman Sheila Bair cautioned in recent congressional testimony, fueled by rising food and energy prices and spiking unemployment rates. Zelman says that the C&D loan troubles “are beginning to spread into the underlying real estate” of office, retail, hotel and other commercial projects. “Anything that’s built vertically on real estate, there’s a good chance the value will deflate.” That will inevitably trigger problems in those portfolios, too. “When the residential real estate market heads south, it isn’t long before commercial real estate follows,” says Rusty Cloutier, CEO of Mid-South Bancorp, a $900 million-asset company in Lafayette, LA.

Already, office vacancy rates in some markets are climbing—northern Virginia has seen rates double to 22 percent over the past year, Zelman says. Somewhat ironically, the financial services industry, itself a big user of office space, could add to the weakness. It already has cut 83,000 jobs due to its woes, and could shed another 175,000 in the coming year, according to executive recruiting firm Gerson Group. “There wasn’t as much overbuilding” of office space as during the late-1980s, says Joseph Hoesley, vice chairman of CRE lending for US Bancorp. “But companies are contracting, and we’re seeing a lot of office space opening up.”

Other sectors of the economy are showing weakness that could contribute to the problem. Apartment operators, for instance, are coming under pressure from the oversupply of condos, many of which are entering the rental market. “Rents aren’t accelerating, but expenses for energy and upkeep are,” Hoesley says. Retail is feeling the strain, too. Starbucks has announced that it will shutter 600 of its U.S. outlets, 70 percent of them opened since 2005. “Nobody wants to build a store in front of a bunch of empty houses,” Cloutier says. Such moves add to the available space and reduce income for borrowers.

Fitch’s Haas argues that while greater losses are inevitable, CRE charge-offs in general won’t approach the dire levels of the C&D market. Enough bankers remember the S&L crisis of the early ’90s, which was rooted in CRE, to have avoided heavy concentrations, and more non-bank permanent financing is employed in big office projects today.

To be sure, some banks are benefiting from the CRE disruption. The virtual shut down of the commercial mortgage-backed securities market has played into the hands of companies with strong balance sheets. US Bancorp, for instance, has been cherry picking clients who are unable to find financing elsewhere or are wary about other lenders’ staying power. “There’s a real flight to quality among clients who had multiple relationships,” Hoesley says. “Now they’re coming to us.”

For most bankers, however, the future will be filled with tougher slogging, as they grapple with the hangover from better days. Smart managements are working to sell languishing properties before valuations drop further. “We learned in the early ’90s that your first loss is your best loss,” Cloutier says. “If you’ve got a project that isn’t going to work, you’re best off taking your beating and getting out of it.” The list of sellers is rising. Wachovia has been seeking a buyer for $350 million of troubled construction loans, analysts say. KeyCorp has reportedly been shopping a $930 million portfolio of residential development loans.

The flurry of selling activity is boosting inventories and depressing prices, accelerating the trouble. Zelman says packages of C&D loans for sale “are stacked up on top of each other,” making it a buyer’s market. New appraisals attached to those loans have left many valuations underwater, driving down portfolio prices. In some cases, bids on loans from former hotbeds are running at mere “pennies on the dollar.” A good price for a package with a face value of $120 million might be $20 million. “There aren’t a lot of good alternatives,” she says.

In this environment, some bankers are employing questionable tactics. A few are foreclosing on solid credits that have violated some kind of technical covenant, then folding them into packages with shakier loans to make them more attractive to investors, analysts say. Others are trying to extend additional credit to debtors through unconventional means. Zelman tells of one builder she knows whose bank recently approached with a whispered proposal: “Why don’t I let you take a personal loan and you can use it to pay your corporate debt so I don’t have to show you as a non-performer.”

Most are going with tried-and-true formulas, stress testing existing loans for signs of weakness and clamping down on underwriting standards for new ones. Many are turning to so-called “recourse loans,” which involve direct personal guarantees from the principals. “We’re closing loans for our own balance sheet now, not for securitization,” says the head of CRE lending for one large bank. “That makes us more cautious.”

Where does the industry go from here? In July, KBW warned that 44 large and mid-sized banks — including such big names as Wells Fargo, Wachovia and Bank of America — might need to raise as much as a combined $30 billion in capital to cover rising credit losses. That would be in addition to the $63 billion raised by 33 banks during the first half of the year. Other estimates are higher.

While the willingness of private equity and other capital sources to pony up has blunted the impact of the crisis so far, many of those investments are now underwater. “At some point, investors might begin to re-evaluate whether putting money into the industry makes sense,” Fitzgibbon says. For smaller banks, raising additional capital could prove extremely difficult. As the banking system’s last line of defense, it’s perhaps small wonder that regulators are working overtime to ensure that bank exposures to CRE stay under control. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved. http://www.us-banker.com http://www.sourcemedia.com

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