Commercial real estate

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Congressional Oversight Panel highlights CRE issues

Over the next few years, a wave of commercial real estate loan failures could threaten America‘s already-weakened financial system. The Congressional Oversight Panel is deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation‘s mid-size and smaller banks, and that as the damage spreads beyond individual banks that it will contribute to prolonged weakness throughout the economy.

Commercial real estate loans are taken out by developers to purchase, build, and maintain properties such as shopping centers, offices, hotels, and apartments. These loans have terms of three to ten years, but the monthly payments are not scheduled to repay the loan in that period.

At the end of the initial term, the entire remaining balance of the loan comes due, and the borrower must take out a new loan to finance its continued ownership of the property. Banks and other commercial property lenders bear two primary risks: (1) a borrower may not be able to pay interest and principal during the loan's term, and (2) a borrower may not be able to get refinancing when the loan term ends. In either case, the loan will default and the property will face foreclosure.

The problems facing commercial real estate have no single cause. The loans most likely to fail were made at the height of the real estate bubble when commercial real estate values had been driven above sustainable levels and loans; many were made carelessly in a rush for profit.

Other loans were potentially sound when made but the severe recession has translated into fewer retail customers, less frequent vacations, decreased demand for office space, and a weaker apartment market, all increasing the likelihood of default on commercial real estate loans. Even borrowers who own profitable properties may be unable to refinance their loans as they face tightened underwriting standards, increased demands for additional investment by borrowers, and restricted credit.

Between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are at present ―underwater– that is, the borrower owes more than the underlying property is currently worth. Commercial property values have fallen more than 40 percent since the beginning of 2007. Increased vacancy rates, which now range from eight percent for multifamily housing to 18 percent for office buildings, and falling rents, which have declined 40 percent for office space and 33 percent for retail space, have exerted a powerful downward pressure on the value of commercial properties.

The largest commercial real estate loan losses are projected for 2011 and beyond; losses at banks alone could range as high as $200-$300 billion. The stress tests conducted last year for 19 major financial institutions examined their capital reserves only through the end of 2010.

Even more significantly, small and mid-sized banks were never subjected to any exercise comparable to the stress tests, despite the fact that small and mid-sized banks are proportionately even more exposed than their larger counterparts to commercial real estate loan losses.

A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American. Empty office complexes, hotels, and retail stores could lead directly to lost jobs. Foreclosures on apartment complexes could push families out of their residences, even if they had never missed a rent payment. Banks that suffer, or are afraid of suffering, commercial mortgage losses could grow even more reluctant to lend, which could in turn further reduce access to credit for more businesses and families and accelerate a negative economic cycle.

It is difficult to predict either the number of foreclosures to come or who will be most immediately affected. In the worst case scenario, hundreds more community and mid-sized banks could face insolvency. Because these banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery, and extend an already painful recession.

There are no easy solutions to these problems. Although it endorses no specific proposals, the Panel identifies a number of possible interventions to contain the problem until the commercial real estate market can return to health. The Panel is clear that government cannot and should not keep every bank afloat. But neither should it turn a blind eye to the dangers of unnecessary bank failures and their impact on communities.

The Panel believes that Treasury and bank supervisors must address forthrightly and transparently the threats facing the commercial real estate markets. The coming trouble in commercial real estate could pose painful problems for the communities, small businesses, and American families already struggling to make ends meet in today's exceptionally difficult economy.

"A congressional watchdog panel warned on Thursday that mounting commercial real estate losses could endanger the banking system and thwart economic recovery.

A total of $1.4 trillion in commercial real estate loans will require refinancing in the next four years, the Congressional Oversight Panel said in a report. More than half of those loans are underwater, written for properties whose value has dropped like a rock.

The expected losses when loans go bad could hit between $200 billion to $300 billion and threaten 3,000 small and mid-size banks with a disproportionate share of commercial real estate assets on their books, according to the panel.

The report is intended to "wave a red flag" to the White House and Congress that the commercial real estate loan market is going to get a lot worse before it gets better.

"We're at a point where even as TARP is ramping down another major challenge in our economy is ramping up," said Elizabeth Warren, the oversight panel's chairwoman. "We need to start now, before the system is on the brink of collapse to figure out a plan," she added.

The panel's research found that 2,988 banks are heavily invested -- with more than three times their assets tied up -- in commercial real estate loans. Of that number, 2,500 banks each have less than $1 billion in assets.

Indeed, many such smaller banks have already failed. Small bank failures"will intensify sharply over the next few years," Warren said.

"When commercial properties fail, the result is a downward spiral of economic contraction, as these are the same small banks that create jobs and boost economic activity," she said.

Solutions: The panel offers a number of possible solutions for policymakers to head off a commercial real estate crisis. For example, it says the Treasury Department should "stress test" banks that are concentrated in commercial real estate loans.

Treasury Secretary Tim Geithner said at a congressional hearing last fall that "it is not realistic or feasible" to review such a large number of banks in a detailed level.

The oversight panel also suggested that the federal government should consider other remedies, including injecting capital into these small banks, buying their toxic assets or guaranteeing loans.

Bank regulators could also simply allow banks to extend underwater loans rather than requiring them to recognize losses, but the panel worries that such a move could delay a rebound in bank lending. But the panel also worries that massive writedowns throughout the banking system could stymie lending and create a "negative bubble."

"There's a need for a nuanced response," Warren said. She said that banks should recognize some commercial real estate losses, but that regulators should monitor them closely to ensure that losses don't spiral downward and drag down the larger economy.

Kanjorski highlights a "Growing Bubble In Commercial Real Estate"

In a note released earlier, Congressmen Paul Kanjorski and Ken Calvert stated that they are launching an "Effort Urging Federal Regulators to Address Growing Commercial Real Estate Market Concerns" which will focus on the economic implications of the "deteriorating conditions in the commercial real estate." Luckily, Kanjorski bypasses the spin cycle and calls the repeat CRE bubble by its proper name:

"The growing bubble in the commercial real estate industry has the potential to infect our economy and slow a recovery," said Chairman Kanjorski. "In order to safeguard the businesses operating on Main Street and protect the millions of jobs depending on commercial real estate, the Treasury and the Federal Reserve now must take needed and urgent action to stave off a potentially devastating wave of commercial real estate foreclosures and bank losses." Wait? What's that? CRE valuations are fair? Isn't that what Merrill Lynch pounds the table on in each and every REIT research report. Maybe, just maybe, bubble and fair value are synonymous - we are not sure.

Luckily, to provide the correct answer, S&P picks today to release their extended industry report titled: The Worst May Still Be Yet To Come For U.S. Commercial Real Estate Loans.

From the summary, S&P notes the following:

Standard & Poor's Ratings Services believes that U.S. banks' real estate exposures may trigger substantial losses on the financial system during the current economic cycle. Each real estate cycle is different, and this one is likely to be different from the one during 1990-1993. In our view, however, that does not mean that this cycle should be any less severe. Although the causes of this cycle, and the players, are different, the sector nevertheless is likely to suffer the same degree of supply and demand imbalances and price declines that historically devalued the collateral backing real estate loans, resulting in severe losses for lenders. The severity of commercial real estate (CRE) cycles has always caused us to view CRE lending as one of the riskiest loan categories for banks. Therefore our risk-adjusted capital (RAC) methodology assigns a higher risk weighting for these loans than for most other asset classes. As a result, banks with high CRE exposure were generally rated lower than banks without this exposure.

In addition, elevated CRE exposure has driven many bank downgrades in the past two years, particularly of regional banks or finance companies with outsize exposures. Even though most highly exposed banks with weaker balance sheets are already rated below investment grade, more downgrades are possible; indeed, approximately 75% of the rated banks with the largest exposure to CRE carry negative outlooks. On a more positive note from a ratings perspective, even though many of the rated banks could suffer heavy losses, we believe that their capital is in most instances sufficient for them to pull through, as long as the losses are realized over a few years rather than taken at once, and as long as liquidity can be maintained. CRE exposure generally tends to represent a higher proportion of smaller, largely unrated community banks' exposures. Therefore, there is a greater proportion of risks in the unrated banking sector.

So there you go: even S&P confirms that should all losses be recognized all at once, without the aid of accounting and regulatory gimmicks, the financial system is likely entirely underwater, and this is only on account of CRE exposure, which as most pundits have been noting should not be a concern for anyone, as it is all under control. Right. One wonders how many of the other "manageable" risk factors are sufficient to destroy banking as we know it should mark-to-myth be replaced with some representation of reality.

The feedback loop of commercial real estate, regional banks and unemployment

It is no secret that the Fed is quite, quite concerned about the ongoing shakeout in the US commercial real estate market in the US, but just in case anyone missed the memos, Dennis Lockhart of the Atlanta Fed has devoted a whole speech to the subject.

Here are some of the key elements of Lockhart’s address, which he was scheduled to deliver at a real estate conference on Tuesday (any emphasis FT Alphaville’s):

Outline -

I will try to give you a sense-as a policymaker concerned with the broad economy-of how I am sizing up the commercial real estate challenge. One of my themes this morning will be the links, or connectivity, between sectors and the potential for troublesome, self-reinforcing interactions.

Disclaimer -

I must emphasize that the views I’ll express are my personal thoughts and are not necessarily shared by my colleagues in the Federal Reserve and on the Federal Open Market Committee (FOMC).

On contagion -

[I]t’s instructive to consider the connectivity among sectors and the potential of a self-reinforcing negative feedback loop involving multiple sectors.

Today, I’m particularly concerned about the interaction among bank lending, small business employment, and CRE values.

To elaborate, there is a tight linkage between CRE values and jobs. In a mid-September conference at the Atlanta Fed, CRE practitioners, investors, and academics agreed that the evolution of the CRE picture will depend greatly on the path of employment.

Small business impact -

Let me go on to show the link between jobs and small business credit. During the last two economic expansions, small firms (those with fewer than 50 employees) contributed about one-third of net job growth. But the depth and duration of this recession have taken a substantial toll on small businesses. In the 2001 recession, small firms held up reasonably well and accounted for only 9 percent of net job loss. In this recession, however, small firms have accounted for about 45 percent of net job losses per our most recent data through the end of 2008.

Small businesses tend to depend greatly on the banking sector-especially community and regional banks-for financing. A Federal Reserve survey earlier in the decade showed that more than half of smaller firms had a credit line or loan with a bank. In addition, about half of these businesses used a personal or business credit card to finance working capital. In this recession, credit standards have tightened for all businesses, including small businesses.

At this juncture, it’s hard to be encouraged about a fast rebound in job growth. As you know, last week’s employment report pushed the official unemployment rate to 10.2 percent, the highest since May 1983. Net job losses continue on a monthly basis but at a declining pace. Because employment growth tends to lag recovery from a recession and because of factors such as small business credit constraints, my current outlook for employment is one of very slow net job gains once the trend reverses, in all likelihood sometime next year. If this view is correct, this job growth outlook doesn’t help the commercial real estate situation.

Likely impact of the CRE problem on the financial system and the broad economy -

While the CRE problem is serious for parts of the banking industry, I don’t believe it poses a broad risk to the financial system. Compared with residential real estate, the size of the CRE debt market is smaller, and the exposure is more concentrated in smaller banks.

However, I am concerned about the potential impact of CRE on the broader economy. Unlike residential real estate, there is not the same direct linkage from CRE to household wealth-and therefore consumption-caused by erosion of home equity. However, there could be an impact resulting from small banks’ impaired ability to support the small business sector-a sector I expect will be critically important to job creation.

To add some detail: At the end of June 2009 there was approximately $3.5 trillion of outstanding debt associated with CRE. This figure compares with about $11 trillion of residential debt outstanding.

About 40 percent of the CRE debt is held on commercial bank balance sheets in the form of whole loans. A lot of the CRE exposure is concentrated at smaller institutions (banks with total assets under $10 billion). These smaller banks account for only 20 percent of total commercial banking assets in the United States but carry almost half of total CRE loans (based on Bank Call Report data).

Many small businesses rely on these smaller banks for credit. Small banks account for almost half of all small business loans (loans under $1 million). Moreover, small firms’ reliance on banks with heavy CRE exposure is substantial. Banks with the highest CRE exposure (CRE loan books that are more than three times their tier 1 capital) account for almost 40 percent of all small business loans.

To repeat my current assessment, while the CRE problem is very worrisome for parts of the banking industry, I don’t see it posing a broad risk to the financial system. Nonetheless, CRE could be a factor that suppresses the pace of recovery. As the recovery develops, the CRE problem will be a headwind, but not a show stopper, in my view.

It’s appropriate to be a bit tentative in the assessment of CRE risk to the financial system, however. In 2007, many underestimated the scale and contagion potential of the subprime residential mortgage-backed securities problem. With this experience in mind, my assessment should continue to be refined.

Overall, Lockhart didn’t paint a doomsday scenario, but his comments about the smaller banks — linchpins of the economy, essential to job creation, failing at an alarming rate, insufficiently regulated — do not reassure.

As BNP Paribas put it in a note on Monday:

There seems to be, only in the US, an unwillingness from a political perspective to further restructure / nationalise banks, which is the crux of the rising unemployment problem. It is the lack of bank lending, that is squeezing businesses, causing them to lay off employees and the politicians need to get a grip on this dynamic rather than wasting one stimulus package after another while increasing the budget deficit.

Defaults on apartment-building loans set record for 1Q 2010

Defaults on apartment-building mortgages held by U.S. banks climbed to a record 4.6 percent in the first quarter, almost twice the year-earlier level, as more borrowers failed to repay debt approved near the market peak, said Real Capital Analytics Inc. in a report.

Defaults on so-called multifamily mortgages rose from 4.4 percent in the fourth quarter and from 2.4 percent during the same period in 2009, the New York-based real estate research firm said today. Commercial-mortgage defaults also rose in the first quarter for loans against office, retail, hotel and industrial properties, Real Capital said.

“Apartment defaults are leading other commercial real estate,” Sam Chandan, global chief economist at Real Capital, said in an interview. “Banks tended to make more aggressively underwritten apartment loans earlier during this last cycle. Credit and pricing reached their peaks for office properties and other commercial assets later.”

The global recession cut demand for U.S. apartments, office space, retail shops, hotels and warehouses during the past two years as jobs disappeared and consumers cut spending. Defaults on apartment-building mortgages surpassed the previous record, set in 1993, for the past three consecutive quarters.

The U.S. savings-and-loan crisis drove apartment-building defaults to 3.4 percent in 1993. Defaults on other types of commercial property debt peaked at 4.6 percent in 1992, according to Real Capital.

The proportion of defaults on office, retail, hotel and industrial properties rose to 4.2 percent in the first quarter of this year, the company said.

U.S. apartments may lead a rebound in commercial real estate as vacancies peak in 2010 and the economy adds jobs, property research firm Reis Inc. said May 19. Reis estimates apartment vacancies will peak at 8.2 percent in 2010, the highest level since the firm began tracking the number in 1980. The number should start to decline in 2011, Reis said.

Real Capital bases its analysis on bank filings and data from the Federal Deposit Insurance Corp.

Commercial real estate delinquencies Feb 2010

The January Moody's CMBS delinquency rate hit a record at 5.42%, after posting the largest one month increase (50 bps) in history. While the deplorable state of CMBS is not a secret to anyone following RealPoint's monthly delinquency data, getting confirmation from a procyclical firm such as Moody's should be enough to wake up some of the optimists that even thought "everyone is talking about the commercial real estate" collapse, nothing is being done to actually fix the underlying causes. Anyone recall "contained" Dubai and its freshly record CDS spreads?

The delinquency by vintage demonstrates a very bimodal distribution, where while the weakness in the 2006-2008 vintages is to be expected, the dramatic spike in 1998-2000, and particularly 1999, is a novel phenomenon.

The reason for this is described by Moody's:

The 1999 vintage had the worst performance in 2009, partly due to ten-year loans from that cohort coming due and attempting to refinance in an unfavorable economic environment. The delinquency rate for the 1999 vintage was 3.59% a year ago and currently stands at 22.52%. We expect to see a significant increase in the delinquency rate of the 2000 vintage in 2010, as the ten year loans mature in an improving, but still credit constrained environment. Unlike recent vintages, which are delinquent mostly in the 60+ day past due category, the anniversary vintages (1998,1999) are delinquent mostly due to maturity default.

Earlier vintages are experiencing a mix of all three types of delinquency. As discussed above, the 1999 and 2000 vintages have a significant share of maturity defaults from ten-year loans. Likewise, the 2004 and 2005 vintages have a large proportion of maturity defaults due to five-year loans. The capital to pay down, refi maturities is just not there. This has a very negative implication on the CRE market, where REITs are trading on the assumption that capital (refi or otherwise) for any and all CRE ventures is again freely flowing.

Commercial real estate delinquencies Nov 2009

"...here is the data on the ongoing deterioration in CMBS, courtesy of Moody's, which data merely confirms data previously presented by RealPoint, the GSEs... "

Aggregate Delinquency Rate

Delinquency increased 37 basis points in October, as measured by the Moody’s Delinquency Tracker (DQT). The delinquency rate now stands at 4.01%, more than six times the rate seen at the same time last year. The rate has increased over 375 basis points from the low reached in July 2007, with further increases anticipated.

In the past month the delinquency rate increased 37 basis points to 4.01%. This increase is in-line with the steady rise in the delinquency rate over the past six months. Five of the last six months have seen a gain in the delinquency rate in the range of 35 to 41 basis points. Only August, with a more modest 21 basis point increase, lies outside this range.

The past six months, May 2009 through October 2009, have had an average increase of 36 basis points in the delinquency rate. This is a significantly higher monthly average change in the delinquency rate than the previous six month period, November 2008 to April 2009, which had an average increase of 21 basis points.

Delinquency by Property Type

Hotels had the largest change in delinquency in October. The delinquency rate for hotels increased 123 basis points, bringing its rate to 6.20%. The hotel delinquency rate has reached its highest point in the history of the delinquency tracker, passing the old mark of 5.92% that occurred in June 2003. All five property types are currently at the highest rate recorded by the Moody’s DQT.

Multifamily remains the worst performing property type in October. The 38 basis point increase in the delinquency rate was primarily influenced by three large properties that are newly delinquent in the eastern region (see Figure 20). The multifamily delinquency rate is now 6.47%.

Delinquency By Vintage

Figure 5 displays the delinquency rate for each vintage as of the end of October. Delinquency was calculated based on loans currently delinquent as a percent of current balance as well as original balance of all CMBS loans in the vintage.

The 1999 vintage now has a delinquency rate over 20%, with significant increases throughout the past year. Less than 17% of the original balance of the 1999 vintage remains outstanding. The 1998 vintage, on the other hand, has had two consecutive months of declining delinquency rates. With the exception of 2005, vintages between 2004 and 2008 now have a delinquency rate exceeding 4%.

Federal Reserve: Prudent Commercial Real Estate Loan Workouts

"The Federal Reserve, along with the other financial regulators of the Federal Financial Institutions Examination Council (FFIEC),1 has adopted the attached policy statement on Prudent Commercial Real Estate Loan Workouts. The Federal Reserve and the other financial regulators issued this policy statement to update longstanding guidance regarding the workout of CRE loans, especially in light of recent increases in such workouts. This guidance is intended to promote prudent CRE loan workouts at regulated financial institutions and to ensure examiners take a balanced and consistent approach in reviewing institutions’ workout activities. If conducted in a reasonable and prudent manner, such workouts are often in the best interest of both the institution and the borrower.

Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of borrowers’ financial conditions will not be subject to criticism for engaging in these efforts, even if the restructured loans have weaknesses that result in adverse credit classifications. In addition, renewed or restructured loans to creditworthy borrowers on reasonable terms will not be subject to adverse classifications solely because the value of the underlying collateral declined.

The examiner’s evaluation of a loan workout should be based upon the fundamentals of the particular loan, considering the project’s current and stabilized cash flows, debt service capacity, guarantor support, and other factors relevant to the borrower’s ability and willingness to repay the debt.

Overview of Guidance

The statement sets forth the appropriate standards for evaluating the management practices, workout arrangements, credit classification, regulatory reporting, and accounting for prudent CRE loan workouts, including:

  • Risk management elements for the loan workout program
  • Loan workout arrangements
  • Analyzing the repayment capacity of the borrower
  • Evaluating guarantees
  • Assessing collateral values
  • Classification of loans
  • Loan performance assessment for classification purposes
  • Classification of renewals or restructuring of maturing loans
  • Classification of troubled CRE loans dependent on the sale of collateral for repayment
  • Classification and accrual treatment of restructured loans with a partial charge-off
  • Regulatory reporting and accounting considerations
  • Implications for interest accrual
  • Restructured loans
  • Allowance for loan and lease losses

The statement includes examples of CRE loan workouts. The examples are provided for illustrative purposes only, and reflect examiners’ analytical processes for credit classifications and assessments of institutions’ accounting and reporting treatments for restructured loans. While the statement includes references and background materials related to regulatory reporting and accounting, appraisals and valuation concepts, and classification definitions, it does not change existing regulatory reporting or accounting guidance or standards. Rather, the guidance addresses supervisory expectations for reporting that reinforces longstanding guidance.

Scope

This statement applies to loans that are secured by multifamily property, and nonfarm nonresidential property where the primary source of repayment is derived from rental income associated with the property (that is, loans for which 50 percent or more of the source of repayment comes from third-party, nonaffiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property. Further, the guidance covers loans for land development and construction loans (including 1– to 4–family residential and commercial construction loans), other land loans, loans to real estate investment trusts (REITs), and unsecured loans to developers. This is consistent with the definition for CRE loans in SR letter–07-1, "Interagency Guidance on Concentrations in Commercial Real Estate."

Conclusion

Federal Reserve Banks are asked to distribute this letter to financial institutions supervised by the Federal Reserve in their districts, as well as to their own supervisory and examination staff. If you have any questions, please contact Jon–Greenlee, Associate Director, Risk Management, at (202) 452-2962; Sabeth Siddique, Assistant Director, Credit Risk, at (202) 452-3861; Robert Walker, Senior Supervisory Financial Analyst, Credit Risk, at (202) 452-3429; Virginia Gibbs, Senior Supervisory Financial Analyst, Credit Risk, at (202) 452-2521; Lawrence Rufrano, Senior Supervisory Financial Analyst, Risk Policy and Guidance, at (202) 452-2808; and Linda Ditchkus, Senior Project Manager, Accounting Policy and Disclosure, at (202) 452-3506.

Should the US government guarantee loans for science parks?

A new Senate bill that just passed committee would drive the creation of more science parks around the U.S. Specifically, the bill would allow the Secretary of Commerce to guarantee up to 80% (!) of loans over $10m for the construction of science parks.

Whoa, good thing that. After all, we don't have nearly enough vacant office space in the U.S. Rates are only running at a near-record 16.5% (according to Reis), with many cities at 20% vacancy and higher. And commercial real estate loans extant are merely teetering and threatening to bring down the regional banking system, so adding a few million more square feet will just give the system a helpful shove into complete insolvency.

I get that bill sponsors Olympia Snowe (R.) and Mark Pryor (D.) want to be helpful and create legislation to drive innovation. And I get that building science parks is fun and cool and way easier than actually doing science. So I understand the temptation entirely.

But are you people completely mad? What are you thinking by adding subsidized office space to a market already under severe stress? Total vacant sublease space in the U.S. is already 82m square feet, and total vacant space is around 800m square feet (according to Colliers). The idea that the government would tromp in adding more space at this point is ... well, nuts. (And don't even get me started about the white elephant nature of science parks, let alone their chronically high vacancy rates.)

Will someone in Sheila Bair's office at the FDIC please talk the Senate out of this? I really wasn't counting on the government itself causing us to have to bail out the entire regional banking system.

U.S. banks choking on real estate loans

"As the U.S. economy pulls out of a recession and the biggest banks return to profitability, mounting defaults on commercial property may keep regional lenders from repaying bailout funds until at least 2011.

Unpaid loans on malls, hotels, apartments and home developments stood at a 16-year high of 3.4 percent in the third quarter and may reach 5.3 percent in two years, according to Real Estate Econometrics LLC, a property research firm in New York. That’s a bigger threat to regional banks, which 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.

The concentration makes regulators less likely to let regional lenders like Synovus Financial Corp. and Zions Bancorporation leave the Troubled Asset Relief Program, analysts said. Smaller banks would remain stuck in TARP, while bigger lenders, including Bank of America Corp., repay the government and free themselves to set their own policies on executive pay.

“Community and regional banks basically became real estate banks in the past 25 years, and now real estate is on its back,” said Jeff Davis, an analyst at FTN Equity Capital Markets Corp. in Nashville, Tennessee. “The largest banks have other areas where they can make money, be it consumer lending, capital markets and asset management.”

Bank Failures

The stakes for taxpayers include whether they’ll get back $36.6 billion held by 35 of the largest regional lenders that received TARP money. Souring commercial real estate loans pose the biggest threat to the U.S. banking industry, according to October testimony to Congress by Sheila Bair, chairman of the Federal Deposit Insurance Corp., and Comptroller of the Currency John Dugan.

Regulators have shut 130 banks this year, all regional or community lenders, costing the FDIC more than $33 billion. Non- performing commercial property loans caused a majority of the failures, said Chip MacDonald, a partner specializing in financial services at law firm Jones Day.

“Somebody that has a lot of CRE exposure is going to be held to a higher standard” to redeem TARP preferred shares, said Paul Miller, a former bank examiner and now an analyst with FBR Capital Markets in Arlington, Virginia. “You’ve got to be careful they don’t allow these guys to pay back TARP, and then a year goes by and have to give it back to them.”

Commercial real estate loans “absolutely could be a factor” in whether regional banks can repay TARP funds, Bair said in an interview on Dec. 4.

Regional Lenders

Among 35 of the biggest regional lenders that retain TARP funds, commercial real estate and construction loans average 37 percent of total loans, compared with 9.5 percent at Citigroup Inc. and Wells Fargo & Co., the two biggest U.S. banks that haven’t announced plans to repay the government, according to data compiled by Bloomberg. The figures were derived from holdings at regional lenders that still have bailout money whose stocks are listed in either the 24-company KBW Bank Index or the 50-company KBW Regional Bank Index.

Of the 35 firms, 25 hold commercial real estate and construction loans equal to 30 percent or more of their total loans, according to FDIC data; seven have more than half of their loans in commercial property.

Nine of the banks with more than 30 percent of their loans in commercial real estate won’t show a profit for 2010, including Birmingham, Alabama-based Regions Financial Corp., Columbus, Georgia-based Synovus and Zions in Salt Lake City, according to Bloomberg’s survey of analysts.

Paying Back TARP

“To pay back TARP, they need to return to profitability, and for them to return to profitability, credit problems have to start to decline,” said Gerard Cassidy, a banking analyst at RBC Capital Markets in Portland, Maine.

Losses may hamper efforts of regional lenders to compete with bigger banks, such as Bank of America, ranked first by assets and deposits. The Charlotte, North Carolina-based lender, aided by profits from brokerage services and underwriting securities at its Merrill Lynch unit, announced last week that it would pay back the $45 billion it took from the government.

If Bank of America and Wells Fargo join JPMorgan Chase & Co. in redeeming TARP preferred shares, they’ll be free to press their advantage in markets they already dominate and to declare dividends and stock repurchases without seeking government approval. Bank of America and Wells Fargo finance about half of all U.S. home loans, and the four biggest banks -- Bank of America, JPMorgan, Citigroup and Wells Fargo -- account for more than a third of all U.S. deposits.

Diversified banks are also better able to capitalize on close-to-zero borrowing costs to make money by trading currencies, commodities and other assets.

Bank Stocks

Stocks of regional banks have taken a bigger hit than their larger peers. The KBW Regional Bank Index is down 28 percent this year. Bank of America and JPMorgan have posted gains this year, while Wells Fargo has dropped 9 percent.

There are more than 8,000 banks in the U.S., most of them community and regional lenders. Regional banks typically operate in several communities or states while lacking national or international operations.

Property owners and their bankers are facing losses because the recession cut into employment and consumer spending, pushing up vacancies at office buildings, shopping centers and hotels and bringing down asset values. Commercial real estate prices may drop as much as 55 percent from their October 2007 peak, Moody’s Investors Service said last month. Office vacancy rates may approach 20 percent in 2010, according to brokers at Jones Lang LaSalle Inc. and Grubb & Ellis Co.

‘Out of Whack’

Synovus, with $968 million in TARP money and two-thirds of its loans in commercial property and construction loans -- the highest of any TARP-holding bank in the KBW Bank Index -- posted five straight quarterly losses and is projected to lose money for all of 2010.

The bank’s failures include a $220 million loan to Sea Island Co., a Georgia real estate development firm, which it renegotiated and declared non-performing in April. Last month, co-lender Wells Fargo took over the deed to Sea Island’s 3,000- acre Frederica community on St. Simons Island that features a course favored by professional golfer Davis Love III.

“We got out of whack in the last four, five years, where we were pushing for growth, trying to keep up with the herd,” said Kevin Howard, Synovus’s chief credit officer. “Real estate, in the Southeast, is where you can get the growth. We let our percentages get higher than we normally have. We are fine, really, with moving it back.”

Zions Losses

Zions, Utah’s biggest lender and recipient of $1.4 billion from TARP, has posted four straight quarterly losses, and analysts are predicting the bank won’t return to profitability next year, according to Bloomberg data. Commercial property loans make up 57 percent of Zions’ portfolio, second-highest among banks in the KBW Index that haven’t repaid the government.

Collateral values are “stabilizing,” and while losses are expected to “increase somewhat,” they will be “extremely manageable” when compared with earnings, bank spokesman James Abbott said in an e-mail.

Other regional banks have seen defaults on projects ranging from a condominium-conversion project in Racine, Wisconsin, that was foreclosed on by Milwaukee-based Marshall & Ilsley Corp., the state’s biggest bank, to a subdivision in Oregon inspired by J.R.R. Tolkien’s “The Lord of the Rings.”

The Shire

Umpqua Holdings Corp., the Portland, Oregon-based bank that has 66 percent of its loans tied up in commercial property, sank $3.4 million into the Shire, a development in Bend, Oregon, with homes that have artificial thatched roofs modeled on the hobbit community in Tolkien’s trilogy. The developer defaulted in July, according to Oregon’s Bend Bulletin newspaper.

Umpqua CEO Raymond Davis said that while the bank did not experience a “significant loss” on the Shire, its real estate portfolio was “showing signs of weakness.” The bank has the highest commercial-property loan ratio of any lender in the regional bank index still holding TARP funds.

Davis said that Umpqua has set aside cash to repay the $214 million in TARP funds that it took from the government last year and is waiting for the economy to show further signs of stabilization before returning the money.

The worst may still be ahead for regional banks, according to Moody’s, which calculated that the non-performing loan ratio for commercial mortgages is higher than for residential ones.

“The commercial real estate problem is looming, and a bit like the rat going through the snake,” said William Bartmann, CEO of Bartmann Enterprises in Tulsa, Oklahoma, and former chairman of Commercial Financial Services, which was among the first companies to purchase assets from regulators during the savings and loan crisis. “We can see that it’s coming, it just hasn’t shown up yet.”

FDIC directive on "prudent loan workouts"

Vacant possessions

"When Peter Cummings and his corporate lending team at HBOS of the UK welcomed leading property entrepreneurs to their hilltop bash at Le Mas Candille hotel during the industry’s Cannes jamboree in March 2007, it was difficult to believe that the real estate dream would become a nightmare for the attendees in just a matter of months.

Such lavish dinners were just one of the many signs of excess during the heady years of the property boom. Certainly, when the crash came that summer, HBOS found itself among many overexposed to a market undergoing its sharpest fall on record.

Commercial property values fell by more than 40 per cent in markets such as the UK, the US, Spain and Ireland, posing problems for boomtime investments made largely with debt. After a time lag that partly reflects government support, the contagion from these losses is only just beginning to be felt in the global banking system.

Further restructurings, defaults and forced sales are inevitable as breaches of loan agreements increase and debt matures – of which the current problems in Dubai, facing a refinancing of $3.5bn (€2.3bn, £2.1bn) of bonds owed by a property group linked to the state, is just the biggest example to date. As with the Gulf emirate’s property debt, there are fears of how widely defaults will be felt within the banking system.

“Real estate debt for banks is the pig in the python and the question is when it will be digested,” says Patrick Vaughan, a well-known European property investor. “It has looked like it would kill the python.”

The scale of lending across the world – with an estimated £3,000bn ($4,940bn, €3,300bn) of property debt outstanding in the US and Europe – and the ferocity of the crash has meant institutions have not been able to afford action such as in the early 1990s, when panicked banks dumped distressed property in spite of more moderate market declines.

HSBC estimates that 85 per cent of UK loans made in the past five years are in breach of lending agreements. But banks are ignoring such problems. Instead they are rolling over loans as these near maturity, in the hope that capital values and loan-to-value (LTV) ratios will rise once again to refinanceable levels.

Analysts fear banks are storing up losses, particularly for lesser quality property. CB Richard Ellis, a consultancy, estimates that there are about £80bn ($132bn, €88bn) of poor quality property loans in the UK alone, or 27 per cent of all the British sector’s debt. More than £30bn worth are in breach of debt agreements or in default, according to De Montfort University – a tally that has doubled in just six months.

“Let me not pretend that it is not something that we are looking at closely. It represents a risk. We recognise that loans with LTVs of over 100 per cent will not be refinanced,” says Andrew Haldane, director for financial stability at the Bank of England. “The hope would be that new sources of finance will come to the market before the refinancing dates.”

The problem becomes acute as borrowers face repayment calls on loans in negative equity that they cannot meet and the financial market cannot afford to replace. Dubai is just the start of refinancing problems.

Much of the debt was generated during the boom of 2001-07, when deal volumes grew on average every year by 38 per cent in the US and 24 per cent in Europe – fuelled by cheap debt that in the case of the US is estimated to have accounted for more than 90 per cent of the $1,400bn transacted.

Such sums illustrate the voracious appetite of the real estate sector but also the over-eager lending practices among banks desperate to be involved in the booming property market.

Swept up in the parties, the meals in the south of France and the larger-than-life property tycoons with super-yachts, it was easy for bankers to become overwhelmed. Everyone was making money, simply because there was always another buyer with another bank willing to take the price even further away from the twin fundamentals of property value – rental income and replacement cost.

So keen were the banks to give money to the sector that many started to give speculators cash as well as debt, sometimes on structured terms that guaranteed an upside for investors with only the thinnest of “skins” in the game – 5-10 per cent of their own equity perhaps. The “meat” of the money, and the risk, was with the banks. This came to an abrupt end in 2007; finance to the sector was turned off.

In the UK, the lending market was dominated by HBOS and Royal Bank of Scotland, accounting for almost half of the £225bn of net outstanding debt. Naturally, concerns have rested with them as values have fallen.

Lloyds Banking Group, the new owner of HBOS, is still taking writedowns on its commercial property book, the legacy of the empire built up by Mr Cummings. Impairment charges of £22.1bn since the end of last year were related substantially to HBOS’s real estate spree.

RBS was just as keen to offer structured finance, creating a loan book that Stephen Hester, chief executive, is now dealing with in robust fashion. RBS will put £39bn of property loans into the government’s asset protection scheme: loans that are either being managed by its workout teams or on a high-risk list.

The APS will prove crucial to keeping such loans afloat. According to Alan Carter of Evolution Securities, government economic stimulus measures have provided “considerable assistance” to the sector. “To be clear, in absolute terms we regard the ongoing indebtedness of the real estate sector as a material risk. However, it is evident that the total meltdown in asset valuations has been avoided, at least for now,” he says.

Elsewhere, Ireland has created the National Asset Management Agency, which will buy €77bn ($114bn, £69bn) of toxic property loans. The Irish banks were particularly carefree in lending to some of the more risky types of real estate, such as development land. The US government has meanwhile acted to underwrite securitised real estate debt and relaxed the rules on defaults.

Ian Marcus, chairman of European real estate investment banking at Credit Suisse, says: “Real estate is not high on the agenda for government but banks certainly are.” Such efforts have helped secure the sector from the mass foreclosure of commercial developments but there are still worries about what happens as more property becomes empty amid the recession, which impacts on the rental income used to service debt.

Income will be key for banks, which ultimately are sanguine as long as interest is paid every month. Nick Robinson, the former managing director of corporate real estate for Lloyds, told the FT in September that further losses would be from borrowers having lost income from the failure of their tenants’ businesses.

For his part, Mr Marcus says: “Banks may overlook a breach of loan-to-values but they will take action if the interest is not paid. Loans then become impaired and banks will have to account for [them] in a different manner. A serious impact from a tenant default means that any borrower will have significant difficulties in refinancing their debt.”

The scale of refinancing represents one of the biggest hurdles for property investors and their banks to overcome. About $1,600bn of commercial mortgage debt is estimated to mature in the next five years in the US and a further €366bn in Europe. This represents a massive equity call on the property sector. In July, a delegation of property financiers used a forum with the Bank of England and Treasury to warn of the threat posed by the lack of finance to cover loans due for renewal.

Those in the group estimate that £100bn could be needed to recapitalise the UK property sector, taking it to a sustainable LTV ratio, which means the industry could be in negative equity until 2017. “We’ve got very excited about the £7bn raised in the UK listed sector but this shows that there is several multiples of that needed to bring loans to safety,” says one group member.

Refinancing has not been more of a problem before because banks have been able to roll loans over, even when in breach. In fact, banks can make good money in bad times by boosting margins and fees. Various phrases have been coined to describe the trend – “a rolling loan gathers no loss” quickly became a cliché – but bankers warn that such manoeuvres are not a long-term solution when the need is to reduce exposure to the sector. One banker says that institutions are kicking the can down the road pretty far but “this is ultimately just delaying the problem in the hope that the world will be a better place”.

Asustained property recovery would go part of the way to saving the situation, although the rebound is still uncertain. UK commercial property has seen 3.2 per cent price growth since the summer, for example, but that has been based on demand for prime property.

So-called secondary property – the majority of the market – is still a problem. “Banks are going to struggle in particular to refinance secondary property where values have fallen steeply until the market recovers,” says Max Sinclair, who co-heads the UK division of Germany’s Eurohypo.

The chief executive of one leading property company says: “The banks are terrified, as they cannot afford the provisions. They simply can’t sell me something at 60 per cent [of] book value as they can’t deal with the losses, and I won’t buy it for a penny more.”

There will be solutions, with banks exploring exit routes ranging from joint ventures to establishing funds and real estate investment trusts. Developers are taking on their sites. It will help that lending is again very profitable, given the high margins and fees on property generally being sold below long-term value. The other banking adage – that good loans are made in bad times – will be true for those who still have the appetite.

Indigestion at some of the larger banks could continue for many years to come, however. Nick Leslau, chief executive of Max Property and a veteran investor, says: “I was buying distressed property from the 1990s crash a decade later. This time is worse. It will be a long process.”

It could certainly be for the many former clients of HBOS, given difficult years ahead under the gaze of the bank’s 200-strong restructuring team. Mr Cummings departed in January and relationship banking has become workout planning. The parties in the south of France are a distant memory.

CMBS problems continue in US and Europe

The immediate outlook for the global commercial mortgage-backed market remains bleak, with delinquency rates heading upwards on US transactions and their European equivalents hit by conservative property valuations.

According to Pennsylvanian rating agency Realpoint, which carries out surveillance on 95% of the US CMBS market, the delinquent unpaid balance on $797.1 billion worth of CMBS transactions stood at $47.82 billion at the end of February, up $1.87 billion from the previous month.

The unpaid delinquent balance on CMBS pools has risen by almost 300% over the past 12 months from the $12 billion figure reported in February 2009, and is now valued at 21 times its March 2007 low point of $2.21 billion, Realpoint said.

February’s delinquency rate was 6%, up slightly from 5.76% in January but more than four times the February 2009 rate of 1.43%.

Delinquencies are highest on transactions issued in the three years leading up to the recent financial crisis, with 77% of the delinquent assets coming from 2005–2007 CMBS vintages. There is also a regional bias to the figures: California, Florida and Texas account for 31% of US delinquencies in February. California alone accounts for 13% of the national total.

Realpoint says the increase in delinquencies is set to continue in the short term. Under its best-case scenario, the agency predicts the delinquency rate will rise to between 8% and 9% over the course of 2010. But its more bearish scenario would see that figure reach closer to 12%.

Meanwhile, Fitch Ratings claims that property valuers and loan servicers are currently too risk-averse in the European commercial property markets when resolving distressed loans, which could negatively affect the credit profile of CMBS transactions.

“These [valuations] may well provide some cover for servicers that sell above what look like conservative valuations,” says Euan Gatfield, senior director in the CMBS team at Fitch. “If there is a negative bias at work in their valuation and, if servicers are being helped to sell at those prices, that could lead to recovery proceeds on defaulted loans being lower than they might have been.

“We’re hardly looking to sell below market value, but market value is a loaded term because it’s official terminology. They’d be criticised for selling below that. But in the general sense of fair value, they have an interest to sell short but they are exposed to retaliation by disgruntled noteholders if that doesn’t work,” Gatfield adds.

The Fed’s CRE exposure

What ties the SIGTARP report, Goldman Sachs CDOs and the mounting concern that is US commercial real estate altogether?

The most recent breakdown of the Federal Reserve’s Maiden Lane III portfolio. That is, of course, the SPV created by the central bank to bail-out AIG by buying up the underlying collateral (those asset-backed CDOs) from some of the stricken insurer’s counterparties.

Watch that commercial real estate CDO bit carefully. It’s a big change from the last update on the portfolio.

Which means that the percentage of the Maiden Lane III CRE CDO portfolio rated AAA has fallen dramatically from 16.7 to 1.9 per cent in just three months. Most of that looks to have shifted to the A+ to A- bucket — still investment grade, but sliding steadily down the ratings table. And very quickly.

JP Morgan offers biggest CMBS offering of 2010

JPMorgan Chase & Co. plans to sell $1 billion of commercial mortgage-backed bonds, giving control of soured loans to a holder of the riskiest portion after another offering ceded power to investors in the safest pieces.

JPMorgan’s sale, the largest this year of the debt, would grant hedge fund H/2 Capital Partners LLC, the buyer of the bottom $50 million slice, primary authority over troubled loans, according to people familiar with the transaction who declined to be identified because negotiations are private. Goldman Sachs Group Inc. and Citigroup Inc. gave those rights to investors of the highest-rated portions in a $788.5 million offering on Aug. 4.

Concern that holders of the riskiest pieces may make decisions favoring their own interests prompted Goldman Sachs to switch from the traditional structure of securities backed by hotels, shopping malls and skyscrapers. Spreading control among numerous senior bondholders may create confusion in the event of defaults, according to NewOak Capital LLC’s Ron D’Vari.

“It’s very difficult to come to terms with delinquent borrowers as it is,” said D’Vari, chief executive officer of the advisory and asset-management firm in New York, and previously the head of structured finance at BlackRock Inc. “If you multilayer that with additional bureaucracy, it becomes more difficult.”

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