Community and mid-size banks, which comprise the bulk of all commercial real estate lending in this country, are once again under the watchful eye of regulators. In March, the Federal Deposit Insurance Corp. (FDIC) issued a letter to all financial institutions warning those with high concentrations of commercial real estate and construction loans to maintain more adequate loan loss reserves and aggressive credit risk-management practices.
In that same communiqué, FDIC Chairman Sheila Bair noted, “Although commercial real estate lending can be a profitable business line for banks, it is a good time to reemphasize the [December] 2006 guidance because a number of banks have significant commercial real estate concentrations, and the weakness in housing across the country may have an adverse effect on those institutions.”
Why all the fuss? Some 96% of the 8,643 banks in the U.S. are considered community banks, those with assets of $1 billion or less. According to the latest FDIC figures, a growing number of them have higher concentrations of exposure to construction lending than in previous years. The number of financial institutions with construction loans exceeding their total capital supply increased by more than 17% during a two-year period ending in the fourth quarter of 2007.
So far, the actual number of failures has been small, with just 30 banks failing since 2000. But three banks closed their doors in 2007, and two have already failed this year. The FDIC is planning for the worst. In March it announced plans to hire up to 138 new employees in its Division of Resolutions and Receivership to help deal with rising bank failures.
“The FDIC, like the other federal regulators such as the Federal Reserve and the Treasury Department, is trying to get enough staff on board to prepare for a very rocky year ahead,” says Ronald Glancz, chair of the financial services group for the Washington, D.C.-based Venable law firm.
The financial woes of Fremont General Corp., in Brea, Calif., have put the company under the microscope. Federal and state regulators ordered Fremont to raise capital by May 26, or sell its banking subsidiary. Fremont has been a leading lender in subprime, to date receiving default notices on $3.15 billion of residential mortgages. The directive mirrors an aggressive federal policy to see banks mark down the value of their assets and raise new capital.
Sam Chandan, director of research for Reis, notes that the heightened exposure of regional and community banks to commercial real estate comes at a time when borrowers face increasing challenges to make their payments.
“Unconstrained borrowers are stepping back from selling their properties where investor interest is weak, but some borrowers will face challenges in meeting their principal and interest obligations or in refinancing. The latter group's numbers will grow later in 2008,” says Chandan. The Federal Reserve reports an early warning sign — delinquencies on commercial loans held by commercial banks ended 2007 at 2.71%, double the rate of a year earlier.
Even candidates have weighed in on increased banking regulation. Recently Sen. Barack Obama (D-Ill.) recommended new proposals that would give the Federal Reserve greater powers to oversee the capital requirements and lending practices of banks, a sentiment echoed by Sen. Hillary Clinton (D-N.Y.).
On March 31, Treasury Secretary Henry Paulson formally announced the Bush administration's plan in the wake of the subprime debacle. The proposed changes address how the banks, mortgage brokerages and insurance companies are regulated. At its core, Paulson's plan proposes placing more oversight responsibility with the Federal Reserve as a “market stability regulator.”
But the matter is not so simple. The nation's banking system is regulated by four agencies, including the Fed, which oversees bank-holding companies and shares supervision of state-chartered banks. Paulson wants to see one agency, separate from the Fed, take on this role.
The plan would eliminate the Office of Thrift Supervision, which oversees savings and loans, and the Commodity Futures Trading Commission. In their place, a new “prudential financial regulator” would oversee banks, thrifts and credit unions.
And yet a third new agency would regulate business conduct and consumer protection, supplanting many of the functions of the Securities and Exchange Commission. Observers give Paulson's plan little chance of succeeding, given the divided Congress in an election year and a lame-duck president. But most pundits expect the new Congress and president to tackle the issue in early 2009.
Many banks have already started getting the message. Real estate construction and development loans increased by only 2%, or $12.5 billion, during the fourth quarter of 2007 over the prior quarter. That is the smallest quarterly increase since the fourth quarter of 2003.
Some banks are now filling a void in the marketplace. City National Bank in Palo Alto, Calif., is forming a commercial real estate lending team to support the middle-market real estate development community in Silicon Valley. “What separates City National from the numerous community banks in the market is our expertise and capacity to participate in the $5 million to $20 million financing niche that defines our real estate business,” says team leader Robert Sherrard.
That niche is under fire from a variety of sources, including investors. One leading indicator, the Nasdaq Americas Community Bankers Index, which tracks more than 500 community banks with a market cap of more than $182 billion, has fallen nearly 23% in the past year.