Community and mid-size banks, which comprise the bulk of all commercial real estate lenders 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.”

Then, in mid-April, U.S. Comptroller of the Currency John Dugan re-raised the alarm, saying banks that had distressed commercial real estate loan portfolios have been too slow to identify and take action against the problem loans.

“Right now, too many community bankers are having too hard a time coming to grips with the problems that have emerged in their commercial real estate portfolios,” Dugan, whose office regulates national or big banks, said in a speech to a financial group, according to a Reuters report.

Why all the fuss? Some 96 percent 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 percent 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., based 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 the subprime debacle, to date receiving default notices on $3.15 billion of residential mortgages. The directive mirrors an increasingly aggressive policy imposed by federal regulators to see banks mark down the value of their assets and raise new capital.

And then there's Chicago-based Corus Bankshares Inc. The bank, with $9 billion in assets has a whopping 83 percent of its portfolio that consists of construction and development loans — with most of those going to condo builders in cities such as Miami, Las Vegas and Atlanta. All of those markets have been hard hit by overbuilding, putting Corus in a precarious position. As of late March, the bank still had a sizable cash cushion — some $300 million according to the Wall Street Journal — that will enable it to muddle through.

Another bank feeling the heat is Wells Fargo. In mid-April, the bank reported net loan charge-offs of $268 million for its commercial real estate portfolio in the first quarter. That's a drop in the bucket compared to the hundreds of billions in subprime writedowns piled up at Wall Street firms. But the number was alarming because it represented a fourfold jump for Wells Fargo from the previous quarter. In the fourth quarter of 2007, it posted $66 million in commercial real estate loan charge-offs.

For his part, Dugan said in mid-April that his office has urged banks with distressed commercial real estate loans to identify borrowers who may be able to repay loans and develop a workout strategy with them, according to Reuters.

Bad timing

Sam Chandan, director of research for New York-based Reis Inc., 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. Still, the Federal Reserve reports that delinquencies on commercial mortgages held by commercial banks ended 2007 at 1.94 percent, near their historic low.

Construction loans are of particular concern because of how they are structured. Typically, they include interest reserves that enable developers to pay less interest on a loan for up to four years. When a project has been completed, a borrower is supposed to pay the balance of the loan in part from income generated by the completed product. Today, however, projects — especially condos — are less likely to open fully occupied, making it more difficult for borrowers to pay down consruction loans. Further, with the credit crunch crippling banks, refinancing into a permanent loan is also difficult.

Even the Democratic presidential candidates have weighed in on increased banking regulation. Recently, Illinois senator Barack Obama 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 New York senator Hillary Clinton.

But long before the two presidential hopefuls brought the issue to the public eye, Retail Traffic's sister publication, NREI, put the issue front and center in a February 2007 cover story entitled, “Small Banks, Big Risks.” Now, more than a year later, federal officials are finally acting, or at least making sweeping proposals in the most radical overhaul of the nation's financial system since the Great Depression.

On March 31, Treasury Secretary Henry Paulson formally announced the Bush administration's plan in the wake of the subprime residential mortgage 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 would like 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 as a top priority early in 2009.

Many banks have already started getting the message. According to the FDIC, real estate construction and development loans increased by only 2 percent, 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 seizing on a niche opportunity in the marketplace. City National Bank in Palo Alto, Calif., announced it is forming a new commercial real estate lending team to support the middle-market real estate development community in Silicon Valley. As team lead Robert Sherrard puts it, “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.”

Right now, that niche is under fire from around the country, including investors. One leading indicator, the Nasdaq Americas Community Bankers Index, which tracks more than 500 community banks with a market capitalization of more than $182 billion, has fallen nearly 23 percent in the past year.

OVEREXPOSED TO CONSTRUCTION LOANS?

The number of financial institutions with growing exposure to commercial construction loan liabilities has increased 17% in the past two years, leading regulators to issue warnings.

Q4 2007 Q3 2007 Q4 2006 Change (Q4 07-Q4 06)
Construction & Development Loans 628,918 616,447 565,282 11.3%
Loans & Leases 30-89 days past due 110,937 92,233 71,507 55.1
Reserve for Losses 101,715 86,948 77,533 31.2
Source: Federal Deposit Insurance Corp.