What will 2010 hold for the banking industry?

Reports in various publications are conflicting as to the health of the real estate industry and its impact on the general economic recovery. An article in the LA Times says that “Commercial real estate will not cause another recession,” while a piece from Business Week states that, “Commercial real estate poses risk to U.S. recovery.” Who do we believe?

The facts are that bank loans dropped by 2.75% or $210 Billion during the third quarter of 2009. On an annualized basis this amounts to 11%. Real Capital Analytics (http://www.rcanalytics.com/) reported only $ 42 Billion in U.S. commercial-real estate transactions through November 2009, down from $136 Billion for the same time frame last year and $489 Billion in 2007. The chart below illustrates the decline in the national averages of sales price per square foot for the major commercial property types.

(Source: http://www.mbaa.org/NewsandMedia/MBANewsLink)

Bankers Reluctant to Refinance

The Federal Reserve’s most recent survey data of senior loan officers from October showed that banks are continuing to tighten standards on commercial real estate loans and appear reluctant to refinance maturing loans for construction and land development. Refinancing loans that are dependent on the rental income of the collateral property is also undesirable because of:

•  the decline in rental rates;
• a rise in vacancy rates;
• and higher capitalization rates,

...all factors which lower the value of the collateral property.

Adversely Classified Assets

It is highly probable that many of these assets have been adversely classified by the bank’s federal or state regulators. A review of recently issued and publicized cease and desist orders by the FDIC reveals that many if not all of these formal actions have provisions titled “Adversely Classified Assets”. These sections require bankers to reduce the bank’s risk exposure in each asset, or relationship, within a certain timeframe. 

• An FDIC cease and desist order consented to by the Bank of Ellijay in Ellijay, Georgia gave the bank 30 days to reduce loans in excess of $1Million which were classified Substandard or Doubtful in the Examination Report.

Reducing Risk Exposure
Reduce is often specifically defined as collecting, charging off, or improving the quality of the asset to warrant the removal of the classification.

A charge off of the loan balance negatively impacts the bank’s Allowance for Loan and Lease Losses and ultimately the capital base. No wonder why bankers are hesitant to offer refinancing.

Improving the quality of the asset is obviously the best option. Such efforts include the bank taking additional collateral, which often times comes in the form of a lien on the principal(s) residence. However, due to the decline in residential property values, this option can also be limited; and obtaining a substantial personal guarantee(s), is also difficult because many developers and investors never intend to repay a bank loan personally.

Outlook for 2010
Estimates vary, but range from an expected $1.3 - $1.4 billion of commercial mortgages that will mature by 2013 with approximately 65% of these credits failing to qualify for refinancing. All this still spells trouble for the banking industry. The FDIC’s troubled bank list totaled 552 as of September 30, 2009, but has surely climbed since that date. Look for large numbers of failures through the first two quarters of this year with a slow down towards the end of the third quarter.