Risky CRE Lending Deadly for Banks

The autopsy of 16 bank fatalities completed this year have identified commercial real estate lending as the primary killer in more than half (nine) of the cases, and an accomplice in one other.

In the seven cases in which CRE was not specified, the primary culprit for the bank failures was identified as lending for acquisition and construction of development projects.

When the FDIC's Deposit Insurance Fund incurs a material loss at an insured depository institution, the FDIC Inspector General is required to make a written report identifying the causes of the loss. A material loss is defined as anything more than $25 million or 2% of an institution's total assets.

In reviewing the 16 material loss reports completed this year on banks that all closed last spring and summer, it becomes clear just how much of a toll commercial real estate took on these financial institutions. The closing of those banks has resulted in losses so far for the FDIC of $2.34 billion. The 16 banks audited had total assets of $7.62 billion at the time they were shut down. They were based in states from coast to coast including: Washington, Wyoming, California, Nevada, Utah, Colorado, Texas, Illinois, Georgia and North Carolina.

Last year in total, 140 banks failed with total assets of $170 billion. While the total cost to the Deposit Insurance Fund has not been tallied, losses have been averaging about 30% of assets. That would calculate to losses for the fund of about $52 billion for last year.

"Federal Reserve examiners are reporting a sharp deterioration in the credit performance of loans in banks' portfolios and loans in commercial mortgage-backed securities (CMBS)," Jon D. Greenlee, associate director, Division of Banking Supervision and Regulation for the Federal Reserve Board, told the Congressional Oversight Panel at a Field Hearing in January. "Of the approximately $3.5 trillion of outstanding debt associated with CRE, including loans for multifamily housing developments, about $1.7 trillion was held on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion."

"Of note, more than $500 billion of CRE loans will mature each year over the next few years," Greenlee continued in his testimony. "In addition to losses caused by declining property cash flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. These losses will place continued pressure on banks' earnings, especially those of smaller regional and community banks that have high concentrations of CRE loans."

The U.S. Congress created the Congressional Oversight Panel in the fall of 2008 to review the current state of financial markets and the regulatory systems overseeing them. The panel was empowered to hold hearings, review official data, and write reports on actions taken by Treasury and financial institutions and their effect on the economy.

The Congressional Oversight Panel compiled extensive research and data on the state of commercial real estate and took comments from Greenlee and many others before issuing a 189-page report this past week entitled: Commercial Real Estate Losses and the Risk to Financial Stability.

The report is starkly downbeat in its assessment of CRE risks on the banking system.

"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," the report concluded.

Between 2010 and 2014, about $1.4 trillion in commercial real estate loans are expected to reach the end of their terms. By Congressional Oversight Panel estimates nearly $700 billion of that debt is presently 'underwater,' a situation in which the borrower owes more than the current value of the underlying property.

"It is difficult to predict either the number of foreclosures to come or who will be most immediately affected," the report concluded. "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."

The problems facing commercial real estate have no single cause, according to the Congressional Oversight Panel. The loans they identified as 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. The panel also noted that many loans 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 factors that increased 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.

The FDIC material loss reports also made it clear that most of the failed banks were either too aggressive in growing their commercial real estate lending portfolios and/or too ill prepared to manage the consequences. Specifically the FDIC auditors questioned the banks' loan underwriting standards on chasing deals either out of their territories or not consistent with their business plans. Those actions, in turn, prompted banks to pursue risky transitory and costly deposits to fund their growth.

The following is a summary of the reports examining the 16 banking failures.

• New Frontier Bank, Greeley, CO; $1.8 bil. in assets New Frontier failed because its board and management did not implement adequate risk management practices pertaining to rapid growth and significant concentrations of residential acquisition, development and construction (ADC) and agricultural loans.
  
  
• First Bank of Beverly Hills, Calabasas, CA; $1.3 bil. in assets First Bank failed because its board and management did not adequately manage the risks associated with the institution's heavy concentrations in commercial real estate (CRE) and ADC loans and investments in mortgage backed securities (MBS).
  
  
• Cooperative Bank, Wilmington, NC; $973.6 mil. in assets Cooperative Bank failed because its board and management did not adequately manage the risk associated with the institution's aggressive real estate lending, particularly in the area of residential.
  
  
• Strategic Capital Bank, Champaign, IL; $537.1 mil. in assets Strategic Capital's failure can be attributed to the board and management's speculative and ill-timed growth strategy involving high-risk assets and volatile funding. Strategic Capital's rapid growth strategy was in contravention to long-standing supervisory guidance related to CRE concentrations and securities.
  
  
• Cape Fear Bank, Wilmington, NC; $466.8 mil. in assets Cape Fear failed because its board and management did not implement effective risk management practices pertaining to rapid growth and significant concentrations of CRE and ADC loans.
  
  
• Mirae Bank, Los Angeles, CA; $410 mil. in assets Mirae failed because its board and management pursued an aggressive growth strategy centered in CRE lending and failed to ensure sound loan underwriting practices.
  
  
• Southern Community Bank, Fayetteville, GA; $380.6 mil. in assets Southern Community failed because of a rapid deterioration in asset quality that led to loan and operational losses that quickly eroded the bank's capital. The majority of Southern Community's lending was in CRE, with a particular focus on ADC loans.
  
  
• Westsound Bank, Bremerton, WA; $324.1 mil. in assets Westsound failed because its board and management did not implement risk management practices commensurate with rapid asset growth and a loan portfolio with significant concentrations in higher-risk ADC loans.
  
  
• America West Bank, Layton, UT; $310 mil. in assets America West Bank failed because the bank's board and management deviated from the bank's business plan and did not effectively manage the risks associated with rapid growth in CRE and ADC lending.
  
  
• FirstCity Bank, Stockbridge, GA; $291.3 mil. in assets FirstCity failed because its board and management pursued a strategy of aggressive growth centered in ADC lending.
  
  
• Great Basin Bank, Elko, NV; $228.8 mil. in assets Great Basin failed because its board did not ensure that bank management identified, measured, monitored, and controlled the risk associated with the institution's lending activities. The institution's loan portfolio included, but was not limited to, out-of-territory purchased participation loans from areas that experienced a significant economic downturn starting in 2007, and a concentration in CRE loans.
  
  
• Bank of Lincolnwood, Lincolnwood, IL; $217.4 mil. in assets Lincolnwood failed because the bank's board and management did not implement adequate risk management practices pertaining to a significant concentration in ADC loans.
  
  
• Millennium State Bank, Dallas, TX; $121.4 mil. in assets MSB's failure can be attributed to inadequate management and board oversight, an aggressive growth strategy centered in CRE lending, weak loan underwriting and credit administration, poor earnings, and an inadequate funding strategy.
  
  
• American Southern Bank, Kennesaw, GA; $113.4 mil. in assets American Southern failed because its board and management materially deviated from its business plan by pursuing a strategy of growth centered in ADC lending.
  
  
• MetroPacific Bank, Irvine, CA; $75.2 mil. in assets MetroPacific, a de novo bank, failed primarily because it lacked stable and consistent management and oversight as a result of significant turnover in key management positions. The bank's board and management were particularly ineffective in implementing risk management practices pertaining to adherence to the bank's business plan and rapid growth and concentrations in CRE and ADC loans.
  
  
• Bank of Wyoming, Thermopolis, WY; $72.8 mil. in assets The Bank of Wyoming's failure can be attributed to the board and management's pursuit of loan growth funded significantly with brokered and other non-core deposits. The bank's loan portfolio was concentrated in CRE and ADC loans made to out-of-area borrowers, obtained through loan brokers and participations purchased.