Fed Worries About CRE

From the WSJ:

Banks in the U.S. "are slow" to take losses on their commercial real-estate loans being battered by slumping property values and rental payments, according to a Federal Reserve presentation to banking regulators last month.

The remarks suggest that banking regulators are girding for a rerun of the housing-related losses now slamming thousands of banks that failed to set aside enough capital during the boom to cushion themselves when the bubble burst. "Banks will be slow to recognize the severity of the loss -- just as they were in residential," according to the Fed presentation.

"More pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposures," New York Fed President Bill Dudley said in a speech Monday.

In another sign that many U.S. financial institutions are inadequately protected against potential losses on commercial real-estate loans, banks with heavy exposure to such loans set aside just 38 cents in reserves during the second quarter for every $1 in bad loans. That is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007.

Loan-loss reserves typically rise and fall during any credit cycle, being drawn down as losses mount. Some analysts and investors say the recession combined with inadequate loan-loss provisions when times were good have left banks dangerously vulnerable to the deteriorating commercial real-estate market.

The Fed presentation painted a bleak picture of the sliding real-estate values and enormous debt that will need to be refinanced in the next few years. Vacancy rates in the apartment, retail and warehouse sectors already have exceeded those seen during the real-estate collapse of the early 1990s. The report also predicted that commercial real-estate losses would reach roughly 45% next year. Valuing real estate has always been tricky for banks, and the problem is particularly acute now because sales activity is practically nonexistent.

These days, many U.S. banks have adopted a policy of extending loans when they come due even if they wouldn't make those loans now. In some cases, values of the underlying property have fallen below the amount of the loan.

Last month's Fed presentation supports criticisms that banks have been slow to take losses on bad commercial real-estate loans. The value of commercial real-estate loans as recorded by banks has declined at a much slower rate than property values since 2005. But banks have been slow to absorb losses on their loans partly due to "capital preservation" concerns, the report states.

Bank examiners are stepping up their scrutiny of commercial real-estate portfolios at U.S. banks. Michael Stevens, senior vice president of regulatory affairs at the Conference of State Bank Supervisors, said regulators are reviewing greater volumes of commercial real-estate loans than they did before the financial crisis erupted.

Commercial real-estate loans are the second-largest loan type after home mortgages. More than half of the $3.4 trillion in outstanding commercial real-estate debt is held by banks.

The Fed presentation states that the most "toxic" loans on bank books are so-called interest-only loans, which require borrowers to repay interest but no principal. Those loans "get no benefit from amortization," the report states.

"Today, most of the borrowers are paying because interest rates are so low, but the question is whether the loans will get paid off when they come due."

Regulators are zeroing in on banks that use interest reserves to mask bad construction loans. When such loans are made, banks typically calculate interest that would be paid and set that money aside, basically paying themselves until the loan becomes due or the property generates cash flow.

Regulators want to make sure banks don't have a false sense of security only because the interest reserve is paying the loan. Banks need to look at "the sources of repayment" to determine whether the loan will get repaid, says Darryle Rude, supervisor of industrial banks at the Utah Department of Financial Institutions.