Construction Loans At Small Banks Concern Regulators

According to the Wall Street Journal Property Report, regulators have grown concerned over the $280 billion in outstanding construction loans to condo developers and home builders sitting on small banks' balance sheets.  Of particular concern is the practice of putting interest that will be paid into an "interest reserve" and then paying themselves out of the reserve until the loan becomes due or the property generates cash flow, thus masking potential problems with the loans until they blow up.  The FDIC is on alert for banks that are not coming clean about problem loans.  A potential hint that a bank has been using interest reserves to hide delinquencies is a large jump in the percent of nonaccruing loans from one quarter to the next without any prior buildup in the percent of delinquent loans.  The banks draw from the interest reserve until the reserve runs out and then they must reclassify the loan as nonacrruing, without ever noting that it was delinquent.  For example, ANB Financial, the failed Bentonville, Ark bank had 2.8% of loans delinquent in the fourth quarter of 2007 followed by 39.6% of nonaccruing loans in the first quarter of 2008.  The ironically titled Integrity Bank had 13.5% delinquent loans in the fourth quarter of 2007 followed by 35.1% nonaccruing loans in the first quarter of 2008.  Integrity Bank has stopped using interest reserves on loans used only for purchasing land without immediate plans for construction and loans on projects that have been delayed or abandoned.  Well, that's a relief.

It is very interesting that banking practices that have more than likely been business as usual for years can be used to mask potential problems during a major downturn.  I'm certainly not a bank accounting expert but I can see how using interest reserves was viewed as a perfectly reasonable practice when delinquency rates and default rates were low.  Unfortunately, when lax lending standards finally caught up with the industry, it became yet another loophole that banks could utilize to delay reporting the inevitable.  It is practices like these that have investors terrified and lead to suspicion about what other surprises are lurking on bank balance sheets.