Fed Worries About Commercial Real Estate

Ok, so maybe it's a bit too late to start worrying about the impending commercial real estate crisis, since it's already begun. But at least one of our regulators has finally woken up and smelled the rot lying on our nation's banks' balance sheets. The WSJ reports that the Federal Reserve made a presentation to banking regulators last month that claimed that banks in the US "are slow" to take losses on their commercial real-estate loans that are being battered by slumping property values and rents (please see prior two posts.) The Fed document was prepared by an Atlanta Fed real-estate expert who is part of the central bank's Rapid Response program to spread information about emerging problem areas to federal and state banking regulators. While this is hardly a rapid response to a problem that reared its ugly head over a year ago, I'll give the boys at the Atlanta Fed bonus points for being ahead of the bank regulators, who allow reckless lending at a financial institution right up until the day the FDIC locks the front doors.

Banks with heavy exposure to commercial real estate loans set aside just 38 cents in reserves for every $1 in bad loans, according to an analysis by the WSJ. This is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007. The WSJ's analysis included more than 800 banks that reported having more than half of their loans tied up in commercial real estate. To make a precarious situation even worse, many US banks have adopted a policy of extending loans when they come due even if they wouldn't make these loans now. It beats the heck out of going through the hassle of seizing the property, attempting to dump it on a market that has little appetite for commercial real estate, and taking a loss because the value of the property is below the loan amount. Best to keep your head firmly buried in the sand, and continue rolling that loan until everything returns back to "normal circa 2007." Another really ingenious tactic used by banks is the practice of using interest reserves to mask bad construction loans. When the loans are made, banks typically calculate interest that would be paid and set that money aside, paying themselves until the loan becomes due or the property generates cash flow. What happens when the developer is stuck with a half-empty building because he couldn't sell or lease the units and he can't get another loan at the same terms? That's when the bank finally takes the hit, even though all the clues were there to begin with.

How big is this problem? $3.4 trillion dollars of commercial real estate debt is outstanding, with more than half held by banks. Obviously not all of it is going to go bad, but much of the issuance from the past five years might unless a solution is found to the refinancing problem. With commercial real estate values already down over 30% and headed for steeper losses, nearly every property financed in the past few years is under water. Most commercial real estate loans are short-term in nature and investors just assumed they could refinance when the loans came due. Are they really going to cough up extra equity to hang on to buildings that they overpaid for? Or are they just going to hand the keys to the bank? Seems like banks need to beef up their property management arms because they are going to wind up owning alot of buildings. But don't worry, the Fed's Rapid Response Team is on it.