The Next Banking Crisis

Trying to call the next banking crisis is like trying to play roulette in Las Vegas or anywhere else for that matter. You know you are more than likely to lose or be wrong.

I think the next banking crisis is going to be fueled by serious problems with commercial real estate loans at banks. Commercial real estate loans are loans made to developers who build, develop, or purchase commercial real estate projects like strip malls, office buildings, hotels, and multi-family housing.

I know I should separate multi-family housing since the federal regulators treat it as a separate category. But, it’s Friday; I would rather be at the beach if the clouds weren’t obscuring the sun.
It is easier to think of them as being in the same pot since they are similar in many respects.

Why are problems loans with commercial real estate going to be the next financial crisis?

Here are my thoughts on why this will be important.

Commercial real estate loans are based on appraisals and estimates of the project’s cash flows. That makes sense in general terms since the property value represents the collateral security for the loan. Cash flows, rents usually, are important because that is the primary source of loan repayment.

When I learned how to underwrite commercial real estate loans, I was taught to make certain there was a solid cushion so that the project and the loan could survive a brief slowdown. Economic and business cycles happen. They have been happening for hundreds of years; it is not new.

We liked to lend when the borrower had real equity at risk in the loan so that the loan to value of the property was less than 80% of the loan amount.

One of the ratios, bankers tend to love ratios for some reason, we used was based on how much money was available to pay the periodic payments. The ratio is formally called Debt Service Coverage Ratio. We thought that a ratio of 1.25 was fairly safe. This means the cash flow from the property was equal to 125% of the required periodic payments.

So where did the bankers lose their prudent way in the last decade?

They believed that property values would continue to increase.

They made small commercial real estate and multi-family housing loans, loans with a loan amount of $1,000,000 or less with little or no documentation.

They made loans where the Debt Service Coverage Ratio was less than 125% at inception and would decrease further as the initial low interest rate rose to its natural level.

They made loans to people who had no experience operating a real estate based business.

They borrowed from the Federal Home Loan Banks to leverage their lending business.

They accepted appraisals that may not have been the best or strongest.

They bent over backwards to make the loans and probably accepted a bunch of loans that would not have been made in normal times.

They adopted a culture and performance attitude that rewarded those who booked the most loans; thus encouraging a culture of risk within the institution.

Oooops.

Doesn’t this sound like what happened with the sub-prime housing loan mess?

I saw this developing back in 2005 when I worked for a multi-billion dollar commercial bank with a large commercial real estate loan portfolio; more than 90% of the loans were commercial real estate. It is now subject to a FDIC cease and desist order to improve the loan portfolio and to build capital. If I were a gambler, I would bet the bank will be gone before year end.

Full and fair disclosure, I was not a commercial real estate lender. I just saw some files of existing borrowers who wanted a short term line of credit.

The signs of trouble are growing.

There was an article in the Los Angeles Times [May 30, 2009, B3] about five Southern California community banks that had received cease and desist orders from the FDIC. Most of the orders were related to lending; improve loan quality, increase capital, and bring in new management. I picked three of the banks to look at their loan portfolios.

New Resource Bank of San Francisco had 87% of its loan portfolio in commercial real estate loans. Mirae Bank of Los Angeles had 75% of its loan portfolio in commercial real estate loans. Independence Bank of Irvine, California had 96% of its loans in commercial real estate. [Source: FDIC March 2009 Call Reports].

I suspect that many of the community banks out there are in similar positions. I think the problem loans will grow as the economy works its way through recovery.

Commercial real estate loans that were made in the last four or five years ago now are fully indexed. Many borrowers took out loans with the idea of holding the property for a couple of years and then selling out for a profit. Property values have fallen so there are no buyers because the existing loan maybe more than the property is worth. Loans are difficult to obtain.

Cash flows from the properties may weaken. You can test this theory by looking at how many stores are vacant in any local strip mall. Lots of empty stores mean no rent payments which mean no money to pay the lender. Unless the borrower has excess cash elsewhere to pay the bills, the loan will go into default.

Raising rent rates is not much of an option since that is most likely to exacerbate the cash flow problem because some tenants will not be able to afford the new payments.

Troubles with commercial real estate loans affect all banks. On Wednesday, Citibank Global Markets Realty Group announced that it would hold a foreclosure auction on its $70 million junior loan it held on the St. Regis Monarch Beach resort in Dana Point, Californa. There is also $230 million worth of senior debt that would have to be paid as part of the auction for a new owner to take control of the resort property.

So, how big is the potential problem?

Large in my mind. There are just over 6,500 community banks according the FDIC’s First Quarter 2009 Quarterly Banking Profile Report. The large banks have all gone through their stress testing; community banks, for the most part, did not have any stress testing so they represent an unknown quantity.

Last week, McKinsey & Company forecasted the banking industry will have to absorb between $750 million and $1 trillion in losses from residential mortgages, commercial real estate loans, credit cards, and high yield/leveraged debt. [Source: McKinsey Quarterly, What’s Next for U. S. Banks, June 5, 2009].

The consequences of the commercial real estate problems go far beyond the loans themselves. If community banks have a problem real estate loan, that takes capital away from small business lending, one of the key elements of an economic recovery. Small businesses account for most of the jobs that are created in the economy.

No new jobs; the recovery takes longer to happen.

Coming up next, how to check on your bank’s condition from the comfort of your home.


Be well and stay happy.