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Why Most Bankers Aren't Lending

With real estate fundamentals and valuations falling, it's best to wait until the storm passes.

The U.S. Treasury and the Federal Reserve have dramatically tried to stimulate bankers to start lending on U.S. commercial real estate. Yet most bankers have been reluctant to do so, even though many real property owners desperately need financial aid. This column explores why many bankers seem unwilling to perform what is a crucial service to restarting the U.S. economy.

The first cause is that bank balance sheets are already overloaded with all types of real estate loans. Real estate lending, including housing, represented around 40% of all U.S. lending from 1996 through 2001. As a result of the stock market crash of 2000, that share shot upward as many investors moved from stocks into real estate.

The total share of property-based loans held by banks jumped from 39.3% in 2001 to 56.3% in 2002, according to the FDIC. That share steadily rose to a peak of 62.8% in 2006. After home prices began to decline, that figure leveled off at 60% in both 2008 and 2009.

Braving the elements

One reason that bankers consider real estate lending unattractive is that the market values of most real properties — residential and commercial — have fallen so dramatically since September 2008. Many bankers hold loans on properties worth much more when they were originated than they are today.

Since relationship lending is now in vogue again, many bankers are willing to make real estate loans to longtime customers who remain financially stable. New customers will have a tougher time securing financing.

Bankers are also leery because commercial property loans have hit near-record delinquency rates as rising unemployment drives vacancies up and retail sales down.

With home foreclosures rising toward almost four million in 2009 and interest rates being held low by federal subsidies, bankers think it is only prudent to reduce their real estate exposure.

Banks also hold complex collateralized debt obligations (CDOs) and other toxic assets that have greatly shrunk in value. Bankers hope such holdings will recover as the economy improves. But there are almost no current markets for those holdings. If bankers sell those assets now, they will take large capital write-offs and may become insolvent.

To prevent that outcome, the government is allowing banks not to mark such holdings to current market values, if there is any hope of future value recovery. But postponing sales means banks have less cash to make loans right now.

Yet another reason that many bankers are unwilling to lend against commercial properties today is that they think big problems — and resulting opportunities — still lie ahead.

As noted in several previous columns, billions of dollars of commercial property loans made from 2000 to 2006 were based on higher market values than now prevail, and larger loan-to-value ratios than bankers are willing to support now. When those loans come due, borrowers will be unable to cover the much larger equity requirements.

This scenario will create opportunities for bankers to foreclose and gain ownership at a low cost, provide added financing in return for a big ownership share, or extend loans at higher interest rates. In short, why should they make loans on questionable properties now when they see more profitable opportunities arising from 2010 through 2013?

Conflicting obligations

Bankers, like all businesses in a capitalistic society, have social functions different from their personal motives. Bankers' primary social function is to store capital provided by savers and transfer it to investors who can make good use of it. The main driver is profits for themselves and their stockholders.

Under present economic conditions, that motivation conflicts with fulfilling their social function concerning commercial properties. The government has poured taxpayer money into banks to help them carry out a social function.

Those funds have prevented the banking system from collapsing, but have not yet returned bank lending to normalcy, at least in the case of commercial real estate. When that will happen remains to be seen.

Tony Downs is a senior fellow at the Brookings Institution. He can be reached at [email protected]

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