Scores of Smaller Banks Projected to Collapse

More than 150 small and medium-sized U.S. banks are currently failing and expected to close by the fourth quarter as bad commercial real estate loans threaten their viability, according to an analysis by the Oakland, Calif.-based research firm Foresight Analytics.

The rate of projected bank closures this year is running six times higher than the 25 failures that occurred in 2008. The volatile lending climate marks a stark contrast from 2007 when only three banks closed.

While nonperforming residential loans are a major contributing factor to the insolvencies, the delinquency rate for commercial loans has trended disturbingly upward, says Matt Anderson, partner at Foresight Analytics, which specializes in real estate market analysis. “We’re expecting that commercial real estate will play a larger role in bank distress moving forward.”

The revelations about the extent of commercial real estate’s role in bank distress come on the eve of the scheduled release on Thursday of a highly anticipated report by the Federal Reserve on the health of the nation’s 19 largest banks.

The Fed has been conducting “stress tests” of the institutions, the smallest of which, KeyCorp, has $105 billion in total assets. Thursday’s report is expected to show that more than half of the big banks need an infusion of capital to safeguard their solvency and ability to lend, in case the economy suffers more shocks over the next two years.

According to published reports, one of the largest banks, Wells Fargo & Co., has been ordered to bolster its reserves to withstand the possibility of further tumbling home prices and an unemployment rate of 10.3%, and Bank of America reportedly needs to beef up its equity by $34 billion, which it is expected to accomplish by converting investments into common stock.

But a careful look at smaller banks, which were not included in the Fed’s study, shows that they bear a growing burden of troubled loans. In all, the nation’s 8,390 banks have $13.9 trillion in assets, and $1.9 trillion in commercial real estate loans.

However, most of the banks, 7,635, are relatively small, with assets of less than $1 billion. More than a third of these smaller banks, 2,562, have disproportionately high concentrations of commercial real estate loans, amounting to at least three times their core capital.

“Our current outlook is that this downturn for commercial real estate will be worse than in the early 1990s,” says Anderson. “It’s about to be proven true again that if you’ve got a big concentration in any kind of lending, one lesson to be learned is that’s a potential problem.”

In the first quarter alone, banks with assets up to $10 billion collectively held $560 billion in outstanding construction loans, with about $280 billion of that total in commercial real estate loans, says Anderson. “With the construction boom that occurred over the last several years, a lot of banks loaded up on construction lending, which in good times was a great source of income but now is a risky place to be.”

Commercial construction loan delinquencies shot up from 6.6% in the fourth quarter to 8.9% in the first quarter of 2009, Anderson says, while apartment construction delinquencies rose from 4.8% to 6.6%. Those rates were far lower than the 22% delinquency rate for single-family construction loans, and 32% for condos in the first quarter.

However, the size of a commercial loan can be many times greater than a residential loan. That means delinquency, defined as nonpayment for 30 days, can have a far more damaging impact on an institution.

Regulators are concerned about smaller banks’ shift over the past two years toward a high concentration of commercial loans in their portfolios as they cut back on residential lending following the home mortgage meltdown. “The concentration issue is a big one,” Anderson says. “I think the regulators are right to be worried.”

About one-third of banks with less than $1 billion in assets have high concentrations of commercial real estate loans, and more than half of the 560 banks on the next rung, with $1 billion to $10 billion in assets, or 350 banks, have a high share of commercial loans, says Anderson.

Foresight Analytics’ watch list of troubled banks, which parallels the Federal Deposit Insurance Corp. (FDIC)’s roll of problem banks, shows approximately 375 banks in the first quarter that were considered undercapitalized or at risk, an increase from 276 in the fourth quarter.

The FDIC, an independent agency created by Congress to maintain stability in the nation’s financial system by insuring deposits and supervising financial institutions, reported that there were 251 problem banks in the fourth quarter. Anderson projects that the number will rise to 350 when the agency’s report is released later this spring.

“Georgia is number one on our list,” says Anderson. The Southern state has 54 of the 328 troubled banks on Foresight’s first quarter watch tally so far, a reflection of the amount of overbuilding underwritten in far suburbs and counties outlying Atlanta. Florida is second on the company’s watch list, with 42 at-risk banks.

When regulators examine a troubled bank, as in the case of the big 19 that underwent stress tests, if equity capital is too low relative to the bank’s size, regulators can order the bank to raise capital and get the institution back to a healthy capital ratio. However, in today’s environment, lenders may find that difficult, and if small banks can’t raise the needed capital, regulators may shut them down.

“We focus a lot of attention on these very large banks that we know the Fed and The Treasury have made a commitment to keeping in business because disruption at that level would destabilize the system,” says Sam Chandan, economist and president of New York-based research firm Real Estate Economics LLC. Unlike the big banks however, smaller community banks are not being propped up by the government, Chandan says. “They would be allowed to fail en masse.”

Most small community banks’ exposure to commercial real estate is even greater than that of large regional banks, Chandan says. “Large regionals are better diversified, so they’re lending in all sorts of areas. They’re not just lending in commercial real estate.” But the lack of diversification among smaller banks poses a threat to them, he says. “You could see a larger number of these banks failing, even though individually any one of them is very small.”

The large maturities coming due later in 2009 and 2010 is part of the banks’ problem. Because credit markets are so constrained, a larger number of delinquencies and defaults could occur because of the difficulty of accessing financing.

“Our expectation is that the default rates [will be] rising significantly over the course of the third and fourth quarters and in 2010,” Chandan says. In February, banks engaged in $11 billion worth of refinancing, but over the course of 2009, the economist projects $264 billion in maturities coming due. The question is whether banks have the capacity to meet that level of demand for refinancing.

Banks have been steadily taking steps to improve their health and lending practices. Earlier this week, the Fed reported that approximately two-thirds of domestic banks tightened their lending standards on commercial real estate loans over the previous three months.

According to the Fed, about 35% of foreign branches and agencies also reported tightening their lending standards on commercial real estate loans over the survey period.

A quarterly survey of senior loan officers released in April also revealed a shrinking market for commercial real estate loans. Some 65% of domestic banks reported weaker demand for the loans, the highest percentage since the survey began tracking loan demand in 1995.

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