Small Banks Threaten U.S. Economy

A congressional panel reports that bad commercial real estate loans are to blame.

Unless there is a strong and immediate improvement in the U.S. economy, it is likely to receive yet another sucker punch from the $1.4 trillion in commercial real estate loans coming due over the next three years. That's the conclusion of a report by the Congressional Oversight Panel (COP) released in mid-February.

Of the approximately 8,100 banks in the U.S., 2,988 are small banks, dangerously exposed to commercial real estate. With little diversification, these banks also hold high concentrations of the riskiest loans such as transition properties and construction loans in secondary or tertiary markets, the panel reported.

“A significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American,” the congressional inquiry reported.

The COP, established by Congress in 2008 to oversee expenditures of the $700 billion Troubled Asset Relief Program, is particularly concerned about the nation's small banks, which are responsible for about half of all small business loans.

That is significant because small businesses have accounted for about 45% of all job losses during the current economic downturn and about one-third of all jobs created during the last two economic expansions, according to the COP.

“The withdrawal of small business loans because of a disproportionate exposure to commercial real estate capital creates a negative feedback loop that suppresses economic recovery,” the COP report stated. “Fewer loans to small businesses hamper employment growth, which could prolong commercial real estate problems by contributing to higher vacancy rates and lower cash flows.”

Of the $1.4 trillion in commercial mortgage debt coming due, about half is underwater, meaning borrowers owe more than the properties are worth. Since 2007, owners have seen their values fall by an average of 40%, the report stated.

In late January, the COP held a field hearing in Atlanta on the issue of declining commercial real estate values and the impact on the banking industry. Property prices in the metro Atlanta office sector have fallen by 50% from their peak in 2007. Meanwhile, 30 Georgia banks have failed since August 2008.

“Many experts believe that Atlanta's experience could foreshadow a problem that could echo across the country,” said COP chairman Elizabeth Warren.

Brian Olasov, managing director with Atlanta-based law firm McKenna Long & Aldridge LLP, testified at the Atlanta hearing, which became part of the COP report. The first step to recovery, he says, “starts with the recognition of the scope and the implications of the problem.”

The federal government's decision over which banks will be allowed to fail or thrive has been controversial throughout the recession. In part, the issue has become heated because there are no easy fixes, no palatable choices.

The COP recognizes in the report that if banks are forced to take write-downs on commercial real estate loans, many more will fail, potentially causing serious harm to the nation's financial system. Conversely, until the billions of dollars of these loans are written down, no meaningful recovery can begin.

“Here in the state of Georgia, we have one out of three banks under some level of enforcement authority,” explains Olasov. “Even if you aren't under an enforcement authority, you're living under the fear of going under an enforcement action.”

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