Feds Ready To Start Pushing Banks Toward CRE Loan Workouts

Here is a great article on Fed and Bank workouts.

With regulators shutting down seven more troubled banks on Friday, the government is getting ready to issue new workout guidelines that will push banks to restructure troubled commercial construction and mortgage loans to head off massive foreclosures that some economists believe could threaten the fragile economic recovery.

Although most of the big banks are reporting solid profits so far, early third-quarter bank earnings reports reflect hits to the bottom lines of banks weighed down by bad commercial real estate debt, especially regional and community banks. The Federal Deposit Insurance Corp. (FDIC) on Oct. 16 closed the 99th bank of the year, San Joaquin Bank in Bakersfield, CA. With the closures of Partners Bank and Hillcrest Bank Florida, both of Naples, FL; American United Bank of Lawrenceville, GA, Flagship National Bank of Bradenton, FL, Riverview Community Bank of Otsego, MN, Bank of Elmwood, WI, and Dupage Bank of Westmont, IL, on Friday, the number of banks and thrifts that have failed since Jan. 1, 2008, now stands at 132 total and shot past the century mark to 106 this year alone.

The 106 failures of 2009 are the most in a single year since 1992. Though nowhere near the scale yet of the huge bank collapses of the late 1980s and early '90s - 534 banks closed in 1989 alone - many analysts believe the current wave of failures is just now getting ready to break. The FDIC has flagged 416 banks and thrifts with combined assets totaling almost $300 billion as at-risk, adding more than 100 to the problem list in the second quarter.

One of the biggest current sources of that risk is losses on deteriorating commercial real estate mortgage, with small- and medium-sized banks particularly overweight in CRE loans, FDIC Chairman Sheila Bair and other federal regulators said in testimony last week before the U.S. Senate Banking, Housing and Urban Affairs Committee.

Bair, Comptroller of the Currency John Dugan and Office of Thrift Supervision deputy director of examinations, supervision and consumer protection Timothy Ward testified they are close to finalizing new guidelines for banks on how to modify troubled commercial real-estate loans to reduce defaults and foreclosures, and how to account for losses from those loans. Some analysts say the "extend and pretend" practices of lenders who extend loan maturities because they're unwilling to seize properties from borrowers and take the losses are prolonging the slump in transaction activity and delaying the process of price discovery.

"The agencies recognize that lenders and borrowers face challenging credit conditions due to the economic downturn, and are frequently dealing with diminished cash flows and depreciating collateral values," Bair said. "Prudent loan workouts are often in the best interest of financial institutions and borrowers, particularly during difficult economic circumstances and constrained credit availability."

Community banks held 38% of the banking industry's small business and small farm loans as of June 30, but "the greatest exposures faced by community banks may relate to construction loans and other commercial real estate loans," Bair said. "These loans made up over 43% of community bank portfolios, and the average ratio of CRE loans to total capital was above 280%."

Up to now, troubled loans at FDIC-insured institutions have been concentrated in three main areas -- residential mortgages, construction loans and credit cards. Net charge-offs for construction loans over the past two years have totaled about $32 billion, with almost 40% for single-family residential construction, Bair said.


But the biggest area of risk for rising bank losses during the next several quarters is commercial property lending. While commercial mortgage-backed securities (CMBS) and other debt vehicles had emerged as significant funding sources in recent years for commercial property, "banks still hold the largest share of commercial mortgage debt outstanding, and their exposure to CRE loans stands at an historic high," the FDIC chief said.

As of June, such debt backed by nonfarm, nonresidential properties totaled almost $1.1 trillion, or 14.2% of all loans and leases, the chairman said.

KeyCorp, a Cleveland-based regional bank with 993 branches in 14 states, this week reported a third-quarter loss of $397 million after setting aside $733 million in reserve for current and future loan losses.

KeyCorp took $587 million in net charge-offs in the quarter, up from $502 million in the previous three months. CFO Jeffrey B. Weeden attributed the increase largely to continued weakness and nonperforming loans in the bank's commercial real estate construction portfolio.

The deep recession, job losses and ongoing credit market disruptions has made this a particularly challenging environment for commercial real estate, reducing demand for space and eroding rents and vacancy rates. Investors have been forced to re-evaluate their required rate of return, causing capitalization rates to rise and property values to decline.

With the CMBS market still shut down, financing is harder to obtain and large volumes of CRE loans are scheduled to roll over in coming quarters, with falling property prices making it more difficult for some borrowers to refinance.

Construction loans have been suffering for a while, but loan losses on CRE properties have been modest so far, with net charge-offs on loans backed by nonfarm, nonresidential properties just $6.2 billion over the past two years, Bair said. However, delinquent loan volume has quadrupled over the same period, and the FDIC expects it to rise further as more commercial loans come due over the next few years.

Few details were forthcoming about the new loan modification guidelines and how they might affect the commercial real estate positions of lenders.

"We don't really have a lot of information at this point," said Charles S. Hyle, executive vice president and chief risk officer for KeyCorp, responding to a question during the company's earnings call Wednesday. "Certainly there have been public statements by the regulators that they are very focused on commercial real estate, but in terms of what impact, how they might change what they're doing, is still very much an open question."

U.S. Federal Reserve Board Governor Daniel Tarullo said in his testimony that the new guidelines will support "balanced and prudent decision making with respect to loan restructuring, accurate and timely recognition of losses and appropriate loan classification."

The guidance will reiterate that loans should not be classified based solely on declines in the value of collateral, Tarullo said.

"The expectation is that banks should restructure CRE loans in a prudent manner, recognizing the associated credit risk, and not simply renew a loan in an effort to delay loss recognition," Tarullo said.

On one hand, banks have raised concerns that Fed examiners don't always take a balanced approach in assessing CRE loan restructurings, he said.

"On the other hand, our examiners have observed incidents where banks have been slow to acknowledge declines in CRE project cash flows and collateral values in their assessment of the potential loan repayment," Tarullo said. "This new guidance, which should be finalized shortly, is intended to promote prudent CRE loan workouts as banks work with their creditworthy borrowers and to ensure a balanced and consistent supervisory review of banking organizations."

-Costar News October 23, 2009