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Banks Under-reserving for Commercial Real Estate Losses

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There has been a peculiar disconnect between the “the crisis is over, on with the recovery” drumbeat of news, and the sobering reality that a good deal of credit bubble overhang still remains to be dealt with.

One of the biggest areas is commercial real estate. Various experts, including Apollo Management’s Leon Black warned of $2 trillion in losses in the offing in the commercial real estate arena. Yet those losses seem not to have hit bank balance sheets and earnings.

The reason is simple. The Wall Street Journal tells us that banks have been dragging their feet on reserving for the losses:

Banks in the U.S. “are slow” to take losses on their commercial real-estate loans being battered by slumping property values and rental payments, according to a Federal Reserve presentation to banking regulators last month….

…banks with heavy exposure to such loans set aside just 38 cents in reserves during the second quarter for every $1 in bad loans, according to an analysis of regulatory filings by The Wall Street Journal. That is a sharp decline from $1.58 in reserves for every $1 in bad loans from the beginning of 2007.

The Journal’s analysis includes more than 800 banks that reported having more half of their loans tied up in commercial real-estate, ranging from apartments to office buildings to warehouses…

Mr. [K.C.] Conway’s presentation painted a bleak picture of the sliding real-estate values and enormous debt that will need to be refinanced in the next few years. Vacancy rates in the apartment, retail and warehouse sectors already have exceeded those seen during the real-estate collapse of the early 1990s, Mr. Conway noted. His report also predicted that commercial real-estate losses would reach roughly 45% next year. Valuing real estate has always been tricky for banks, and the problem is particularly acute now because sales activity is practically nonexistent….

Last month’s Fed presentation supports criticisms that banks have been slow to take losses on bad commercial real-estate loans. The value of commercial real-estate loans as recorded by banks has declined at a much slower rate than property values since 2005. But banks have been slow to absorb losses on their loans partly due to “capital preservation” concerns, the report states…

Commercial real-estate loans are the second-largest loan type after home mortgages. More than half of the $3.4 trillion in outstanding commercial real-estate debt is held by banks.

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15 comments

  1. Skippy

    Go HFT and accounting gimmicks, tax the real economy (whats left) and citizens on the sly till they can afford reality.

    Skippy…the Guys and Gals over in Afghanistan wish they could too.

  2. Mary

    “What are the implications? Consider the $1-$1.5 trillion in commercial mortgages being held as whole loans at commercial and savings banks in the U.S.** Because whole loans are “held to maturity,” they are typically carried at full value until the borrower actually defaults. Never mind that the underlying collateral is now worth far less than the mortgage.

    But banks aren’t forced to take writedowns until an event of default. To avoid that they can play all sorts of games to make things easier for the borrower. According to Alpert: Banks and other lenders with loans collateralized by income-producing properties have been offering borrowers nearly any forbearance imaginable: loan extensions, interest rate reductions, delayed principal payments, wavers of covenants and guarantees, and in some instances additonal funding—anything and everything to avoid taking a current loss, as long as there is some cash flow or reserve balance to draw on so as to maintain that the loan is performing against its (often heavily modified) terms.

    The bottom line is that banks still have hundreds of billions of losses buried on their balance sheets. Commercial real estate prices aren’t coming back, which means these loans will have to be marked down eventually. The longer banks wait, the more painful the write downs will be.

    Bank shareholders should take note. Assuming the government isn’t going to absorb all these losses, their equity may eventually be wiped out.

    Rolfe Winkler
    The CRE disaster
    http://blogs.reuters.com/rolfe-winkler/2009/07/23/the-cre-disaster-comparing-with-residential/

    1. DownSouth

      Mary,

      Rolfe Winkler says “Bank shareholders should take note”.

      Why?

      I think eh gets it right (see comment below). Bank shareholders can all but rest assured that, under the current political scenario (known as “Change We Can Believe In”), banks will be bailed out by the federal government. Is it not this sentiment that is really driving bank share prices?

      And as SidFinster (also see comment below) suggests, anyone who dares suggest that the bailouts should cease is going to be branded a “communist.”

      Actually, as we saw in Pittsburgh at the G20, the new catchall pejorative is “anarchist.” Anyone who had the impudence to suggest that the bailouts should stop was branded an “anarchist” and their message brutally suppressed by the new American fascist regime. Here’s an excellent and hilarious video that conveys the sentiments of the students concerning how our new America works:
      http://www.youtube.com/watch?v=dm1kSMSDJBw

      And if you’re wondering what an “anarchist” is, a student made up this list and posted it on a campus discussion forum:

      an ANARCHIST is, but is not limited to, anybody who:
      1. Rides, or is in possession, of a bike.
      2. Talks through a megaphone. Offenses include telling people to be peaceful, not resist, and follow orders.
      3. Tries to exercise the right or free speech without inducing or suggesting harm or violence to any individual or establishment.
      4. Tries to talk to the police. Common offenses include, but are not limited to:
      ” Why are you doing this to us?”
      “How can I peacefully leave?”
      5. Takes video, pictures, or is in possession of a camera that might document the truth.
      6. Tries to help/care for those who are in immediate danger or harm.
      (e.g. see Iraq medical war veteran, and helpful towers residing pitt student)
      7. Is in possession of any object that will protect them from tear gas.
      8. Buys a lighter on a Friday
      9. Follows police orders by walking, rather than running.

      http://www.whathappenedatpitt.com/forum/viewtopic.php?id=18

  3. SidFinster

    Are you seriously suggesting that banks would play accounting and legal games to avoid owning up to losses and taking a capital writedown?

    If so, you must be some kind of Communist!

  4. Peripheral Visionary

    Unfortunately, this is a depressingly pervasive issue. I recently received a notice from my bank–a small local bank, previously very conservative in its lending operations–informing customers that it was “working with” a number of real estate developers who apparently were having difficulty. “Working with”, in this case, is likely in the form of forbearances or even additional funding in the desperate hope that somehow a real estate developer saddled with huge amounts of debt and properties that can’t be sold will somehow turn around. In other words, pouring money into a hole in the ground, or sending good money after bad.

    The bad news is that the commercial and development portfolios of the banks are doing poorly–but the very bad news is that they are likely blowing even more money on ill-advised attempts to mitigate the situation, which will ultimately prove to be unsuccessful and costly.

  5. Siggy

    Commercial real estate is the next debunkle. What is being debunked is that you can’t buy a property on cap rate lower that 6% with financing at 75% of current market value and be reasonably certain that the transaction will perform.

    Acquisitions made at any price in the expectation that the debt can be rolled into perpetuity are nuts. And nuts is what we have unfolding. The options that seem to be developing for lenders is: a really big hit, 50% to 75% of the face amount of the loan; or, string it out and hope that the loss can be mitigated to say 10 to 15% of the face amount of the loan. Give that some thought, what would a 15% loss on a loan mean to the bank’s equity position? In far too many cases it will mean restructuring and liquidation.

    My advice to a banker so impaled on what was his exhuberance is to find a job that he can do with some competence, McDonalds might be wise consideration.

  6. cougar_w

    While the FED can’t bail out 1000 banks in a year, or absorb that much bad paper (er…. can it?) it doesn’t need to.

    Smaller and regional banks will go bust and be sold by the FDIC to larger banks (solving two problems at the same time). The FED has, can and WILL bail out any of the larger banks up to the amount of many billions (with a B) $US, for values of “many” up to 2000, and perhaps more than that.

    There is NO BOTTOM to the well of fiat dollars. They will throw numbers with 10 or 11 zeros on them at the big banks on a daily basis forever. Period.

    Once the currency is properly hyperinflated into the stratosphere the debts still on the books will be easy to pay. The race right now is to get hyperinflation in time to cover the debts with wheelbarrows of cash, before any more big banks fall over.

    As for hyperinflation itself that is a problem only for the middle class, which will be entirely vaporized. But the middle class can be rebuilt (or so the oligarchs will imagine) assuming TPTB decide having such a class toddling around the place offers the right ROI.

    And no I’m not being even remotely sarcastic.

    cougar

  7. Jefferson

    It explains why the Fed is having such a hard time getting anybody to participate in the TALF program for commercial real estate.

  8. Hugh

    Quelle surprise! Those above are right. Who needs reserves when you have the Fed and Treasury to bail you out. This is just more evidence that banks are and remain insolvent.

  9. bob

    The game is pretty evident by now. Banks get cheap money from the Fed and the Treasury. They hide their bad investments and growing insolvency for as long as they can. They use the cheap money that should be set aside as reserves to make leveraged investments and short term profits as their true position gets slowly worse. They pretend their short term gains are bottom-line profits and their businesses are healthy. They give themselves generous pay packages and bonuses. The Fed and the Treasury wink and look the other way until the whole thing falls apart. Then the banks go back for another bailout. It will probably work for a few more cycles.

  10. Richard Kline

    Why should most banks _care_ about the implosion of commercial re? Most of the big banks are dead, but are supplied with a) marbles, b) guarantees, and c) the lovingkindness of regulatory forebearance well past the event horizon of fabulation and madness. Said banks of any size will be permitted by their regulators simply to ignore the losses and continue to ‘operate’ on the public’s dime. Oh yeah, small banks are toast, but the FDIC will be used to force the mid-size banks to pony up for the losses there.

    Problem, problem, me no see problem? In the real world, yes, there’s a problem as the public gets stuck with those losses progressively more over the next yea years to come as a metastisizing liability on various public ledgers which no one will look at either. But in the Candyland which is Big Money USA, nah, there’s no crisis, the party’s roarin’ along. The One Party system, that is. . . . This won’t end well, but everybody on the Wall Street-Beltway axis has already decided that the chumps—i.e. the public—are gonna get stuck with the bill and the criminal complaint.

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