Banks Lowering the Boom on Small Builders

The New York Times reports tonight on how banks are clamping down on credit to small homebuilders, with the result that many will go out of business.

There were several things I found surprising about the piece:

1. That banks are getting stringent now. The housing market has been on a rapid decline since the summer of ’07 (and showing signs of weakness in the superheated markets earlier) and only NOW are banks tightening credit to home builders in a serious way? This is like closing the barn door after the horse is in the next county.

2. Banks are being indiscriminate. Builder = bad. Although banks routinely make knee-jerk cuts in credit crunches, I am always surprised to see it in operation. Suddenly calling in a credit line would fell most business borrowers. Some of the losses incurred will be self-inflicted. And even for borrowers that were over extended, an orderly wind down (seeing if they had any viable subdivsions near completion and letting them finish them) would often have produced a better outcome.

From the Times:

Dave Brown, one of this [Tempe, Az] city’s best-known home builders, had kept his head above water through the housing downturn, not missing a single interest payment on his loans.

Though Dave Brown’s home-building firm had not missed a payment during the housing downturn, one of his banks suddenly demanded millions of dollars in additional collateral.

So he was confounded a few months back when one of his banks, spooked by the decline in his company’s revenue, suddenly demanded millions of dollars in additional collateral to continue carrying loans on his projects.

He was unable to come up with the money, and in October, JPMorgan Chase foreclosed on five of his developments. Shortly thereafter, Brown Family Communities, 33 years in the business, decided to shut its doors….

“The reality is, we’re seeing conditions in home construction and home finance that are the worst since the Depression,” said Steve Fritts, associate director of risk management policy at the Federal Deposit Insurance Corporation, the government agency that insures bank deposits…

No hard count exists of precisely how many builders have gone out of business since the downturn began. According to an estimate by the National Association of Home Builders, at least 20,000 builders — about a fifth of the total nationwide — have closed up shop in the last two years….

With the industry still owing hundreds of billions of dollars in loans made at the market peak, many more face insolvency in the coming months and years. “Probably north of 50 percent will fail,” Ms. Zelman said.

Much of that borrowed money went to finance land deals that now appear to have been catastrophic miscalculations. In cities like Phoenix, where housing starts are near record lows, demand for undeveloped land has plummeted, and prices have followed…

Yves here. If the banks were funding land speculation, they deserve to have their heads handed to them. Back to the article:

Even builders who are up to date on their interest payments or still managing to sell houses are getting trampled, as in the case of Mr. Brown.

“They’re not distinguishing the track records of one borrower against another,” said John Fioramonti, a real estate consultant in Scottsdale, Ariz. “If you’re a builder, you are a bad risk.”…

More than 15 percent of loans for single-family home construction were in some form of default by September 2008, up from 10 percent in January of that year, according to figures from Foresight Analytics, a housing analysis firm. Still, until recently, banks had largely chosen to keep past-due borrowers afloat, in the hope that a housing recovery might pave the way for them to repay their debts in full.

Only now, with the economic outlook darkening, are lenders stepping up foreclosures of troubled loans. Zelman & Associates, a housing analysis firm, estimates that losses on land and construction loans could eventually reach $165 billion, one reason federal regulators are pushing banks to come to grips with the problem.

“When we talk to regulators now, they say they’ve lost patience,” said Ms. Zelman, who is chief executive of Zelman & Associates.

In this climate, keeping loan payments up to date — something many builders are struggling mightily to do — is not necessarily any protection.

Many loans in the building industry are of short duration, coming up for renewal at least once a year. This allows banks to take a fresh look at the financial health of a borrower, as well as the assets securing their debt. A steep fall in cash flow or a decline in the value of the collateral — usually building lots or half-built houses — can mean an automatic default, whether a borrower has missed payments or not.

Print Friendly, PDF & Email


  1. Anonymous

    I have family in Scottsdale and in the building/decorating game, high end market too and all I can say is Boom or should I say Paffawpht, the sound of implosion, their goners.

    This time next year or sooner I bet they will be enjoying the double wide lifestyle. Its going to be interesting to see how the younger/better off (fast money) segment of the population copes with their new lifestyles.


  2. Steven J. Balassi

    One item is worrying me! How are banks going to ever make money if they don’t lend? My guess is they will try to only loan to the best customers. Will this be enough to make a profit?

  3. Anonymous

    What is imploding everywhere in the economy, is the “forward” provision of credit:

    – supplier credits to customers

    – bank credit for trade (slightly improved)

    and so on and so forth.

    In essence, we are going back to a system where in order to be in the business, you got to be able to finance your own activities.

    BTW Yves, I read your previous comments to me re China — it require a detailed response best done by email to you — very complex issues which happens to be my specialty.

    So please excuse the lack of response — fee paying work has priority over blog posts.


  4. bg

    I have a friend. Actually a close friend who is a truly honerable person. She is likely soon sending in Jingle mail on her $2M 6000 square foot home. She is a mortgage broker. Her husband is a recently laid off car salesman. There never was much equity. And their combined income at one point was sufficient to cover the mortgage.

    When you accuse the banks of lending for land speculation, I have to laugh. Minsky told us this is what societies do after long periods of low risk prosperity. Even good banks. Even my friends.

    I still love them.

  5. Anonymous

    They are better off to pack up everything in a easy to move trailer in the garage, then enjoy the house for the remainder of time before the Sheriff comes.

  6. Yves Smith


    There is a lot of research that shows that most people overestimate their performance and their odds of success (the Lake Woebegone “all children are above average” syndrome).

    Banks are supposed to be constitutional pessimists to counterbalance that. So in my book, for your friends to have gotten themselves in over their head is a lot more understandable than banks enabling it.

  7. ndk

    Banks are supposed to be constitutional pessimists to counterbalance that. So in my book, for your friends to have gotten themselves in over their head is a lot more understandable than banks enabling it.

    I don’t blame the banks as much as others do. I tend to pin more blame on heavily interventionist monetary policy and willingness to rescue those about to detonate than the banks themselves.

    The shadow financial system dished out the great majority of bad loans and leverage in this situation, to no small extent mediated by Wall Street, not our regional and local banks, which may yet have been having a few too many crumpets with their martinis. The thrifts didn’t overextend themselves in 1980’s fashion, but in far more mundane boom/bust style.

    I see many forces alongside the Minsky-esque propensity of all banks to assume bad risks in good times as mentioned by bg. During long periods of uninterrupted disinflation and mild recessions, risk-taking banks and individuals gradually command more capital and a greater share of the economy.

    Investors and speculators will seek profit and risk; it’s what they do. They will do so through channels other than the banks if they must. It’s very clear they have multiple procyclical forcing functions.

    If we failed anywhere, it was in our support of those cyclical functions, through rewarding avarice and stupidity — which, I might mention, is paying off in spades today. As we persist in stopping routine financial forest fires, this is only the natural, unnatural outcome.

    Get ready for more.

  8. bg

    “So in my book, for your friends to have gotten themselves in over their head is a lot more understandable than banks enabling it.”

    Of course you are right. But there is a gap between understandable and likely. Organizational intelligence is based on incentives that are not as self correcting as we like to believe.

  9. Anonymous

    My opinions: We should let housing prices drop to their natural levels, without any intervention from the gov. Full transparency. Banks have less trouble lending when they know what the real value is. This both hurts (balance sheets) and helps banks (increased lending possibilities). It is only natural that banks are getting tougher on creditors. Is not this what we want? Loose credit created this problem, now there is much complaining about banks tightening credit policies. In my lifetime I have seen real estate bubbles where home prices dropped 10,000 in ONE week. It was not the end of the world. We all knew our homes were worth 10,000 less. Nothing was hidden from us. Free enterprise and capitalism and free markets work, at least until they become so distorted that nobody knows what the business model is.

  10. russell1200

    The confusion of developers with home builders does not help make the issues any clearer. Brown was a developer most likely. Most of the bid “home builders” are also developers.

    These developers are generally highly leveraged, and it can generally be taken for granted that a developer who gets caught in the wrong stage of development when the economy turns (its usually a more local phenomena of course) are going to get killed.

    J.P. Morgan from my worms eye and anecdotal view point are huge horses rear ends. They are busy pretending to be the white knight while hammering people at the ground level. I am sure that they decided that they did not have the resources to go through every situation in detail and to simply liquidate the loans as soon as a red flag came up.

    Much more acceptable behavior if they were not in up to the hips in their own government grantees.

  11. DownSouth

    russell1200 said: “Much more acceptable behavior if they were not in up to the hips in their own government grantees.”

    Yes, ironies abound in this comedy of absurdities.

    Insolvent banksters have been annointed judge, jury and executioner to administer the coup de grace to fellow FIRE industry participants, while a tax cheat has been nominated to be chief tax collector of the land.

    Really, you couldn’t make this stuff up. It couldn’t get any more bizzare if it were the storyline from some telenovela from some banana republic.

  12. Bob_in_MA

    Yves: If the banks were funding land speculation, they deserve to have their heads handed to them.

    You mean have their heads handed to the taxpayer, right?

  13. lineup32

    ” A steep fall in cash flow or a decline in the value of the collateral”

    Decline in collateral value is the key and says it all regarding the role of RE in credit creation and what we can expect going forward for other segments of the business community including AG that has used RE/equity assets as collaeral.

  14. Anonymous

    Yves, you should be blaming the NYT for the tardiness, not the banks. Banks have been canceling credit lines for small businesses for over a year.

  15. Anonymous

    I don’t think it was the bad loans alone that caused the crisis. From what I have read it was thede-regulation passed in 2001 that allowed the banks to “bet” with derivitives on the loans going up or down. It was this kind of betting/borrowing “on margin”, without any collateral, that caused the great depression and our current situation.

  16. Hu Flung Pu

    Yves, this article is misleading and slightly absurd. I’m 100% confident that Dave Brown had only “not missed a single payment” to his bank because of the “interest reserve” conventions for accounting for construction loan repayments. The only reason “he” was able to “make” his payments is because such payments were coming out of his interest reserve, in which the bank is in essence paying itself interest until the project is completed and the loan paid off in full. I’m sure the bank looked at his projects and the new market values and pulled the plug because they rightly saw a huge hole and determined it made no sense to forward this clown even more money – that is, they didn’t want to throw good money after bad. The problem is that so few folks understand construction lending (and the related accounting) that Dave Brown can misrepresent the situation – while being technically correct – for everyone in Readersville. No, I feel quite sure that Dave Brown’s projects were in the crapper and the bank was just cutting its losses. “I hadn’t missed a single payment” – That is classic!! Every banker in the country who read that article laughed his ass off at that statement. The more accurate statement would have been, “The bank hasn’t missed making a single payment to itself on my behalf. They’re just concerned that when I have to actually start making payments out of my own capital that I won’t be able to make them.” Uggh.

  17. russell1200

    Hu Flung Pu:

    I don’t think we are talking about an actual construction loan here. We are talking about a loan to a developer based on the expected cash returns of the project. The initial payments on the loan are scheduled before project completion (by arrangement) so in effect the bank does pay itself the interest. But the bank also gets to book the payment, and they weren’t complaining about it before.

    You can argue the sensibility of the loan after the fact, but the developer was making the payments.

    Typically these types of development loans go bust when the term of the loan is not as long as the length of the project, and the project is not able to refinance. A number of partially built high rises in the Carolinas can testify to the sensibility of this arrangement.

  18. vladimir

    Got news for the NYT. This is old news! My formerly successful 30 year old construction company began negotiating with our lender August 11, 2008. We proposed a workout to free up our own capital sunk in other assets. This would have allowed us to service our construction loan interest pmts and survive.
    5 months, and dozens of meetings later, we have yet to hear their response!!!
    The construction lenders are in such chaos, trying to delay booking “non-performing assets, NPAs, (read, construction loans behind on interest) as far into the future as possible. Their retirements depend on bank stock valuations, which depend on profitability, which dictates keeping NPAs off the radar. Moreover, they are trying to keep one step ahead of the FDIC shutting them down.
    The banks are effectively insolvent but as long as the music keeps playing, and the CFOs can effect intransigence and obfuscation on their underlings, the illusion that they are just working through a “rough patch” will remain the media and the public perception. A new website, will be launched 1/28/09 to chronicle the difficulties faced by builders, subcontractors and suppliers during this unprecedented credit contraction and housing collapse, and talk about the shakey condition of highly leveraged construction lenders. Check it out next week.

  19. Hu Flung Pu


    I’m not sure what you’re getting at. Yes, we’re talking about an “actual construction loan” here. What you described in your post is an “actual construction loan,” interest reserve and all.

    Yes, technically, the developer was “making the payments,” but that was point of my post. In reality, the bank pays itself on behalf of the developer using the bank’s own money (via the interest reserve). The bank wasn’t “complaining about it before” because they thought they might be made whole at some point. Once that dream went up in smoke they decided to foreclose. Makes sense to me.

    It’s unlikely that the “refinancing” problem in Mr. Brown’s case was “the length of the project.” Rather, it’s more likely that the prices that would be garnered for the finished properties weren’t anywhere near what the loan balances were. Thus the stoppage.

    Mr. Brown would have us believe that he’d been paying down his loan with his own capital – which is patently false – and then the big bad bank came along and foreclosed. He was merely using part of the proceeds of his construction loan to pay the bank back, which is how all construction loans work. Believe me, if Mr. Brown had been able to come up with enough of his own equity capital to cover the hole in the current LTV his loan would still be on the books and he’d be in business. That’s how construction lending works.

  20. tom

    What american homeowners are finally learning is that your worst investment is is a home. After mortage payments based on the rule of 78’s[where equity building is a joke] real estate taxes, maintance and regular upkeep doesn’t keep up with inflation, and that wonderful tax deduction is really a fallacy. Rent for life,take that 20% downpayment and invest it wisely, and put those real estate taxes away for your retirement. That’s what the our generation is learning the hard way.

Comments are closed.