Commercial Real Estate's Coming $1.4 Trillion Crisis

In a report released Thursday, the Congressional Oversight Panel sounded the alarm bell about a potential crisis involving $1.4 trillion in commercial real estate loans that will come due between now and 2014. The panel warns that the "financial crisis will not end" because of the "potential impact that breakdown in those markets could have on local communities, small businesses, and individuals."It is feared that when these loans come due, companies will be unable to repay or refinance them because of deteriorating conditions in the commercial real estate market. Most of these loans were made at the top of the real estate bubble in 2007 and have lost as much as 40% of their value. Nearly half are underwater -- the properties are worth less than balance of their loans.

The panel's warning shouldn't come as a surprise. As early as May 2009, analysts warned that failures of commercial real estate loans could mean trouble for 500 small banks, with the potential for hundreds of bank closures in the next five years. Also in May, Foresight Analytics said nearly 3,000 banks and thrifts were estimated to have commercial real estate loan portfolios that exceed 300% of their total risk-based capital. Regulators consider 300% a red-flag level, although not all banks that exceed that threshold will fail.

Alarm bells were also sounded in September 2009, when the Shared National Credit Review found that banks, hedge funds, insurance companies and pension funds could face an additional $53 billion in large loan losses. The examiners conducting the review considered loans of at least $20 million that were underwritten by three or more banks to finance commercial real estate projects, corporate buyouts and other big ticket items. This Shared National Credit exam is conducted yearly by four federal bank regulatory agencies. The value of loans tagged as "substandard," "doubtful" or "loss" nearly tripled to $447 billion, or 15.5% of the total loans reviewed. That's up from 5.8% in 2008.

Remembering the S&L Crisis, and Avoiding Its Mistakes

The panel recommends that banks be grouped into three categories:

  • "A" banks, which operated on the most prudent terms and have financed only the strongest projects.
  • "B" banks, which have commercial real estate portfolios that have weakened, but are largely still based on performing loans,
  • "C" banks, which have portfolios that are weak across the board.
The panel says the "key to managing the crisis is to eliminate the C banks, manage the risks of the B banks and to avoid unnecessary actions that force banks into lower categories." The report also cautioned that any attempt to fix the community banks should "proceed in a way that does not repeat the pattern of the 1980s" seen during the savings and loan bailout.

The report pointed to a possible model for action illustrated by the recent moves by the FDIC to accept banks failures. When "write-downs are no longer a consideration, sell the assets at a discount," and then either partner with the buyer to "realize a future value" or absorb the losses. The panel pointed to the Corus Bank agreement with MB Financial as an example of a successful model for partnering.

We're headed for a roller coaster ride when the commercial real estate crisis hits. The panel concluded that when commercial properties fail, it will create a downward spiral of economic contraction, job losses and deteriorating store fronts, office buildings and apartments. This will lead to the failure of banks serving those communities. And since local banks play a critical role in financing the small businesses that create a large percentage of the U.S. economy's new jobs, their widespread failure could disrupt communities, undermine the economic recovery, and extend an already painful recession.
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