Initial findings of our most recent analysis show thathundreds of banks are grappling with commercial mortgage defaultsmatching or exceeding the profile of the last two year’sCRE-related bank failures.

Sam Chandan PhD with MarkGaudette

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The count of US bank failures rose to eighty-three this pastFriday when the Federal Deposit Insurance Corporation (FDIC)announced that the Nevada FinancialInstitutions Division had closed Nevada Security Bank (NSB). Actingas receiver, the FDIC has facilitated the prompt transfer of NevadaSecurity’s deposits to Oregon’s Umpqua Bank. NSB's branches willopen this Monday morning as part of the Umpqua Bank network. TheFDIC’s loss sharing agreement with Umpqua Bank will cost theDeposit Insurance Fund an estimated $80.9 million.

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In its last quarterly filing, reflecting bank assets andliabilities as of March 31, 2010, Nevada Security Bank reportedhaving net loans and leases of $330 million. Of that total, almosttwo-thirds, $204 million, was in commercial real estate. Commercialreal estate, multifamily, and construction loans combined totaled$275 million, just over 83 percent of the bank's lending balancesheet. NSB's concentration in commercial real estate was compoundedby the deterioration in the performance of the underlyingmortgages. The default rate on its commercial real estate loans was10.6 percent in the first quarter, more than double the nationalaverage. Similarly, the default rate on its construction loans was25.8 percent.

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Commercial Real Estate and Bank Failures: NevadaSecurity Bank in Context

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Deterioration in the performance of commercial real estate andconstruction loans has been amongst the key causal drivers ofstrains in the regional and community bank sectors. While thedefault and loss experience in these banks’ commercial real estateportfolios varies substantially, smaller lenders' average exposureto real estate is clearly higher than at their largest peers. Asfor how significant a role commercial real estate has played indriving some banks from the problem list to ultimate failure, therehas been little formal research thus far.

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To better understand the role of commercial real estate as adriver of stresses on bank health, we have studied fifty-six bankfailures that have occurred since mid-year 2008. In each of thesecases, the resolution of the failure resulted in a loss to theFDIC's Deposit Insurance Fund (DIF). Under Section 38(k) of theFederal Deposit Insurance Act, the Office of the Inspector General(OIG) of the FDIC undertakes a Material Loss Review in each ofthese cases. From the Loss Review, we can observe the OIG's owndetermination of whether commercial real estate and constructionloan losses were significant drivers in each bank’s demise.

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Across the thirty-six bank failures where commercial real estatewas cited by the OIG, the average default rate on commercialmortgages was 11.4 percent in the last quarter during which thebank was active – three times the average bank commercial realestate default rate of 3.8 percent in the fourth quarter 2009.Surpassing commercial defaults, the default rate for multifamilymortgages across the same subset of failed banks was 17.9 percent;the construction loan default rate, 29.7 percent.

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The exceedingly high default rates in the commercial,multifamily, and construction loan pools weighed on the failingbanks because these loan pools represented a large share of eachbank’s total lending. On average, the sum of commercial,multifamily, and construction loans represented 75 percent of netloans and leases at failed banks cited for commercial real estateexposures. 45 percent of the combined balances were in commercialreal estate specifically. By way of comparison, the averagecommercial real estate concentration across all active banks atyear-end 2009 was 15 percent. Default rates were generally lower atfailed institutions with larger concentrations, suggesting that theabsolute count and volume of defaults may be an equally importantmetric in assessing bank health.

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To the extent that high concentrations in non-performingnon-residential real estate undercut bank health in a significantshare of the analyzed bank failures, the study benchmarks caninform our understanding of which banks face potential problems inthe near- to medium-term outlook. This exercise suggests that alarge number of banks are at-risk because of their combinedexposure to non-residential real estate and a coincidentdeterioration in the performance of those portfolios:

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7,721 banks – roughly 97 percent of all active banks in thefirst quarter – have at least some exposure to commercial realestate. Of these, 565 currently report commercial real estatedefault rates of at least 10 percent. Even when employing thehigher benchmark of an 11.4 percent default rate (the averagecommercial real estate default rate for failed banks where the OIGcited the sector exposure), 440 banks report higher default ratesin their legacy commercial portfolios. These banks represent morethan 5 percent of all FDIC-insured institutions and 3 percent ofthe system's total assets.

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Dr. Sam Chandan

An irreverent take on the macroeconomic environment. Dr Sam Chandan is President and Chief Economist of Chandan Economics and an adjunct professor in real estate and public policy at the Wharton School of the University of Pennsylvania.