Initial findings of our most recent analysis show that hundreds of banks are grappling with commercial mortgage defaults matching or exceeding the profile of the last two year’s CRE-related bank failures.

Sam Chandan PhD with Mark Gaudette

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

In its last quarterly filing, reflecting bank assets and liabilities as of March 31, 2010, Nevada Security Bank reported having net loans and leases of $330 million. Of that total, almost two-thirds, $204 million, was in commercial real estate. Commercial real estate, multifamily, and construction loans combined totaled $275 million, just over 83 percent of the bank's lending balance sheet. NSB's concentration in commercial real estate was compounded by the deterioration in the performance of the underlying mortgages. The default rate on its commercial real estate loans was 10.6 percent in the first quarter, more than double the national average. Similarly, the default rate on its construction loans was 25.8 percent.

Commercial Real Estate and Bank Failures: Nevada Security Bank in Context

Deterioration in the performance of commercial real estate and construction loans has been amongst the key causal drivers of strains in the regional and community bank sectors. While the default and loss experience in these banks’ commercial real estate portfolios varies substantially, smaller lenders' average exposure to real estate is clearly higher than at their largest peers. As for how significant a role commercial real estate has played in driving some banks from the problem list to ultimate failure, there has been little formal research thus far.

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

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

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

To the extent that high concentrations in non-performing non-residential real estate undercut bank health in a significant share of the analyzed bank failures, the study benchmarks can inform our understanding of which banks face potential problems in the near- to medium-term outlook. This exercise suggests that a large number of banks are at-risk because of their combined exposure to non-residential real estate and a coincident deterioration in the performance of those portfolios:

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