The Next Big Challenge for Community Banks

According to government and private-sector data compiled by the Federal Reserve Board, banks held a whopping $1.3 trillion of the $3.1 trillion worth of outstanding commercial and multifamily real estate debt at year-end 2011. With close to $1.7 trillion of this real estate debt set to mature over the next five years, there is a very real possibility that debt supply will not meet debt financing demands. The fact is that lenders are hesitant to take any risk and the moderate levels of CMBS originations we are seeing are not providing enough liquidity to refinance this massive debt. As a result, a vast number of real estate assets will simply be handed back to lenders or face foreclosure.

Much of the blame for this debt has been placed on banks’ non-performing commercial real estate loans—and, indeed, the ratio of non-performing loans at the Top 100 banks is still a substantial 5.2%, according to recent data from Trepp Bank Navigator. Meanwhile, the Federal Reserve reports that 6.12% of commercial real estate loans for all banks are delinquent as of the fourth quarter of '11.  

The possibility of increasing levels of non-performing loans rests squarely on community and small regional banks, which have greater exposure to this asset class. In addition, risk to community banks tends to center around lending activity, unlike the largest banks where risk is more commonly associated with trading activity. Finally, community banks are subject to increasing regulatory pressures. For these reasons, we believe community banks will continue to be greatly affected and slower to recover. This is problematic since their ability to support small business in their geographic area is vital to job growth and, therefore, the overall US economic recovery.   

The latest trend is that examiners are criticizing a growing number of performing loans at community and regional banks due to deflated underlying collateral values. This has created a new category of loans that bankers will need to address. Generally, the borrowers are current on all scheduled principal and/or interest payments. However, examiners urge the banks to classify these loans as substandard because current appraisals indicate a collateral value less than that required by the terms of the loan.

The devaluation of collateral can manifest in a variety of ways. For instance, regulators may require a bank to classify an otherwise performing loan on a stabilized office building, with leases at market rates, as non-performing, if the value of the property is perceived to be less than adequate to cover the debt. Examiners also take into account properties’ geographic locations and companies’ business lines when evaluating loans.

Regulators are typically charged with taking a conservative view of collateral and the servicing capacity of the borrower, and it is an anxious time for lenders, as a shortfall in collateral value could trigger a “performing non-performing loan,” and likely move substantial new debt into the non-accrual category.

That being said, community banks have been fairly vocal in expressing concerns about how examiners are classifying loans even when the loan payments are current and borrowers can meet their debt obligations. In August 2011, the US House of Representatives Financial Institution Subcommittee on Financial Institutions and Consumer Credit conducted a hearing into supervision of community banks. Gilbert Barker, the Office of the Comptroller of the Currency’s Deputy Comptroller for the Southern District, testified about OCC examination policies and procedures.

Barker acknowledged that a loan will not necessarily be considered good quality just because it is current, as the OCC also needs to evaluate the borrower’s ability to make future payments required by the terms of the loan. He cited examples of bank-funded interest reserves on commercial real estate projects where those reserves are being used to keep the loan current, but expected leases or sales have not occurred as projected and property values have declined. Other examples he cited were terms that require interest-only payments for extended periods and the use of proceeds from other credit facilities to keep otherwise troubled loans current.

While Barker agreed that examiners should not criticize loans simply because a borrower is located in a certain geographic region or operates in a specific industry, he also noted that market conditions could influence repayment prospects by impacting the cash flow potential of a business’ operations or of underlying collateral, which regulators are expected to consider in evaluating a loan.

With a surge of commercial real estate debt on the books of the banking system being scrutinized for various reasons, it’s clear that community banks will need to take action on these loans in order to preserve capital and remain solvent. Incorporating a thoughtful loan sales strategy would prove beneficial in restoring the balance sheet for many banks while demonstrating real solutions to regulators.

Bliss A. Morris is founder and CEO of First Financial Network and a member of the DAI editorial advisory board. She may be reached at bmorris@ffncorp.com. The views expressed here are the author’s own.