Will bad commercial real estate loans set off Banking Crisis II?

10/08/2009 3:20 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

It’s going to be an interesting earnings season for bank stocks.

The U.S. Federal Reserve has recently been out banging the pots about a new banking crisis, one in the $3.4 trillion market for commercial real-estate debt, that in size, at least, ranks up there with the original meltdown in residential mortgages.

But this time it won’t be the big boys like Citigroup (C) and Bank of America (BAC) that take the biggest hits. No, the damage will be worst among smaller local and state banks that have loaded up their portfolios with loans to local real-estate developers, builders, and businesses.

The Wall Street Journal calculates that there are more than 800 banks that have at least half of their total loan portfolios committed to commercial real estate loans. In total banks account for about half of the $3.4 trillion in real estate debt.

What’s the big problem?

Banks have been excruciatingly slow to write down their bad commercial real estate loans. In the second quarter, according to the Wall Street Journal, the 800 banks with the biggest exposure in this sector set aside just 38 cents in reserves for every dollar in bad loans. That’s a huge drop from the $1.56 in reserves for every $1 of bad loans that these banks had at the beginning of 2007.

Banks have been practicing what’s called “extend and pretend.” So that they don’t have to show the loan as in arrears or in default banks have been extending deadlines for borrowers. And they’ve been pretending that those extensions will fix the problem even when they know the borrower will never be able to pay. As long as the bank can convinced itself that it will be paid eventually, it doesn’t have to write this off as a bad loan.

As a result the market prices of commercial real estate have declined much faster than the value of the commercial real estate loans carried on bank books.

Regulators have put the pressure on banks in recent weeks to start valuing their portfolios more realistically, to stop extend and pretend strategies, and to end tricks like paying interest to themselves for projects that have clearly gone belly-up.

If enough of these banks have to fess up, earnings season for financials could get really ugly.

How ugly? Think of the recent failure of Corus Bank, the biggest bank failure to 2009 to date. The Federal Deposit Insurance Corp. (FDIC), which took over the bank, auctioned off Corus assets to a group of private equity investors for $2.5 billion. (The FDIC had earlier sold off Corus’s deposits.) Those assets had a book value, according to Corus of $5 billion.  What was in that portfolio of loans? Oh, things like the banks$997 million in condominium loans in South Florida. Of those loans $873 million were in nonaccrual status, meaning that Corus wasn’t getting paid interest of principal. Of its assets, 44% were classified as non-performing by the bank at the end of March.

It’s hard to tell what banks might report really bad numbers. The ratio of reserves of non-performing assets is a good place to start because a bank that has been under-reserving and where the ratio of reserves to bad loans is falling could be headed for trouble. But that’s only a place to start since the banks that have been very aggressive about writing down the value of their loan portfolios can look like they’re under-reserving.

Here are three banks with big commercial real estate exposure that I’d watch carefully as earnings season unfolds. From these three reports, you should be able to get a sense of how ugly the quarter will be, if pressure from regulators has upped the pace on write-downs and reserve accumulation, and if any of the banks heavily committed to the sector were smart enough to dodge the worst of the trouble. (Any bank that can pull off that track deserves your close attention and perhaps some investment dollars.)

The three names I’d urge you to watch to see how big the problem will be for earnings this quarter are Sun Trust Banks (STI), Comerica (CMA), and Zions Bancorp (ZION). The three banks report on October 22, October 20, and October 19, respectively.

One strategy to keep in mind: if the commercial real estate loan numbers look ugly enough, it could lead to a route of all bank stocks. That would be the time to pick up shares of the big banks that don’t have proportionally as much exposure to commercial real estate loans. I’ll post a few big names with small exposure next week.

Related Articles on STOCKS