Here comes another set of dodgy U.S. loans
Banks in the U.S. face a new source of write-downs and failures in the coming year as loans made to developers to finance residential and commercial property development rapidly go bad.
And as these loans are old-fashioned and concentrated in smaller banks, their fate is particularly interesting as it indicates that issues with the banking system go far deeper than the so-called “toxic assets” belonging to the largest lenders that have thus far gotten most of the attention and government aid.
They are also a great illustration of the difficulties of stopping a housing and deleveraging crash.
Called Acquisition, Construction and Development (ADC) loans, they total 8.4 percent of all bank loans, just below a 30 year peak, and are used by developers to buy land, put in infrastructure and construct housing or commercial and office space.
And because they are dependent on a reasonably healthy real estate market — someone who is willing to buy or rent the properties — when projects are completed, they are now in deep trouble.
“Everyone in the media is focused on consumer foreclosures. What they’re not focused on is the builder developer foreclosures which are only in the early innings and which will continue to wreck havoc as these assets are liquidated at depressed prices. Until they are cleared there can’t be a stabilization in home prices,” said Ivy Zelman, a longtime housing analyst at Zelman & Associates, who thinks the pressure will cause “hundreds of banks” to be closed and liquidated.
“The Federal Deposit Insurance Corporation doesn’t have the funds to deal with all this. They don’t have the scalability to deal with all these problem banks. They can’t examine the smaller banks fast enough,” she said.
Zelman estimates that U.S. banks risk having to charge off an additional $84 billion of ADC loans between now and 2013, equal to a hit of nine percent of Tier 1 capital.
That is damage banks can ill afford just about now, given the rising trend in delinquencies on consumer and home purchase loans, not to mention a deteriorating outlook for commercial loans.
Non-performing ADC loans hit 8.5 percent at the end of the year, up from just 3.2 percent the year before. Loans delinquent between 30-89 days are also up, by 25 percent in the quarter to 2.9 percent. And developers, struggling to try to survive without reliable cash flow from sales, are drawing down on commitments from banks that are not secured. The percentage of unsecured construction loans drawn down hit 73 percent, above the peak seen during the 1990s real estate slump and a crucial sign of builder distress.
FDIC FUNDING CRUNCH
Of particular concern is the way in which ADC loans are concentrated in smaller and community banks, which tend to have long and deep relationships with local developers. ADC loans account for 47 percent of non-performing loans at small banks as against 14 percent at larger banks.
And you can’t blame mark-to-market or toxic securitizations for these losses. They are considered held-to-maturity and are not typically included in any complex securities.
Chris Whalen of Institutional Risk Analytics, which specializes in bank risk analysis, sees ADC loans as part of the difficulties banks face with commercial real estate, and believes that regulators will be forced to get tough with banks in forcing them to write down exposure to struggling firms and deals.
“It will be subject to an impairment test and than they will have to start charging it off. The regulators are already beginning to force the community banks,” he said.
And while smaller banks being closed by the FDIC may not get the attention of a bailout of a big bank like Citigroup, every failure depletes resources and hurts credit availability.
The FDIC fund fell by almost half in the fourth quarter alone, touching $18.9 billion as it set aside a large portion of money for actual and expected bank failures. The FDIC has said it needs a bigger cushion but moves to impose special fees on healthy banks will inevitably hit profitability and credit availability.
Democratic Senator Christopher Dodd, chairman of the Senate Banking Committee, is moving to introduce legislation that would more than triple — to $100 billion — the FDIC’s line of credit with the Treasury Department.
But even beyond bank failures, ADC loan woes point to the intractable problems of a real estate bust.
Banks, while trying to reduce their overall exposure to these loans, have been reluctant to pull the rugs from under borrowers because, as with a house foreclosure, they end up owning a hard-to-sell underlying asset. But more foreclosures are coming, and with them fire sales as banks compete with those developers who still are in business and with homeowners and with foreclosure sales to liquidate inventory.
That will drive land and real estate prices down further and suck others into what amounts to a negative self-reinforcing cycle.
That’s true for housing, true for banking and true for the economy.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund —