Reckoning day for small banks

Billions in bad construction loans pose test for America's lenders

BY MICHAEL CORKERY, JENNIFER S. FORSYTH AND LINGLING WEI
Wall Street is bracing for re gional arid small U.S. banks to fess up to significant losses from their mounting volume of soured con- struction loans made primarily to home builders.
According to the Federal Deposit Insurance Corp., a Washington, D.C., bank regulator, $45.4 billion of the $631.8 bifflon in construction loans outstanding at the end of the first quarter were delinquent. When banks announce second-quarter re suits in coming weeks, they are expected to report sharp increases in loans that builders can't repay. Banks are also facing intensifying pressure from federal and state reg ulators to deal with the problem loans on their books.
That will put additional pressure on an already stressed financial sys tem. Banks have begun to dump bad construction and land loans at dis counts, curtail new lending and halt construction projects that are un der way to preserve capital. Some analysts even see a wave of bank fall- ures as a possibility.
"Across the industry, the second quarter is going to be a tough quar ter," says Keith Malo, chief executive of the National BankofArizona, a unit of Zions Bancorp that lent heavily to home builders and developers. "It's going to continue to be tough until the real-estate market hits a bottom."
Scores ofbaiiks were already suf fering headaches by the end of the first quarter, according to a review by The Wall Street Journal of FDIC filed reports by 6,919 banks that make construction loans. The smallest banks, those with total assets of less than $5 billion, faced the b坡- gest problems. The WSJ analysis didn't include savings-and-loan institutions, or so-called thrift banks.
Nearly one in three of the banks analyzed-or 2,182-had construc tion-loan portfolios that exceeded 100% of their total risk-based capital, a red flag to regulators, although it doesn't mean the bank is in danger of failing. Risk-based c即ital is a cush ion that banks can use to cover losses.
Even more alarming, 73 of those banks had construction-loan delin quency rates of more than 25%. Exec utives at all of the banks that re sponded to questions acknowl edged the problems but expressed confidence they had the capital to weather the storm.
At Bremerton, Wash.-based Westsound Bank, new Chief Execu tive Terry Peterson agreed that his bank became "much, much too con- centrated" in construction loans. About 43% of Westsound Bank's con- struction and land loans in the first quarter were delinquent.
Mr. Peterson was appointed CEO recently to clean up the troubled bank, after regulators issued a "cease and desist" order in March re quiring the bank to change lending practices. "We are pretty much us- ing all of our human capital to ad- dress our loan problems," he says.
Larger regional banks also face mounting construction-loan prob lems, but are in decent shape. Thirty- eight of them had more than 100% of their total risk-based capital in con- struction loans at the end of the first quarter, but only nine of those faced delinquency rates of more than 10%. Over the next few quarters, banks are expected to begin recording much larger losses. In 2007 and the first quarter of this year, U.S. banks wrote down just 0.7% of their residential construction and land as- sets as bad debt, accordIng to Zel man&Associates, a research firm. Over the next five years that figure could rise to 10% and 26%, which would amount to about $65 billion to $165 billion, Zelman projects.
During the housing boom, many small and regional banks doubled down on construction loans because they were largely shut out of the home mortgage market dominated by large originators. But now the banks' difficulties are threatening to sharply shrink the home-building industry. Credit Suisse analyst Dan Oppenheim estimates that as many as 50% of the closely held builders won't survive be- cause of the tightening lending envi ronment and housing downturn.
Strategies for coping with the problem loans vary widely. Large banks, such as IndyMac Bancorp Inc. and KeyBank, have been trying to sell billions of dollars of construction and land loans. IndyMac said in a Ill- ing Monday that it was working with regulators to shore up its capital.
"The banks are running as fast as they can to get out of housing," says Tom McCormick, president of Asto nla Homes, a large, closely held builder in Las Vegas.
Mr. McCormick is involved in a fight with KeyBank, which recently initiated foreclosure proceedings on a $24 million construction loan fi nancing a Las Vegas housing project. Mr. McCormick says the bank took that action even though his company was current on debt payments. In court documents, Key- Bank says the builder fell behind.
Mr. McCormick says he found in- vestors to buy out his loans at 70 cents on the dollar, but the bank re fused. He also says that KeyBank has prevented him from closing home sales. "I personally think the factthatyouwould punish any inno Cent home buyer...is shameful," Mr. McCormick wrote in an email to Key- Bank executives. A spokeswoman for Keycorp, KeyBarik's parent, de dlined to comment.
Many smaller banks have been more willing to work with struggling builders rather than foreclose on their projects. But these banks are coming under pressure from regula tors to more aggressively write down their loans, amid declining real- estate values. This process could force many more loans into default.
Some community banks are bris tling under the regulatory pressure. "The federal government is being too reacfionar" says Damiari Kassab, chief executive of Michigan-based Warren Bank, which reported that 47% of its construction loans are de linquent. "They want to see it done as quickly as possible. I say, 'Can't we just relax, take a deep breath and work with the borrowers?'，，
Analysts question whether some small banks are putting off foreclo sures because they lack adequate capital to absorb the large losses.
But Mr. Kassab says, "We are dragging our feet on purpose where we can. We want to foreclose as the last resort. We see these borrowers at the grocery store and at church. It's part of our mission as a commu nity bank to help them."
Banks seeking a quick fix by sell- ing off their troubled loans may find fewer buyers. Laurence Pelosi, an ex ecutive director of Morgan Stanley Real Estate, a major land investor, told the Pacific Coast Builders Con- ference last week that the appetite for distressed residential real estate may be waning among some inves tors. "The complexity of the busi ness and the increasing opportuni ties in the commercial sector may lead to a shift away from residen tial," Mr. Pelosi says. "That will have a further impact on values."
-Tom McGinty
contributed to this article.