Growing Problems with Construction Loans

Here’s an update on part of the commercial real estate sector’s loans from Floyd Norris at the NYT. He delves into the growing problems with construction loans.

Reports filed by banks with the Federal Deposit Insurance Corporation indicate that at the end of June about one-sixth of all construction loans were in trouble. With more than half a trillion dollars in such loans outstanding, that represents a source of major losses for banks.

Construction loans were highly attractive in recent years for many banks, particularly smaller ones without a national presence. One reason was that other types of loans were not easy to make. A handful of big banks came to dominate credit card loans, for example, and corporate loans were often turned into securities.

Construction loans, however, needed local expertise and were not easy to standardize. In a booming real estate market, there were few losses on such loans.

The problems now extend well beyond loans for the construction of single-family homes, where banks have been taking losses and cutting back their commitments for a couple of years. At the end of June, $173 billion in construction loans related to single-family homes was outstanding, barely more than half the peak level reached in the fall of 2006, when the housing market was booming.

It is in commercial real estate construction — be it stores or office buildings — that the pain seems likely to rise. At the end of June, $291 billion in such loans was outstanding, down only a few billion from the peak reached earlier this year.

If you read this blog regularly or others for that matter, this news, except perhaps for the size of the problem, doesn’t come as a great surprise. It’s part of the reason that we are just at the front-end of another banking crisis that’s going to engulf the smaller banks. Keep in mind that this is just one piece of the CRE problem facing the small and not so small banks. Loans for the acquisition of existing properties also represent a huge overhang for them.

A lot of small banks are going to fail. That’s a given. Of more import is what do the smaller banks do to generate earning assets in the future. Auto loans, credit cards, and most business lending is controlled by the large banks. At least for some time, the regulators will likely put a leash on the amount of real estate exposure that banks are entitled to accumulate which leaves precious few lending opportunities for small commercial banks.

It’s quite possible that this crisis has broken the business model for small banks.

Graph: NYT

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