Commercial Real Estate Poses a Major Risk to Recovery

• The FDIC's Quarterly Banking Profile shows how bad commercial real estate loans are driving rising bank failures.
• Credit quality in construction and development loans has decayed far more than other areas, especially for medium and large banks.
• The states most susceptible to commercial loan defaults generally have high commercial real estate vacancy rates, high unemployment rates, and concentrations of large banks.

One of the biggest downside risks to the U.S. economy today is the potential for widespread bank failures fueled by bad real estate and commercial loans. We are already seeing this problem on a smaller scale: Many of the 84 bank failures to date this year were tied to bad commercial real estate loans. These bank failures have diminished the reserves of the Federal Deposit Insurance Corp., forcing the government agency to raise insurance assessments on banks and loosen rules on what sort of parties may bid to acquire failed banks. Bank failures and the uncertainty generated by such a high volume of bad loans have already frozen many credit market segments since last autumn, including commercial mortgage-backed securities. More bad loans and more failed banks would eventually lead to a general credit crunch, starving businesses of needed capital for investment, preventing consumers from financing large purchases, and otherwise jamming the gears of the economy just when a recovery from the recession seems within reach.

Last week's FDIC Quarterly Banking Profile contained troubling news, especially when one looks beyond the top-line numbers. The FDIC's dwindling deposit insurance fund now stands at $10.4 billion and would have been even lower except for a dramatic $9.1 billion increase in assessments earned, which came out of an emergency surcharge the agency imposed earlier in the year. Although the FDIC has not announced a second surcharge or tapped its $500 billion credit line that Congress extended earlier this year, the agency did leave the door open to such moves in the near future should bank failures rise even more. Also in the profile, deposit growth came to a halt, and the banking industry reported a net loss. Worse, the country now has 416 problem institutions—37% more than last quarter—suggesting that even more banks are likely to fail in the coming quarters. Since many of the bank failures are tied to bad real estate and commercial loans, the data attached to the FDIC's announcement are more troubling than the top-line figures.

To increase its chances of finding buyers for all these failed banks, the FDIC has now deemed private equity firms eligible, but under tighter rules than for banks. To prevent private equity firms from quickly reselling failed banks and to minimize the possibility the failed bank will fail again, the FDIC is requiring a minimum 10% ratio of high-quality capital to total assets, double the cushion required of banks, and a three-year holding period.

The profile's most troubling news came in the detailed reports of loan delinquencies and charge-offs, which point to the primary drivers behind bank failures. While the problems in residential real estate are well-known, growing troubles are being seen in commercial loans. The FDIC reports rising delinquency and charge-off rates in most categories, particularly in construction and development loans. In the second quarter, the construction and development delinquency rate was 13.4% and the charge-off rate was 4.4%, both up from negligible rates at the beginning of 2007.

Bad loans are showing up most frequently at midsized regional banks, causing great concern, because although their failure would significantly harm the banking system, they are not considered "too big to fail." Midsized institutions—defined by the FDIC as having total assets of $1 billion to $10 billion and which tend to have a regional rather than national focus—have the highest rates of delinquency and charge-off in construction and development loans and in multifamily real estate loans. Other institutions above that asset cutoff—including Colonial Bank in Alabama with $25 billion in assets and Guaranty Bank in Texas with $13 billion in assets—have also failed, alarming many observers of regional banks.

A state-by-state analysis reveals the surprising geographic dimensions of deteriorating commercial credit quality. To be clear, the analysis identifies the location of the headquarters of the banks issuing the loans, not the location of the properties or firms attached to the loans. Construction and development loans, with an average delinquency rate of 13.4% and which have the worst credit quality among all loan classes, are most likely to be delinquent in banks in the District of Columbia (38.6% delinquency rate) and the states of Washington (27.5%), Illinois (23.7%) and Arizona (21.9%).

Commercial real estate loans—which include loans on office buildings, retail space, and so on, but exclude loans on multifamily residential properties—do not show the elevated rates of delinquency and default seen elsewhere, but the trend is troubling. The current national delinquency rate of 2.9% is more than four times higher than in early 2007, and the national charge-off rate of 0.5% is seven times higher than in 2007. By state, the worst commercial real estate delinquency by far is found in Michigan, with a 5.6% rate. Michigan now has the nation's highest unemployment rate at 15%, so reduced demand for offices and retail stores is not surprising. Florida, Utah, Illinois and North Carolina all have a 3.7% delinquency rate. All but Utah have unemployment rates at least 1 percentage point above the national average, while Utah's status is most likely related to banks headquartered in the state rather than conditions there.

Multifamily residential real estate loans are also showing weakening credit quality, with a national average delinquency rate of 3.3% and a charge-off rate of 0.8%. Credit quality is worst for banks headquartered in the District of Columbia, where 15.4% of all such loans are delinquent. Other states above the 8% threshold are Florida (13.1% delinquency rate), New Mexico (10.1%), and Michigan (9.6%). Most intriguingly, there is little connection between these states and the residential housing bubble states, except for Florida. The charge-off rates also show a high geographic concentration, with Arizona (5.1% charge-off rate), Michigan (4.8%), Utah (4%), and Florida (3.4%) leading the way. Again, Utah's presence on the list likely reflects large national banks rather than conditions inside the Beehive State.

If future defaults follow current delinquency patterns, we should expect an acceleration of bank failures. Mortgage-related troubles have characterized the financial crisis so far, but banks that are significantly exposed to noncurrent commercial real estate loans—broadly defined to include construction and multifamily loans—are generally not in the states associated with the housing crisis. Unlike the trend of housing-related bank failures, many in the current wave are medium-sized and regional in focus, rather than the giant national banks whose stumbles have become emblematic of the crisis. Coming failures may increasingly be located in areas with high vacancy rates such as Florida, with high unemployment rates such as Michigan, and with concentrations of large banks. Unfortunately, the data do not tell us the location of the troubled properties, nor do they tell us how those properties link to particular banks.