The Congressional Oversight Panel's February oversight report, "Commercial Real Estate Losses and the Risk to Financial Stability," expresses concern that a wave of commercial real estate loan losses over the next four years could jeopardize the stability of many banks, particularly community banks. Commercial real estate loans made over the last decade - including retail properties, office space, industrial facilities, hotels and apartments - totaling $1.4 trillion will require refinancing in 2011 through 2014. Nearly half are at present "underwater," meaning the borrower owes more on the loan than the underlying property is worth. While these problems have no single cause, the loans most likely to fail are those made at the height of the real estate bubble.
The Panel found that "a significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American." When commercial properties fail, it creates a downward spiral of economic contraction: job losses; deteriorating store fronts, office buildings and apartments; and the failure of the banks serving those communities. Because community banks play a critical role in financing the small businesses that could help the American economy create new jobs, their widespread failure could disrupt local communities, undermine the economic recovery and extend an already painful recession.
more J. Conclusion
There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public. An extended severe recession and continuing high levels of unemployment can drive up the LTVs, and add to the difficulties of refinancing for even solidly underwritten properties. But delaying write-downs in advance of a hoped-for recovery in mid- and longer-term property valuations also runs the risk of postponing recognition of the costs that must ultimately be absorbed by the financial system to eliminate the commercial real estate overhang.
It should be understood that not all banks are the same. There are “A” banks, those who have operated on the most prudent terms and have financed only the strongest projects. There are “B” banks, whose commercial real estate portfolios have weakened but are largely still based on performing loans. There are “C” banks, whose portfolios are weak across the board. The key to managing the crisis is to eliminate the C banks, manage the risks of the B banks, and to avoid unnecessary actions that force banks into lower categories.
Any approach to the problem raises issues previously identified by the Panel: the creation of moral hazard, subsidization of financial institutions, and providing a floor under otherwise seriously undercapitalized institutions. That should be balanced against the importance of the banks involved to local communities, the fact that smaller banks were not the recipients of substantial attention during the administration of the TARP, and the desire that any shake-out of the community banking sector should proceed in a way that does not repeat the pattern of the 1980s. The alternative, illustrated by recent actions of the FDIC, is to accept bank failures, and, when write-downs are no longer a consideration, sell the assets at a discount, and either create a partnership with the buyers to realize future value (as was done in the Corus Bank situation) or absorb the losses.
There appears to be a consensus, strongly supported by current data, that commercial real estate markets will suffer substantial difficulties for a number of years. Those difficulties can weigh heavily on depository institutions, particularly mid-size and community banks that hold a greater amount of commercial real estate mortgages relative to total size than larger institutions, and have – especially in the case of community banks – far less margin for error. But some aspects of the structure of the commercial real estate markets, including the heavy reliance on CMBS (themselves backed in some cases by CDS) and the fact that at least one of the nation’s largest financial institutions holds a substantial portfolio of problem loans, mean that the potential for a larger impact is also present.
There is no way to predict with assurance whether an economic recovery of sufficient strength will occur to reduce these risks before the large-scale need for commercial mortgage refinancing that is expected to begin in 2011-2013. The supervisors bear a critical responsibility to determine whether current regulatory policies that attempt to ease the way for workouts and lease modifications will hold the system in place until cash flows improve, or whether the supervisors must take more affirmative action quickly, as they attempted to do in 2006, even if such action requires write-downs (with whatever consequences they bring for particular institutions). And, of course, they must be especially firm with individual institutions that have large portfolios of loans for projects that should never have been underwritten.
The stated purpose of the TARP, and the purpose of financial regulation, is to assure financial stability and promote jobs and economic growth. The breakdown of the residential real estate markets triggered economic consequences throughout the country. Treasury has used its authority under the TARP, and the supervisors have taken related measures in ways they believe will protect financial stability, revive economic growth, and expand credit for the broader economy.
The Panel is concerned that until Treasury and bank supervisors take coordinated action to address forthrightly and transparently the state of the commercial real estate markets – and the potential impact that a breakdown in those markets could have on local communities, small businesses, and individuals – the financial crisis will not end.
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