Tip of the Iceberg: More Banking Problems Could Surface

Bad Real Estate Loans Are at the Core of Financial Market Turmoil and Those Problem Loans are Still Growing

Bailout or no bailout, the country's commercial banks are facing an industry-altering round of consolidations, restructuring and tighter federal regulation as they grapple with confronting nearly a trillion dollars of bad debt. The latest federal government data shows a growing number of failed banks, problem banks and problem loans. And according to private industry research, the federal government data doesn't even begin to reveal the full size of the iceberg under the surface of the financial ocean. In the past few weeks, the financial services industry has already witnessed unprecedented corporate wreckage on Wall Street and an extraordinary transformation of the financial markets. Gone is the independent investment banking industry (Bear Stearns, Lehman Brothers and Merrill Lynch). Re-emerged has been the often-criticized universal banking model in which financial services companies offer both investment services and commercial savings and loans services (Goldman Sachs, Morgan Stanley and Bank of America). And the federal government has virtually taken over the securities markets (Fannie Mae, Freddie Mac), imposed itself into the insurance industry (AIG) and proposed a $700 billion bailout plan for Wall Street. And more of the same may be coming. See related CoStar Advisor coverage by Senior News Editor Randyl Drummer: Wall Street Crisis Hammers Development Financing The Top of the Iceberg: Current State of Banking The Federal Deposit Insurance Corp. (FDIC) has been called in as receiver for 11 banks so this year through today, and the federal regulator expects bank failures in the near term to increase. The FDIC's "problem list" of banks grew to 117 institutions as of June 30, up from 90 at the end of the first quarter. That is largest number on the list since the middle of 2003. Total assets of problem institutions increased from $26 billion to $78 billion. A concentration in real estate has been a common theme among the bank failures in 2008. Rising levels of troubled real estate loans has led many institutions to increase their provisions for loan losses. Loss provisions at the end of the second quarter totaled $50.2 billion, more than four times the $11.4 billion the industry set aside in the second quarter of 2007. Almost a third of the industry's net operating revenue went to building up loan-loss reserves and not to making more loans. However, for the ninth consecutive quarter, increases in delinquent loans surpassed the growth in reserves. The amount of delinquent loans and leases (90 days or more past due or in nonaccrual status) increased by $26.7 billion (20%) during the second quarter, following a $26.2 billion increase in the first quarter and a $27 billion increase in the fourth quarter of 2007. Almost 90% of the increase in delinquencies in the last three quarters consisted of real estate loans. Also, the net charge-off rate of bad loans has risen to its highest level since 1991. To be fair, the primary culprit behind the banking mess has been residential real estate loans and most of the government action and media attention has been focused on problems in the housing market. However, banks are beginning to see an increase in troubled commercial real estate loans, even though the ratio of these troubled assets is far less than in the early 1990s during the last major upheaval in the financial markets. The total amount of multifamily and commercial real estate loans delinquent more than 30 days at the nation's commercial banks is up 65% from June 30, 2007, to more than $20 billion. The amount of commercial properties taken over by banks through foreclosures is up 23% from the second quarter 2007 to $14 billion. Current delinquent commercial real estate loans represent only 4.24% of all outstanding CRE loans at commercial banks. While that is the highest it has been since 1995, is not even close to the peak of 12.07% at the start of 1991. And year to date, commercial banks have charged off more than $870 million in commercial real estate loans and recovered only $79 million of that amount. The current charge off rate for all commercial real estate loans is still less than 1% (0.93%) and that compares to high of 2.54% in the second quarter of 1992. Private Research Peers Beneath the Surface Martin D. Weiss, Ph.D. and president of Weiss Research Inc. sent a report to Congress this past week that painted a more drastic picture than current conditions. Weiss said there are 1,479 U.S. banks and 158 U.S. thrifts at risk of failure, with total assets of $3.2 trillion - more than four times the amount of the proposed federal bailout and 41 times the amount of assets of banks on the FDIC's list of troubled institutions. "There should be no illusion that the $700 billion estimate proposed by the administration will be enough to end the crisis," Weiss said in announcing his report. "Nor should there be any false hopes that the market for U.S. government securities can absorb the additional burden of a $700 billion bailout without putting major upward pressure on U.S. interest rates, aggravating the very debt crisis that the government is seeking to alleviate." The bailout plan whether it passes Congress or not, is an insufficient step to deal with our current credit crisis, agreed Campbell R. Harvey, professor of finance, The Fuqua School of Business, Duke University. "While most of the focus has been on Wall Street, there are hundreds, if not a thousand banks, that may be insolvent if their assets, which include capital market instruments, were marked-to-market. Over the next six months, we are faced with the specter of a massive number of bank failures," Harvey wrote in a report this week entitled: The Financial Crisis of 2008: What Needs To Happen after TARP. TARP stands for Troubled Asset Relief Program, the moniker given to the U.S. Treasury's bailout program. As a way of comparison, Harvey noted that the Resolution Trust Corp. initiated in 1989 took over and disposed of more that $550 billion in assets in its lifetime, which is roughly $900 billion in 2008 dollars, he added. "Today's situation is larger in scale than the S&L crisis. The combined assets of just two firms, Lehman Brothers and Washington Mutual, $946 billion, exceeds the assets targeted during the S&L crisis," Harvey said. "Note the total assets of Wachovia Corp. were $812 billion as of June 30, 2008." "It is naïve to think that the $700 billion TARP program will solve our financial crisis," Harvey added. What's on the Horizon New research this week from TowerGroup found that the weeks and months to come will bring more mergers and restructuring for the US banking industry, even as the drive for greater regulation, transparency, and cooperation continues to be debated. At the same time, financial institutions will return to a focus on more traditional banking activities, as credit terms become tighter, capital is withheld from the market, and economic growth is further stifled. TowerGroup said it believes the banking industry is on the verge of a new hierarchy. Strong banks will press their advantage with new products and services; new competitors will enter the market as the industry industrializes; and the need for greater integration across client databases, risk management capabilities, and products will cause bankers to realize they must abandon the cultural silos that have hindered their progress toward make the whole greater than the sum of its parts. "This market crisis, the worst in our long-term collective memory, is not over," Standard & Poor's Ratings Services wrote in a report this week entitled: When the Smoke Clears, What Happens Next with U.S. Financial Institutions. "Although we anticipate more difficulties, we should still begin to consider what the financial institutions industry may look like when the smoke clears. We believe the landscape is likely to be vastly different, but the changes could contribute to a healthier and more fiscally sound U.S. financial system." In the short term, the Darwinian effect of survival of the fittest could eliminate the weakest players and lead to less robust competition but could also bring an element of stability, S&P reported. "We can envision a major overhaul of the established, 75-year-old regulatory regime," S&P wrote. "A final outcome seems to be the possibility of the Federal Reserve playing a central role in examining and supervising financial institutions, as well as promoting the safety and soundness of the financial system. The national regulators may turn their sights on containing systemic risk if another large institution fails, regulating hedge funds and private equity funds, and regulating the over-the-counter market for trading complex financial instruments." for more information see: www.houstonrealtyadvisors.com or www.houstonrealtyadvisors.net