By Mark Heschmeyer

May 13, 2009

If the current economic malaise brings down any of the largest banks in the country, commercial real estate likely WON’T be the culprit. Office, industrial and retail properties specifically are even less likely to bring down the nation’s top banks.

The 19 largest U.S. banks, which account for 70% of the bank holdings of this country, were the focus of the U.S. Federal Reserve ‘stress tests’ results released this past week. Under the worst case scenarios envisioned for the current recession, commercial real estate losses would cost those banks $53 billion in losses this year and next.

While that is a lot of money, it still pales in comparison with residential loan losses, which still would make up the bulk of the projected losses, $185.5 billion. In fact, exposure to commercial real estate loans falls way down the line in terms of producing projected losses for banks. Trading and counterparty investments would lose $99 billion; consumer loans $83.7 billion; credit card loans $82.4 billion; business loans, $60.1 billion; only then comes commercial real estate.

The two-year loss estimates totaled about $600 billion in the more adverse scenario for the 19 bank holding companies.

Estimated losses on residential mortgages are substantial over the two-year scenario, consistent with the sharp drop in residential house prices in the past two years and their projected continued steep fall in the more adverse scenario. The effects of reduced home prices on household wealth and the indirect effects through reduced economic activity, also push up estimated losses on consumer credit, including losses on credit cards and on other consumer loans. Together, residential mortgages and consumer loans (including credit card and other consumer loans) account for $322 billion, or 70% of the loan losses projected under the more adverse scenario.

Even in terms of percentages of losses, commercial real estate loans hold up better on the banks’ books than its other assets and investments. About 22.5% each of residential real estate loans and credit card loans would go bad but only 8.5% of commercial real estate loans would go bad.

To cover those potential losses, the Federal Reserve has asked the 19 banks to raise $75 billion in additional common equity by next November.

“This was a carefully designed, credible test,” said U.S. Treasury Secretary Tim Geithner. “Banks supervisors applied a historically high set of loss estimates on securities and loans, as well as a conservative view towards potential earnings that could act as a buffer against those losses.”

“These are estimate of potential losses and earnings that could occur in the event of a more severe recession. They are not a prediction of where the economy is headed,” Geithner added. “The results are less acute than some had expected, in part because concern about the risk of a more severe recession have diminished, market have improved, and banks, in anticipation of the release of the stress test, have acted in the last few months to increased capital.”

The stress test process involved the projection of losses on loans and investment assets, as well as the firms’ capacity to absorb losses. To analyze commercial real estate loans, the bank holding companies were asked to submit detailed portfolio information on property type, loan to value (LTV) ratios, debt service coverage ratios (DSCR), geography, and loan maturities.

Loss rates on commercial real estate loans reflected realized and projected substantial declines in real estate values. However, federal supervisors analyzed loans for construction (both residential and construction) and land development, multifamily property, and non-farm non-residential projects separately. And the bulk of the projected losses in the commercial real estate come from the construction and land development loans. Income producing properties fared much better.

The stress tests projected a baseline loss of 9% to 12% for construction loans and a worse case scenario of 15% to 18%; multifamily losses had a projected baseline loss of 3.5% to 6.5% and a worse case loss of 10% to 11%; office, industrial and retail properties had a projected baseline loss of 4% to 5% and worse case loss of 7% to 9%.

The results of the stress tests “were good news and were generally received as such, although it is important not to take excessive comfort from what remains essentially a highly educated guess as to the future of the banks in a very uncertain environment,” concluded Douglas J. Elliott , a fellow in economic studies at The Brookings Institution. “The test appears to be somewhat tougher than the base case of the International Monetary Fund, but not nearly as harsh as the most pessimistic analyses.”

“This implies that while we may well have turned the corner, we can be far from certain that the solvency crisis in banking is over,” Elliott wrote in a paper this week. “Even if it is, the stubborn credit crunch will last for considerably longer. The banks will be in a better position to lend more freely as a result of the modest influx of new capital and the greater benefit of the confidence boost from passing the tests. However, the depth of this recession and the shattering of the securitization market will keep credit tight for some time.”

One unintended side effect of the results of the stress test, Elliott said is that they will work against the government’s plan to encourage investors to buy toxic assets from the banks.

“The government’s reassurance that these banks have, or will soon have, the capital to handle even the stress scenario without selling their toxic assets makes it harder for the regulators to pressure the banks to actually sell,” Elliott concluded. “This matters because the banks generally believe that even with government incentives the private investors are looking to pay unreasonably low prices for these assets.”

The banks would generally prefer to hold onto the assets until they can get a better price, Elliott reasoned.

Generally across the board, the 19 bank holding companies put to the stress tests, said they believe the stress test assumptions were unreasonably conservative and actual losses will be far less than projected.

Regions Financial Corp. in Birmingham, AL, questioned whether it should be required to raise additional capital now to provide for a two-year adverse economic scenario, particularly in view of the fact that Federal Reserve Chairman Ben Bernanke this past week said that he expects the economy to begin recovering during 2009.

Regions said it believes that the stress test results do not accurately reflect the loan losses that Regions is likely to experience even in the “more adverse” economic scenario. In particular, the anticipated two-year cumulative loss ratio of 13.7% projected on its commercial real estate is sharply higher than Regions’ actual annualized loss ratio on its portfolio in the first quarter and sharply higher than that projected for the other banking companies.

Bank of America Corp. in Charlotte, NC, was projected to have a 2-year loss rate on its commercial real estate loans of 7.4%, or 3.7% per year. Bank of America said its actual first quarter annualized loss rate on the equivalent portfolio was 1.68%. So, loss rates would have to more than double to 3.9% and remain there for the remaining seven quarters to reach the FRB’s projections.

Additionally, the FRB’s loss rate is well above the combined commercial and commercial real estate peak loss rate experienced by Bank of America in either the 1991 recession or the 2002 recession.

Individual CRE Stress Test Results

For some time now, commercial real estate defaults have been one of the other shoes waiting to drop on the economy, and that day may be closer at hand. Real Capital Analytics has reported that delinquent commercial real estate loans grew by 43 percent by the end of the first quarter of 2009 to $65.9 billion, compared with $46 billion at the end of last year.

That hardly means that investment activity is going to grind to a halt, though. Indeed, one owner’s serious misfortune is another’s opportunity. A large (even trophy) example of that would be last week’s sale of Boston’s John Hancock Tower, which was snapped up at auction by Normandy Real Estate Partners and Five Mile Capital Partners L.L.C. for $661 million. Broadway Partners paid a princely $1.3 billion for the structure back in the hard-to-remember days of 2006, but more recently defaulted on the loan.

Both Bloomberg and Reuters, citing unnamed sources, are reporting that casino owner MGM Mirage, which has been vexed recently by the reduced amounts people are willing to spend these days on gambling and other casino entertainments, is talking to private equity firm Colony Capital L.L.C. about refinancing some debts–provided Colony gets a lien on one or more of MGM’s properties. But fresh investment in CityCenter, the unfinished mega-project on the Strip, may not be in the offing. Currently the lending waivers for CityCenter expire on April 13.

An old joke goes like this: You could line up all the world’s economists end-to-end and they still wouldn’t reach a conclusion. The same might apply for noted analysts. In a note to investors on Monday, Calyon analyst Mike Mayo downgraded the bank sector, citing continuing risks posed by credit card and commercial real estate loans. He thinks that in 2010, banks are going to lose on their loans, proportionally speaking, more than they did during a bad year of the Great Depression — 3.5 percent, compared with 3.4 percent in 1934.

On the other hand, Rochdale Research analyst Dick Bove, also in a note on Monday to investors, noted that “my belief is that the economy has turned.” Losses for the banking sector, he asserted, have already peaked.

Who to believe? Wall Street wasn’t quite sure on that point, with the major indices gyrating on Monday. Ultimately, bank stocks–major gainers in recent weeks–took a hit, leading to an overall decline. The Dow Jones Industrial Average was down 41.74 points, or 0.52 percent. The S&P 500 lost 0.83 percent and the Nasdaq was down 0.93 percent.

One rippling effect of mall behemoth General Growth Properties’ bankruptcy may be that it will help re-establish something that’s been missing from much of the commercial property investment market for a while now: pricing.

Sellers have been sitting on the sidelines, and so have buyers, waiting. GGP can no longer warm the bench regarding the disposition of at least some of its properties now. The market will thus ascertain those prices, probably to the benefit of healthier REITs and other major potential buyers, such as Simon Property Group or Vornado.

High-profile bankruptcy sales may not be the only way for commercial real estate to find pricing metrics again, however. Some are betting that such mechanisms as auctions will do the trick as well. “When the market has a hard time determining the price point of a particular property, an auction can create competition that determines value,” John DeMato, president & CEO of Global Real Estate Auctions, told CPN.

DeMato, a former vice president with Inland Real Estate Auctions, recently started Global with other former Inland execs to take advantage of what they see as a prime opportunity for real estate auctions. It used to be that auctions were more common for “properties with more than one potential redevelopment use, or that are unique in character or use,” he said. Those kinds of properties were difficult to value in any market.

“Now, that definition–difficult to value–is being applied to virtually every property on the market because of the recent problems with overvaluation in appraisals and the tightening of lending standards,” DeMato noted. “Auctions aren’t last resorts any more.”

According to the U.S. Department of Commerce, housing starts dropped 10.8 percent in March compared with February, when construction was unexpectedly up–an anomaly, probably. The March total represents an annualized rate of 510,000 units, and is down 48.4 percent from March 2008. Building permits were down 9 percent in March compared with the previous month, an indication that construction in the industry will remain depressed.

That’s been interpreted as bad news for homebuilders, and it may be in the short run, but how many new houses does the market need at this point? According to some estimates, the U.S. has more than a year’s inventory of unsold residential properties on the market, while other observers claim that it will take two or three years to burn off the excess.

In other housing news, RealtyTrac, which tracks residential foreclosures, said that foreclosures were up nationwide in March. The number of filings, ranging from default notices to actual repossession in RealtyTrac’s methodology, was over 341,000 in March, up 17 percent from February, and up 46 percent from March 2008. And which states continued to see the highest foreclosure rates? Nevada and Arizona.

Wall Street shrugged off such numbers on Thursday. The Dow Jones Industrial Average ended up 95.81 points, or 1.19 percent, while the S&P 500 was up 1.55 percent and the Nasdaq gained 2.68 percent.

MARCH 5, 2009

The Office of the Comptroller of the Currency was slow to mandate changes at a pair of banks that were taken over by the government in July, the Treasury Department’s Office of Inspector General said in a report.

The OCC was faulted for its supervision of First National Bank of Nevada and First Heritage Bank, both of which were owned by First National Bank Holding Co. of Scottsdale, Ariz. Despite identifying various problems over a number of years, the federal regulator didn’t act quickly enough to make sure the banks changed their behavior, the report concluded.

“We believe that OCC did not issue formal enforcement action for any of the banks in a timely manner, and was not aggressive enough in its supervision of the banks in light of their weak management practices,” the inspector general’s office said in the report, which is dated Feb. 27.

First National and First Heritage were taken over by the government last July, at an estimated cost of $862 million to the Federal Deposit Insurance Corp.’s insurance fund. The inspector general’s report blamed the failure of the firms on losses from their commercial real-estate loan portfolios, as well as inadequate risk management.

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The gaps in oversight of the banks were the subject of a page-one article in The Wall Street Journal in October. Comptroller of the Currency John Dugan, in a letter accompanying the inspector general’s report, didn’t dispute the findings. “We agree that, based on our experience with these two banks, it is appropriate to take additional measures to reinforce certain expectations and requirements to our examining staff,” Mr. Dugan wrote in the letter. Sixteen banks have failed so far this year, and banks are collapsing at a much faster pace than the 12 that were seized by regulators in the fourth quarter of 2008. A total of 25 FDIC-insured financial institutions failed last year.