Builder loans are the forgotten land mine in U.S. credit crisis
By James Saft ReutersPublished: March 10, 2009
LONDON: Banks in the United States face a new source of write-downs and failures in the coming year, as loans made to developers to finance residential and commercial property development rapidly go bad.
Because these loans are old-fashioned and concentrated in smaller banks, their outcomes are particularly interesting, as they indicate that issues with the banking system go far deeper than the so-called toxic assets belonging to the largest lenders that have thus far gotten most of the attention and government aid.
They are also a great illustration of the difficulties of stopping a housing and deleveraging crash.
Called acquisition, construction and development, or ADC, loans, they total 8.4 percent of all bank loans, just below a 30-year peak, and are used by developers to buy land, put in infrastructure and construct housing or commercial space.
And because they depend on a reasonably healthy real estate market when projects are completed - someone who is willing to buy or rent the properties - they are now in deep trouble.
"Everyone in the media is focused on consumer foreclosures," said Ivy Zelman, a housing analyst at Zelman & Associates. "What they're not focused on is the builder-developer foreclosures, which are only in the early innings and which will continue to wreak havoc as these assets are liquidated at depressed prices. Until they are cleared, there can't be a stabilization in home prices."
Zelman thinks the pressure will cause "hundreds of banks" to close.
"The Federal Deposit Insurance Corporation doesn't have the funds to deal with all this," she said. "They can't examine the smaller banks fast enough."
Zelman estimates that U.S. banks risk having to charge off an additional $84 billion in ADC loans between now and 2013, equal to a hit of 9 percent of Tier 1 capital.
Nonperforming ADC loans hit 8.5 percent at the end of 2008, up from just 3.2 percent the year before.
Developers, struggling to survive without reliable cash flow from sales, are drawing down on commitments from banks that are not secured. The percentage of unsecured construction loans drawn down hit 73 percent, above the peak in the 1990s real estate slump and a crucial sign of builder distress.
Of particular concern is that ADC loans are concentrated in smaller banks, which tend to have deep ties to local developers. ADC loans account for 47 percent of nonperforming loans at small banks, compared with 14 percent at larger banks.
And you cannot blame mark-to-market or toxic securitizations for these losses. They are considered held-to-maturity and are not typically included in any complex securities.
Chris Whalen of Institutional Risk Analytics, which specializes in bank risk analysis, sees ADC loans as part of the difficulties banks face with commercial real estate and believes that regulators will have to get tough with banks.
"It will be subject to an impairment test, and then they will have to start charging it off," he said. "The regulators are already beginning to force the community banks."
And while smaller banks being closed by the FDIC may not get the attention of a bailout of a big bank, every failure depletes resources and hurts credit availability.
The FDIC fund fell by almost half in the fourth quarter alone, touching $18.9 billion as it set aside a large portion of money for actual and expected bank failures. The FDIC has said it needs a bigger cushion, but efforts to impose special fees on healthy banks will inevitably hit profitability and credit availability.
Senator Christopher Dodd, Democrat of Connecticut and chairman of the Senate Banking Committee, is moving to introduce legislation that would more than triple - to $100 billion - the FDIC's line of credit with the Treasury Department.
But beyond bank failures, ADC loan troubles point to the intractable problems of a real estate bust.
Banks, while trying to reduce their overall exposure to these loans, have been reluctant to pull the rugs from under borrowers because, as with a house foreclosure, they would end up owning a hard-to-sell underlying asset. But more foreclosures are coming, and with them fire sales, as banks compete with developers, homeowners and other foreclosure sales to liquidate inventory.
That will drive land and real estate prices down further and suck others into what amounts to a self-reinforcing negative cycle.
That's true for housing, true for banking and true for the economy.
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