Smaller banks at risk if commercial real estate falters

A blizzard of commercial real estate defaults could bury hundreds of community banks, a congressional watchdog reports Thursday.

The Congressional Oversight Panel, created to oversee the government’s bailout fund, is warning that losses on commercial real estate loans could reach $300 billion, potentially wiping out “hundreds more community and midsize banks” and drying up the credit needed to restore the economy to health.

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Over the next three years, a commercial real estate collapse “could overwhelm an already-weakened financial system,” panel Chair Elizabeth Warren says in an interview. “The commercial real estate problems would be tough to absorb in any economic environment. But they come at a time when the economy is fragile and the banking system is even more fragile.”

Bank failures numbered 140 last year and 16 so far in 2010. Now, commercial real estate is absorbing a one-two punch:

•A weak economy has pushed vacancy rates higher and rents lower, forcing developers to default on loans. Standard & Poor’s says the situation looks like the early ’90s commercial real estate meltdown that killed hundreds of banks. Citing figures from the real estate firm CB Richard Ellis, S&P says office vacancy rates reached 17.3% in the third quarter of 2009 and are likely headed higher, vs. a peak of 18.9% in 1991. Retail vacancies are already at 12.3%, vs. 11.3% in ’91. S&P says most banks it rates can survive if losses spread over a few years.

•About $1.4 trillion in commercial real estate loans will mature between now and 2014, which in many cases means developers will need to refinance or make balloon payments that exceed the value of the underlying properties. Deutsche Bank estimates that more than 65% of commercial real estate loans might not qualify for refinancing because banks have tightened underwriting standards and property values have collapsed.

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Smaller banks will bear the brunt of commercial real estate losses: “Over the last decade, the Wall Street banks sucked up all the credit card and home mortgage lending that used to be the bread and butter of these community banks,” Warren says. So they turned to commercial real estate.

A robust economic recovery “would be the best elixir,” says real estate analyst Jonathan Miller. “Our forecast suggests that probably will not happen.”

Will the government rescue little banks the way it rescued big ones? Says Warren, “Who will bear the losses? Some will be borne by investors, some will be borne by community banks and some may be borne by taxpayers. … We’re going to have to make some tough choices.”

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