Regulators Reassure Lawmakers That Banks’ CRE Distress Has Not Hit a Tipping Point

But That Doesn’t Mean Banks Won’t Be Stressed for Several Years To Come

With numbers like $185.5 billion of distressed CRE bank assets on the books at the end of 2010 and another $62 billion in delinquent CMBS loans, the Congressional Oversight Panel in Washington, DC, recently called banking officials to testify on The Current State of Commercial Real Estate Finance and Its Relationship to the Overall Stability of the Financial System.

And officials were circumspect in their outlooks. Yes, the rate of deterioration in market and credit conditions has leveled off, and yes there are some early signs of price stabilization in a number of key markets. Nonetheless, CRE delinquencies and losses are expected to remain elevated for some time.

“While we expect significant ongoing CRE-related problems, it appears that worst-case scenarios are becoming increasingly unlikely,” said Patrick M. Parkinson, director, Division of Banking Supervision and Regulation Commercial Real Estate at the Federal Reserve Board.

“CRE portfolio loan concentrations are not a significant risk factor for systemically important financial institutions,” Parkinson added. “Some systemically important financial institutions have substantial exposures to commercial mortgage-backed securities (CMBS) and to derivatives securities such as CRE collateralized debt obligations. However, risks in these areas have been reduced, as significant mark downs have already been taken on these securities.”

“In addition, conditions in the CMBS market have been improving, with spreads tightening and some new deals coming to market,” he continued. “However, we see losses in CRE to be an ongoing negative factor in bank portfolios that will need to be worked through over the next several years.”

“Additionally, Parkinson said, “delinquency rates on loans backed by existing nonfarm, nonresidential properties leveled off in 2010. Still, even if CRE delinquency metrics continue improving, there remains a sufficiently large overhang of distressed CRE at commercial banks such that loss rates for this portfolio will likely stay high for some time and many banks with CRE concentrations will remain under stress.”

Sandra Thompson, director, Division of Supervision and Consumer Protection at the Federal Deposit Insurance Corp., said banks should not count on the CMBS markets to come to their rescue.

“Disruption in the CMBS market has had a significant impact on market liquidity and has contributed to lower CRE valuations since 2007. A return of CMBS financing is likely to be slow, improving gradually over time with the recovery in CRE market fundamentals,” Thompson said. “In the interim, CRE valuations will likely remain under pressure, and the sector will continue to be highly dependent on depository institutions for new credit.”

“Distressed CRE loan exposures take time to work out,” she added, “and in some cases, require restructuring and/or charge-offs to establish a more realistic and sustainable repayment program given cash flow deterioration.”

Dave Wilson, deputy comptroller, Credit and Market Risk Office of the Comptroller of the Currency, said that even as the commercial real estate markets are beginning to recover, banks and thrifts lag that recovery.

“Notwithstanding the modest improvement in vacancy rates, net operating income – a key driver for CRE property values and the primary source for loan repayment – continues to decline across most CRE sectors. This is because leasing rates remain soft,” Wilson told the congressional panel.

“Given the continued weakness of CRE capital markets, the overhang of commercial mortgages that mature in the next few years represents one of the greatest risks to CRE loan performance,” Wilson added. “Approximately $2.2 trillion of CRE loans are scheduled to mature from 2011 to 2018, with CRE loans from banks representing more than 60% of all maturities over the next few years.”

“Additionally,” he said, “a substantial portion of CRE debt that was expected to mature in 2010 may have been extended into 2011 or later. Permanent or rollover refinancing of these loans may be difficult due to lower property values coupled with lenders’ and investors’ greater reliance on in-place cash flow and more stringent loan-to-value requirements.”

“One mitigating factor is the current low interest rate environment, which allows for some projects to cash flow since debt service requirements are low,” Wilson said. “If interest rates increase without a corresponding improvement in the economy, CRE refinancing difficulties would be exacerbated. This is a situation that we are continuing to monitor.”

Wilson said he expects CRE portfolios will continue to be a drag on national banks’ performance for at least the next 12 to 18 months.

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