Local and regional banks have so many souring commercial real estate loans that they have begun to fail at a rate not seen since . . . well, you know. The latest was Colonial Bank of Alabama, which was rescued last week at a cost to the Federal Deposit Insurance Corp. of about $2.8 billion, the sixth-largest bank failure in history. And over the coming year, it will be a rare Friday afternoon that the FDIC doesn’t announce the takeover of some bank that lent too much to local builders and commercial real estate developers despite abundant evidence that a bubble had developed. It’s a good bet the agency will have to replenish its coffers by drawing on its line of credit from the U.S. Treasury.
Then there’s the matter of half a trillion dollars in securitized loans that were made during the bubble and will be coming due over the next few years. These will need to be refinanced. Unless the securitization machine can be cranked up again, there’s simply not enough lending capacity at the banks and insurance companies to fill the gap. Moreover, there can be no refinancing until the current owners of the buildings come up with billions of dollars in fresh equity to make up for what has already been lost.
Consider the example of a hypothetical office building bought for $100 million back in the go-go days, with 90 percent of the purchase financed with borrowed money. Now, suddenly the loan needs to be refinanced, but the value of the property has fallen to $65 million. In the new conservative environment, the owner can only get a new loan for $40 million, which means that in order to avoid foreclosure and keep ownership of the building, he has to come up with an additional $50 million in equity. Given that the value of the building would have to hit $90 million before anyone would realize a dime in profit, investors probably won’t be lining up for that opportunity.
So how does all this get resolved?
In the case of buildings that still generate rents sufficient to pay the monthly interest charges, the lenders — that is the holders of the mortgage-backed securities — will probably agree to extend the loan for a few years in the hope that property values quickly rebound and the market for securitized loans revives. “Amend, extend and pretend,” as my friend Arthur, the real estate maven, put it.
In the case of projects with rising vacancies and falling rents, however, the more likely scenario is that the lenders would foreclose on the property and sell it for whatever they can get. The problem is that if too many buildings are dumped on the market at the same time, it would trigger a self-reinforcing downward cycle that could depress property values even further, leading to more foreclosures and causing even more banks to fail. That’s what happened back in the savings and loan crisis.
Hang on – this financial crisis isn’t over just yet.
– Steven Pearlstein, “Commercial Credit Crunch Means We May Not Be Out of This Yet”, The Washington Post, August 21
Excellent piece by Steve Pearlstein from Friday’s Washington Post. Everybody should read it.