by Calculated Risk on 11/10/2009 09:23:00 AM

From Atlanta Fed President Dennis Lockhart: Economic Recovery, Small Business, and the Challenge of Commercial Real Estate

[H]ow serious is the CRE problem for the financial system and the broad economy?

First, let me provide some overview comments: While the CRE problem is serious for parts of the banking industry, I don't believe it poses a broad risk to the financial system. Compared with residential real estate, the size of the CRE debt market is smaller, and the exposure is more concentrated in smaller banks.

However, I am concerned about the potential impact of CRE on the broader economy. Unlike residential real estate, there is not the same direct linkage from CRE to household wealth—and therefore consumption—caused by erosion of home equity. However, there could be an impact resulting from small banks' impaired ability to support the small business sector—a sector I expect will be critically important to job creation.

To add some detail: At the end of June 2009 there was approximately $3.5 trillion of outstanding debt associated with CRE. This figure compares with about $11 trillion of residential debt outstanding.

About 40 percent of the CRE debt is held on commercial bank balance sheets in the form of whole loans. A lot of the CRE exposure is concentrated at smaller institutions (banks with total assets under $10 billion). These smaller banks account for only 20 percent of total commercial banking assets in the United States but carry almost half of total CRE loans (based on Bank Call Report data).

Many small businesses rely on these smaller banks for credit. Small banks account for almost half of all small business loans (loans under $1 million). Moreover, small firms' reliance on banks with heavy CRE exposure is substantial. Banks with the highest CRE exposure (CRE loan books that are more than three times their tier 1 capital) account for almost 40 percent of all small business loans.

To repeat my current assessment, while the CRE problem is very worrisome for parts of the banking industry, I don't see it posing a broad risk to the financial system. Nonetheless, CRE could be a factor that suppresses the pace of recovery. As the recovery develops, the CRE problem will be a headwind, but not a show stopper, in my view.

It's appropriate to be a bit tentative in the assessment of CRE risk to the financial system, however. In 2007, many underestimated the scale and contagion potential of the subprime residential mortgage-backed securities problem. With this experience in mind, my assessment should continue to be refined.

As Lockhart noted earlier in the speech, small business employment has been especially hard hit during the current employment recession. (Note: this is probably one of the key reasons that the BLS birth/death model has overestimated new job creation).

Many of the banks in trouble because of CRE lending are also key lenders to small businesses. Therefore this might limit small business financing, and further inhibit small business job creation.