by Calculated Risk on 7/28/2009 12:36:00 PM

From San Francisco Fed President Janet Yellen: Outlook for the U.S. Economy and Community Banks. A few excerpts:

[T]he normal dynamics of the business cycle are turning more favorable. Some sectors are poised to rebound simply because they have sunk so low. For example, the auto industry has cut production so far that inventories have begun to shrink, even in the face of historically weak demand. Just slowing the pace of inventory liquidation will bolster economic activity. This story holds for many sectors of the economy where spikes in inventories occurred as cautious consumers cut back on purchases of durable goods, and businesses slashed spending on equipment and software. Looking forward, the demand for houses and durables should also eventually revive as old and broken-down goods need to be replaced. The resulting demand will help the economy recover.

But that recovery is likely to be painfully slow. History teaches that it often takes a long while to recover from downturns caused by financial crises. Financial institutions and markets won’t heal overnight. And it will take quite some time before households have repaired their tattered finances. Until recently, households were saving less and borrowing more in response to wealth gains in both stocks and housing. This pattern made their balance sheets vulnerable to adverse developments and the crashes in both house and stock prices during the last two years destroyed trillions of dollars of their wealth. Not surprisingly, the personal saving rate has now shot higher and I expect to see subdued consumer spending for some time. The unprecedented global nature of the recession also will act as a drag. Countries recovering from financial crises often receive a boost from foreign demand, but neither the United States nor its trading partners can count on such external stimulus this time.

A gradual recovery means that things won’t feel very good for some time to come. The unemployment rate currently is 9½ percent, and this figure is likely to rise further. Moreover, even after the economy begins to grow, it could still take several years to return to full employment. The same is true for capacity utilization in manufacturing, which has declined so far that it has fallen “off the charts”—now standing at its lowest level in the postwar period.

Finally, even though downside risks to the outlook have diminished, there remains some chance that economic conditions could turn out worse than what I’ve sketched. High on my worry list is the possibility of another shock to the still-fragile financial system. Commercial real estate is a particular danger zone...

And on community banks:

Now let me turn to the business environment facing banks. The industry is going through one of the most difficult periods in modern times. ... Bank profits are down, loan delinquencies are up, and failures are climbing.

... Recessionary effects normally take some time to work their way through loan portfolios. So, even though I expect economic growth to resume in the second half of this year, banking conditions are likely to remain quite weak for another year or two.

To date, the community banks under greatest financial stress are those with high real estate concentrations in construction and land development lending. Banks that liberally funded speculative housing and condominium construction, and those that funded land acquisition and development, have been hardest hit. Over 20 District financial institutions have failed since last year. The vast majority of them had high concentrations in residential construction and development lending. In fact, these banks had construction loans that averaged about 40 percent of their loan portfolio, well above the District average of 16 percent. Unfortunately, some banks that aggressively pursued these loans had weak appraisal and risk-monitoring systems.

The next area of significant vulnerability for the banking system, particularly for community and regional banks with real estate concentrations, is income-producing office, warehouse, and retail commercial property. Market fundamentals in most western states are deteriorating. Vacancy rates are rising and rent pressures are hurting property cash flows. Office vacancy rates in both Boise and Portland are expected to reach or exceed 20 percent over the next year or two, the highest rates these cities have seen in many years. Retail shopping centers are struggling with falling occupancy rates and pressures to grant rent concessions. Property values are falling sharply across wide areas of the country, including the Pacific Northwest. Some analysts forecast that commercial property values could experience falls similar to housing of 30 to 40 percent.
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Our biggest concern now is with maturing loans on depreciated commercial properties. In many cases, borrowers seeking to refinance will be expected to provide additional equity and to have underwriting and pricing adjusted to reflect current market conditions. In some cases, borrowers won’t have the resources to refinance loans.