by Calculated Risk on 11/02/2009 02:12:00 PM

Testimony of Jon D. Greenlee, Associate Director, Division of Banking Supervision and Regulation on Residential and commercial real estate

[T]he condition of the banking system is far from robust. Two years into a substantial economic downturn, loan quality is poor across many asset classes and, as noted earlier, continues to deteriorate as weakness in housing markets affects the performance of residential mortgages and construction loans. Higher loan losses are depleting loan loss reserves at many banking organizations, necessitating large new provisions that are producing net losses or low earnings. In addition, although capital ratios are considerably higher than they were at the start of the crisis for many banking organizations, poor loan quality, subpar earnings, and uncertainty about future conditions raise questions about capital adequacy for some institutions. Diminished loan demand, more-conservative underwriting standards in the wake of the crisis, recessionary economic conditions, and a focus on working out problem loans have also limited the degree to which banks have added high-quality loans to their portfolios, an essential step to expanding profitable assets and thus restoring earnings performance.
emphasis added

On Commercial Real Estate (CRE):

Prices of existing commercial properties have already declined substantially from the peak in 2007 and will likely decline further. As job losses have accelerated, demand for commercial property has declined and vacancy rates have increased. The higher vacancy levels and significant decline in the value of existing properties have placed particularly heavy pressure on construction and development projects that do not generate income until after completion. ...

As a result, Federal Reserve examiners are reporting a sharp deterioration in the credit performance of loans in banks’ portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of 2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for multifamily housing developments. Of this, $1.7 trillion was held on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion. Also at the end of the second quarter, about 9 percent of CRE loans in bank portfolios were considered delinquent, almost double the level of a year earlier. Loan performance problems were the most striking for construction and development loans, especially for those that financed residential development. More than 16 percent of all construction and development loans were considered delinquent at the end of the second quarter.

Of particular concern, almost $500 billion of CRE loans will mature during each of the next few years. In addition to losses caused by declining property cash flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. The losses will place continued pressure on banks' earnings, especially those of smaller regional and community banks that have high concentrations of CRE loans.

The current fundamental weakness in CRE markets is exacerbated by the fact that the CMBS market, which previously had financed about 30 percent of originations and completed construction projects, has remained closed since the start of the crisis. Delinquencies of mortgages backing CMBS have increased markedly in recent months. Market participants anticipate these rates will climb higher by the end of this year, driven not only by negative fundamentals but also by borrowers’ difficulty in rolling over maturing debt. In addition, the decline in CMBS prices has generated significant stresses on the balance sheets of financial institutions that must mark these securities to market, further limiting their appetite for taking on new CRE exposure.

Higher vacancy rates, sharply lower rents, reduced leverage and much higher cap rates - back in July, Brian called this the "neutron bomb for RE equity"; destroys CRE investors and banks, but leaves the buildings still standing.