PrintA year after bad home loans cost banks billions of dollars and nearly crippled the economy, a looming second wave of loan problems could threaten the existence of regional banks such as KeyCorp, Huntington and Fifth Third.
Only this time around, the culprit isn't shaky home mortgages. It's bad commercial real estate loans.
In Cleveland and across the country, more commercial property owners are missing loan payments and facing foreclosure. And the industry is staring down billions in maturing loans, which will need to be refinanced in a lending environment where cash remains costly and scarce.
Commercial loans will be "the most prominent area of risk" for banks over the next several months, Federal Deposit Insurance Corp. Chairman Sheila Bair told Congress last week. Banks took losses on $6.2 billion in loans backed by commercial properties in the past two years, she said, and the amount is likely to grow sharply as more loans come due.
Bair's comments come as the tally of bank failures nationwide has hit roughly 100 this year - an average of one every three days.
"Some banks are very strong right now," said banking expert Fred Cummings, president of Elizabeth Park Capital Management in Beachwood, citing U.S. Bank, Chase, PNC and FirstMerit among those operating in Greater Cleveland. They're actively lending, taking market share and gaining momentum from investors, he said.
It's a different story, though, for Key, Fifth Third and Huntington, all of which are expected to post losses for the third and fourth quarters and for all of 2010. All three banks report third-quarter financial results this week.
"Can all three of these other banks remain independent longer term? That's really where we are," Cummings said.
Widespread problem
The commercial loan problem ranges from apartment buildings to office complexes and shopping centers.
Across the country, commercial property values have dropped by 35 percent to 40 percent. Office building vacancies are rising, as companies that have cut jobs give space back to their landlords. Strip shopping centers, including clusters of small retailers and big-box hubs, have reached their highest vacancy rate in 17 years, according to data from real estate research firm Reis Inc. Malls are the emptiest they've been in at least a decade.
Cummings said he worries that commercial real estate losses will sucker-punch banks that had to raise a lot of money this year by creating thousands of shares of new stock. Creating shares is akin to printing money. It spreads any profits in the future over more shareholders, making it difficult for the banks to post positive news on a per-share basis.
The government in May told 10 of the nation's largest banks, including Key and Fifth Third, that they needed to raise enough money to survive an extra rough economy through 2010.
Key last spring had $18 billion in commercial real estate loans on its books, and Fifth Third had $21 billion. The government said they each had to brace for losses in the 13 percent to 14 percent range.
Meanwhile, banks like AmTrust are still teetering from the blows of the residential mortgage crisis.
Considering that the residential market hit bottom in 2008, the worst commercial real estate losses could be expected in 2010 because there is normally a two-year lag, said banking analyst Terry McEvoy of Oppenheimer & Co. in Maine.
Several issues at work
Commercial real estate borrowers are having trouble for several reasons. First, their tenants are in distress. Job cuts mean many companies need less office space. Store closings have created vacancies in shopping districts. And borrowers whose loans are coming due are having trouble refinancing, especially as property values have dropped by more than one-third.
"We're still in the early innings of losses for commercial real estate," McEvoy said.
And regional banks - midsize banks that operate in several cities or states, including Key, Fifth Third and Huntington - are more exposed to commercial real estate than are the more diversified major national banks, he said.
The banks say they don't expect the government's worst-case scenarios to occur. But just in case, they have big war chests to cover potential losses.
Regional Midwest banks tended to make commercial loans in volatile areas like Florida and California. Their other big concentrations are in Ohio and surrounding states that have been rocked by bad times in the auto industry and rest of the manufacturing sector.
Yuliya Demyanyk, a researcher at the Federal Reserve Bank of Cleveland who specializes in real estate, said the commercial real estate loan crisis poses a greater threat to midsize and smaller banks. They tend to have more exposure to bad commercial real estate loans and are less likely to be saved by the government.
"The smaller banks, these are the banks that are holding most of this stuff," she said.
"The small banks are not systemically important. That means they might fail. . . . There might be an issue with hundreds and hundreds of smaller banks."
Is worst still to come?
Demyanyk said it's too soon to tell whether the worst still lies ahead for commercial real estate. Her analysis shows the total volume of delinquent commercial real estate loans fell in the second quarter both regionally and nationally.
"This is a positive development," she said. It shows that either the loans are going bad at a much slower rate or that banks are being proactive by taking losses on them early rather than dragging them out.
But Cummings expects commercial real estate losses to start being a big deal next year, particularly if more stores close and leave empty spots in shopping plazas after Christmas.
"These losses haven't been material yet," he said. "The worst is yet to come."
Regardless, there is good news for the broader economy, Dem-
yanyk said. The commercial real estate market is about one-fourth the size of the residential mortgage market. That means even steep losses shouldn't ravage banks like bad mortgage loans did.
Economist Jack Kleinhenz of Kleinhenz & Associates in Cleveland Heights doesn't foresee devastation but said big hits are a real risk. And if banks take big losses, that could make them tighten lending even more.
"We're just waiting," Kleinhenz said, "to see if the other shoe drops."
To reach this Plain Dealer reporter: tmurray@plaind.com , 216-999-6315