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Commercial Apocalypse for Banks? Maybe Not

Commercial loans had been cast as a horrific mess headed straight for the banking sector as recently as six months ago, but the impact is proving to be less painful and more targeted than some had feared.

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Here's why: Big banks have relatively little exposure to commercial lending and learned an important lesson from the residential real estate meltdown. They tended to take big, preemptive write-downs on those assets early and were also able to raise a hoard of capital to cover future losses.

For instance, commercial mortgages comprise just 7% of the loan portfolios of the Big Four money-center banks — Bank of America , JPMorgan Chase , Citigroup and Wells Fargo — according to Moody's.

Other banks that were part of the Fed's stress test last year have more than twice that exposure, at 16%, while the rest of the banks rated by Moody's have one-quarter of their loan books weighted in commercial.

Meanwhile, S&P took a look at the small community banks it doesn't rate, whose credit quality it "generally consider[s] to be speculative." Those at the bottom of the barrel had 70% of their assets backed by commercial real estate.

Essentially, the smaller the bank, the more exposed it tends to be to commercial loans, which are having severe problems. Those problems are only expected to get worse through 2011, with higher vacancies, more pricing pressure, additional defaults and corresponding charge-offs.

"We believe CRE [commercial real estate] loan losses have lagged the recent recession, and we are expecting them to rise sharply by the end of 2010," says S&P credit analyst Ronald Charbon.

The default rate for commercial loans recently topped 4% for the first time since the S&L crisis, according to Real Capital Analytics. The research firm expects defaults to top out at a new record of 5.4% next year.

Property values backing the debt have dropped by more than 40% since the 2007 peak, according to one benchmark index. That's an especially foreboding sign for two reasons: The $1.3 trillion worth of maturities due for refinancing over the next few years, and a severe lack of capital.

Where's the Opportunity?

The Big Four banks — and many mid-market competitors — tapped investors for hundreds of billions of dollars in fresh funding over the past couple of years. They could probably get more if they needed to. But small lenders have far less access to the capital markets.

As Robert Klingler, an attorney who works with small lenders at Bryan Cave, recently put it: "A $200 million community bank that's privately held can't go and say, 'I want to raise $1 million on Wall Street. There's just no interest."

So where do the opportunities lie in the commercial mess? Big banks who have room to growtheir commercial books — as well as the capital to lend — and private equity firms buying up their tiny, struggling competitors.

The Obama administration has been eager to open the lending spigots for small businesses. Lawmakers — whose constituents have been very vocal about loan woes — have been happy to comply with additional funding requests.

As a result, the Small Business Administration has been funneling tens of billions of dollars' worth of incentives to banks, which have eagerly accepted corresponding guarantees to issue new loans.

"Credit availability is better," says Barry Sloane, CEO of SBA lender Newtek Business Services. "We were in a freeze-up, so anything's better than a freeze-up."

Secondly, there are opportunities in commercial real estate — the most brutally battered segment of commercial lending — though they're few and far between, and the picture is complicated. CRE originations rose 12% last quarter, according to the Mortgage Bankers Association. The growth was driven largely from lending for retail and office properties, areas that aren't expected to improve this year.

"The ones that come to us most often are the ones that can't get money," explains Sloane, who was speaking about borrowing in broad terms, not CRE specifically. "You have to be careful because as a lender you're adversely selected."

Finally, the securitization market appears to be improving which will help feed the lending process if it continues.

To say that CMBS issuance was "frozen" and remains "icy" may be the understated cliché of the year: New issuance dropped to $3 billion in 2009 from $230 billion in 2007.

Banks in the 'Danger Zone'

However, a $400 million government-backed CMBS [commercial mortgage-backed securities] deal in December looks like it may have been the first sign of a slow thaw. A handful of private deals quickly followed, each worth $500 million or less. Another one presently being marketed represents more than $700 million.

Of course, in all of this, the winners appear to be the big, well-capitalized banking titans — not their small, struggling peers.

Wells Fargo and Bank of America have been out in front of the pack in terms of new commercial lending, offering "fierce competition" for community competitors, according to Sandler O'Neill analysts. Each of the Big Four money-center banks posted declines in commercial lending last quarter, partly because of ongoing writedowns, but it will be interesting to see what emerges from second-quarter results.

As it applies to securitization, it's probably no surprise that big investment banks — at JPMorgan, Bank of America and RBS — are the ones who have handled new CMBS offerings (and received corresponding fees.)

The only bank of the Big Four with serious commercial exposure is Wells Fargo, with commercial, industrial loans and commercial real-estate loans representing 10.7% of total assets. But its NPA ratio for those loans remains in check, at 3%. The only one with substantial weakness in its commercial portfolio is Citigroup, which is facing a 9.4% NPA ratio. Yet its exposure is extremely limited, with the commercial book representing just 1.1% of assets.

Importantly, all of their Tier 1 risk-based capital levels are strong, ranging from 9.9% to 11.5%.

So the banks in the commercial danger zone are ones with big exposure and weak capital, but publicly traded institutions caught in this trap are few and far between, mainly because they recognized the problem early on.

For instance, Popular is a Puerto Rico-based lender with a lot of commercial debt and relatively little capital coverage, but it's performing better than the banks around it, some of which it recently acquired. IberiaBank also has a lot of commercial debt, with much of it souring, but its capital levels are incredibly strong.

Other banks weighed down by commercial burdens, like Sterling Financial , seem to have found respite from private equity.

Buyout firms are understandably eager to buy stakes in struggling lenders on the cheap, but the deals have become less attractive of late with the government able to drive harder bargains for failed banks because of increased competition, and restrictions on ownership stakes and management controls perceived as limiting potential upside for the acquirers.

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Disclosure information was not available for LaCapra or her company.

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