Archive for October, 2010

Failed Banks…….The Story Continues

Many people are asking why so many banks are still failing even though the roots of the credit crisis go back to 2007.  The simple answer is that the FDIC has limited resources and can only focus on a certain number of banks at any given time.  Just like a doctor in a hospital ward focuses on the sickest patients first, the FDIC has focused their attention on the weakest banks first.

The bigger question is when it will all come to an end and get back to “normal”, whatever that means these days.  My guess is that it could literally be 10 years before we start seeing new bank charters being granted on any significant level.  We still have a long way to go before banks are finished working through the bad loans they have now and the regulating agencies that grant bank charters will likely be slow to forget the lessons of the past three years (and years still to come).

The first wave of bank failures was associated with institutions that had heavy concentrations in residential real estate.  This market fell very far, very fast and took many banks down with it.  Early in the credit crisis, many of the banks that were not concentrated in residential real estate touted the fact that they were concentrated in commercial real estate loans and that they were insulated.  Unfortunately for these banks, there problems were just over the horizon.

Commercial real estate is generally valued on the level of rents a property can earn.  During a time of high unemployment there is lower demand for all types of commercial rental properties — office, retail, warehouse, and others.  Lower demand produces lower rents.

Weakness in the commercial real estate market has developed more slowly because leases expire at different times.  Any given property many have a series of leases that expire any time from this year to five years from now or even longer in some cases.  As leases expire in a market like the one we are in, tenants have many options and can lock in lower lease rates.

On the surface this does not seem like a huge problem but a quick analysis reveals the real issue.  Take a typical office building in which the average rent is $20 per square foot.  The total expenses for this building may add up to somewhere in the neighborhood of $17 per square foot and the last $3 per square foot is the profit to the owner (known as “net operating income” or NOI in the real estate business).  In the current market, a building with an average rent of $20/sf in 2006/2007, may only be able to sign new leases with rents of $15/sf.  The owner’s costs of managing a building are relatively fixed so in this example, they are now taking a $2/sf loss but this is far better than letting the space go unleased which would result in a $17/sf loss for that particular space.

For banks that are concentrated in Commercial Real Estate, this is a major issue because the building they hold as collateral is now valued at significantly less than it was at the time the loan was made.  But because leases expire at different times, the cracks in the foundation of the Commercial market have been much slower to emerge than those of the residential market which appeared almost overnight.

This problem will continue for several more years as commercial real estate owners work through the challenges of covering a relatively fixed expense based with lower rents.  Compounding the problem is the increasing number of commercial foreclosures………..If an investor buys a building out of foreclosure, their cost per square foot is lower than that for neighboring buildings and they can make a profit even at much lower rental rates.  This puts owners of non-foreclosed properties at a further disadvantage as they try to compete against properties with a much lower cost basis.  It is a downward spiral that will negatively affect commercial real estate for years to come as well as the banks that have financed those properties.

So what about the banks that will survive?  Where are their loans concentrated?  The best performing loans in the current market are ones to strong individual borrowers and to profitable operating companies.  Contrary to many media reports, banks ARE still lending and many banks never stopped lending at any point throughout the credit crisis.  Generally, credit standards are very similar to what they were at any point in the recent past and banks are still lending based on these standards.  The banks that aren’t lending, in many cases, are avoiding adding new loans because of capital issues (see previous post on capital).

As the economy reemerges (yes, it will reemerge) consumers and commercial borrowers will regain their strength and many of the banks that lend to them will in turn regain their strength.  In the short term however there will be some additional weakness in the market and there will be additional bank failures as a result.

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