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The next stress tests

Scott Jagow Sep 16, 2009

The Federal Reserve is planning to conduct a new round of analysis on smaller banks around the country, according to the Associated Press. The goal is to figure out just how much danger lurks in the commercial real estate market.

From AP:

The Fed review is focused on roughly 800 regional and community banks, the official said. The Fed’s “stress” tests earlier this year on the 19 biggest banks already examined commercial real-estate loans.

Unlike the “stress” tests, the Fed’s examinations of smaller banks are not expected to be made public. The extra scrutiny of commercial real estate loans is being done through the normal supervisory process, the official said.

Instead of going over individual banks with a fine-toothed comb, the Fed will be trying assess risk across the industry. And here’s why:

Ninety-two banks have failed this year, according to the Federal Deposit Insurance Corp. Hundreds more are expected to collapse in the next few years largely because of problems with commercial real estate loans.

That sounds especially scary considering that we’re “technically” getting out of recession. We’ve been hearing for months that commercial real estate is the next shoe to drop, but how heavy is the shoe? From the Atlanta Journal-Constitution:

Nearly half of all the commercial real estate mortgage loans in the U.S. are coming due within the next five years. Deutsche Bank believes that 65 percent or more of these loans will fail to qualify for refinancing. Existing high vacancy rates will continue without new job creation.

But Jim Rohr, CEO of PNC Financial Services recently expressed some optimism to the Washington Post. He said commercial real estate will not be another housing market collapse:

Rohr explained his reasoning: Banks hold mortgages on homes. If a homeowner defaults on his or her mortgage, the bank loses that stream of revenue.

Banks also hold mortgages on shopping malls, a big chunk of the commercial real estate sector. If the economy forces one of the mall’s tenants to go out of business, the bank should be able to re-rent that space, albeit at a lower rate, Rohr said.

So, even though the bank’s revenue stream is diminished from the commercial property, it is not halted, as it is from the residential property.

Another reason for optimism is that the Fed is acting now, instead of trying to dismantle a bomb after it’s already exploded. This week, the IRS also issued a new rule that might help alleviate some of the problems with commercial real estate loans. From the Wall Street Journal:

“There is today a stalemate caused by tax fears involving borrowers, lenders, servicers and investors” that is holding up “a significant number” of loan modifications and extensions, Jeffrey DeBoer, CEO of the Real Estate Roundtable, which has been pushing for the change.

The new rule would grant leeway to servicers to negotiate with borrowers on performing loans that may not be coming due for some time. The change applies to all loan modifications that were made after Jan. 1, 2008.

Commercial Mortgage Securities Association President Patrick C. Sargent, said the new guidance won’t have a tremendous impact because servicers already have been working with borrowers to extend or modify loans.

So, there’s a question mark there. And boy, the risk analysis of hundreds of community banks is yet another thing piled onto the Fed’s plate, which is scary in and of itself.

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