Midsize Banks Most Vulnerable to Looming Commercial Real Estate Bust

I've written before about the bomb that's set to fall on U.S. banks in the form of deteriorating commercial real estate loans. Many of these institutions are already buckling because of high losses on their home loans. So a bust in CRE mortgages would hurt, and could be the coup de grace for many banks.

Since 2007, the value of commercial property in the U.S. has plunged 36 percent, according to the MIT Center for Real Estate. Heavy resulting losses on CRE loans, which fund the construction of offices, shopping malls, industrial parks, condos, hotels and other business enterprises, are likely to ripple through the economy. In contrast to the battered residential mortgage market, where a handful of big banks did most of the lending, numerous banks across the country have lots of CRE loans on their books. The problem is industrywide and nationwide.

CRE lending amounts to a huge chunk of change. Nationally, the number of commercial mortgages held by banks has roughly tripled since 1999, peaking at $1.8 trillion in 2008. If there's any good news in the above chart, it's that the growth in the level of overdue loans has dipped in recent months (click on chart to expand). This could mean that CRE loans are falling apart less quickly. Banks also could be moving more aggressively to write them off.

Several factors are driving the problems with CRE loans. Most important is rising unemployment. Fewer jobs means, for example, more office and apartment buildings sitting vacant. No tenants means no cash flow, which leaves banks holding the bag. Commercial mortgages, which often involve balloon payments, are also typically harder to restructure than residential loans.

The most vulnerable segment of banks are midsize institutions, meaning those with $10 billion to $100 billion in assets. That's because these banks typically have a higher concentration of CRE loans on their books than, say, residential mortgages. At bottom, courtesy of investment research firm Concept Capital, is a list of the top 10 publicly traded midsize banks ranked by CRE concentration (The data only encompasses non-farm and nonresidential loans, which is one category of CRE loan).

The publicly listed midsize bank with the highest ratio of CRE loans is W Holding, which offers business and consumer financial services in Puerto Rico. In its most recent quarter it had a net loss of $4.3 million. The major reason for that decline: "decreased net interest income as a result of non-accrual loans and the repricing of variable rate construction and commercial loans," according to W Holding's second-quarter earnings report. Over the last 52 weeks its shares are down 81 percent.

Cathay General, most of whose 49 U.S. branches are based in California, recorded a second-quarter net loss of $24.7 million, as its charge-offs on commercial loans spiked. Its shares have fallen 72 percent over 52 weeks, while return on equity for the first half of 2009 was -2.25 percent. By contrast, it's well-stocked for future economic shocks (for now), with a total capital ratio of more than 14 percent.

The biggest player on our list is Utah's Zions Bancorp. The $53 billion-asset bank holding company, whose shares have fallen 64 percent, lost $40.7 million in the quarter. Total nonperforming loans at Zions have risen more than $900 million since Dec. 31, a surge it attributes mostly to degrading CRE loans in Texas, Nevada, Arizona and California, and to commercial and industrial loans primarily in Texas and Utah.

A caveat: Just because a bank is deep into CRE doesn't mean it's in financial trouble. The No. 4 bank on the list, First Citizens, has long been, and remains, profitable, as its $141 stock price indicates. Nor does it predict whether an institution will fail. That depends on lots of things, including the quality of a bank's managment, ability to raise capital, and diversity of its business and loan portfolio, along with macroeconomic trends, which obviously are uncertain.

Still, given the growing problems with commercial mortgages, a high exposure to CRE suggests a bank will feel the impact as related losses mount. Expect lots of financial turmoil for midsize banks, and a fair number of outright collapses, in the months to come.

Graph courtesy of the Federal Reserve Bank of Cleveland.