After an initial flurry of bank failures in January, the pace of bank closures more recently has slowed. There has been only one failed bank so far in February, and there were none at all this past Friday night, the first failure-free Friday in several weeks. The apparent bank closure slowdown does not, however, mean that the worst is past; indeed, if a recent Congressional watchdog committee report is accurate, there may be many, many more bank failures ahead.
The Congressional Oversight Panel was created to oversee the expenditure of TARP funds and provide recommendations on regulatory reform. The Panel is chaired by Harvard Law Professor Elizabeth Warren.
On February 10, 2010, the Panel released its 190-page February Oversight Report, entitled "Commercial Real Estate Losses and the Risk to Financial Stability." The Report can be found here, and the Panel’s February 11, 2010 press release about the Report can be found here.
The Report paints a dire picture of the current and likely future performance of outstanding commercial real estate loans. The Report begins by observing that the Panel is "deeply concerned that commercial loan losses could jeopardize the stability of many banks, particularly the nation’s mid-size and smaller banks, and that as damage spreads beyond smaller banks that it will contribute to prolonged weakness throughout the economy."
The fundamental problem is that between 2010 and 2014, about $1.4 trillion in commercial real estate loans will reach the end of their terms. Nearly half are "underwater," meaning that the borrower owes more than the property is currently worth.
The commercial real estate borrowers’ problems are two-fold. The weakened economy means that the borrowers are having problems realizing sufficient cash from the properties to cover their principal and interest obligations (or, to give the problems its technical name, to maintain their "debt service coverage ratio"). The deeper problem is that when their debt obligation matures, they won’t be able to refinance the loan due to tougher bank underwriting standards or property value decreases.
Figure 31 on page 72 of the Report graphically illustrates the problem. The bar graph shows that commercial mortgage maturities will hit their highest levels between 2010 and 2014, with the peak coming during 2012 and 2013.
The timing of the debt maturities is all the more unfortunate, because they arise as signs point to continued (and perhaps progressively worse) deterioration of real estate market fundamentals. As the Report notes, "commercial real estate metrics tend to lag overall economic performance." For the last several quarters vacancy rates have risen and average rental prices have fallen for all major commercial property types.
Unless the nascent economic recovery picks up sufficient momentum to reverse these negative trends, the likelihood is that many of the maturing real estate loans will fail. Which means trouble for many smaller banks.
According to the Report, 2,988 of the roughly 8,100 U.S banks have a "CRE Concentration," meaning that such loans represent at least 300% of total capital or that construction and land loans exceed 100% of capital.
The danger is not just to the banks, according to the Report; rather, because of the downward spiral that defaults trigger, "a significant wave of commercial mortgage defaults would trigger economic damage that could touch the lives of nearly every American."
The Report is neutral on the possibility whether an economic recovery could avert the worst of these concerns, saying only that "there is no way to predict with assurance whether an economic recovery of sufficient strength will occur to reduce these risks before the large-scale need for commercial mortgage refinancing is expected to begin in 2012-2013." The Report urges the Treasury and the banking regulators to "take coordinated action to address forthrightly and transparently the state of the commercial real estate markets."
Although the Report itself does not address this issue, an accompanying problem that is exacerbating these issues for many smaller banks is the banks’ past issuance of "trust preferred securities" to raise capital and fund loans. As I discussed at greater length here, these hybrid debt-equity instruments were a popular way in recent years for many banks to raise funds. Between 2000 and 2008, more than 1,500 small and regional banks issued about $50 billion in trust preferred securities, according to a February 12, 2010 Wall Street Journal article (here).
But as the current banking crisis has unfolded, certain features of these securities have operated to magnify many banks’ woes. The first is that the buyers of these instruments were in many cases other banks. As the issuing banks’ finances have deteriorated, the value of the instruments to the investor banks has also declined. Indeed, the deteriorating value has contributed to the demise of at least some of investor banks (about which refer here).
As the Journal article itself notes, these instruments give the buyers certain preferences. However, the existence of these preferences, which ensure that the holders of the instruments would be first in line to recover losses, means that other prospective investors now are wary of making any further investments, for fear that their investments would be subordinated to the trust preferred securities holders. These circumstances leave some banks unable to raise additional capital, "increasing the possibility that some of the weakest banks could fail."
Many banks are trying to repurchase their trust preferred securities at steep discounts, in a bid to circumvent these problems, but many of the holders (in many cases, other banks with their own problems) are reluctant to sell and be forced to recognize and absorb their losses. As the Journal article notes, "the standoff is particularly perilous for banks that are reeling from deteriorating real-estate portfolios."
The bottom line is that many banks will face daunting circumstance possibly for several years to come. These concerns in turn present a challenge for D&O insurance underwriters as they struggle to assess the risk exposures associated with these financial institutions. Whatever else might be said, it does seem likely that the current unsettled D&O insurance marketplace for lending institutions will continue.
As one time, and for many years, I was responsible for managing a team of D&O underwriters. If I were managing D&O underwriters today, particularly if our portfolio of risks included lending institutions, I would require all of my underwriters to read the Congressional Oversight Panel’s latest Report. It makes for some sobering reading.
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