Deutsche Bank: Construction Loan Defaults Coming
Interesting piece from Deutsche Bank on rapidly deteriorating Construction loans. DB predicts that “construction loans will be the epicenter of bank loan problems”
• By far the riskiest type of loan product in bank portfolios;
• Substantial portion represents loans to homebuilders;
• Market currently penalizing properties with vacancy issues extremely severely;
• Newly constructed (or only partially constructed) properties are the poster children for vacancy problems in CRE;
• Values of most newly constructed properties are down massively;
• Expect extremely high default rates and extremely high loss severity rates, both likely to be in excess of 50%;
• Total expected losses of 25% or more.
In a reversal of the Residential Real Estate market, the exposure for large money center banks is low — smaller regional and community banks have the highest construction loan exposure.
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Construction loan exposure for smaller banks has nearly doubled since 2004
Construction loans are structured with upfront reserves — meaning that it takes much longer for CRE defaults to occur. Low short-term interest rates also means reserves can last longer — BUT, as DB notes, Once reserves are exhausted, defaults will skyrocket.
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The current delinquency rate is 15%, but may head much higher
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Source:
The Outlook for CRE and Its Impact on Banks
Richard Parkus
Deutsche Bank, 30 July 2009
http://gm.db.com/IndependentResearch
August 5th, 2009 at 12:36 pm
There is the construction loan problem but the tsunami to hit the beach will be the commercial loans that are going to default next. Do not worry we can fire up the printing press to pay for that one too!
August 5th, 2009 at 12:50 pm
then these banks will fall like dominoes- they have no clout w/ the Treasury and the Fed as we found with the TBTF banks – they had a win/win plan- and friends in the right places-
you must be a massivley bloated enterprise to get the USG on your side- think C, BAC & GM
August 5th, 2009 at 12:51 pm
How about referencing open, public available, sources.
August 5th, 2009 at 1:02 pm
Then why is the IYR still going up and my SRS going down?
August 5th, 2009 at 1:06 pm
>>Then why is the IYR still going up and my SRS going down?
SRS like any other multiple reverse ETF should be a day trade at best. the old addage the market can stay irrational longer than you can stay solvent applies. CRE will suffer but as BR points out they take far longer to unwind and right now the can is being kicked down the road. homebuilder i know of that are sitting on inventory aren’t being very aggressive on price due to waiting for the ‘inevitable’ bounce back in pricing power + being given some leeway by their lenders who are probably having the same delusions. RE will be a downward staircase pattern with slight blips up along the way but we’re nowhere near a bottom. how you play that in the IYR/SRS market is anyone’s guess but so far the facts haven’t gotten in the way of the trends.
August 5th, 2009 at 1:21 pm
In a reversal of the Residential Real Estate market, the exposure for large money center banks is low — smaller regional and community banks have the highest construction loan exposure.
Sounds like DB saying: Really, it’s not us this time!
August 5th, 2009 at 1:36 pm
CR has been all over the number of new bank failures each week, but maintains (if I’m recalling this correctly) that the number will ultimately fall far short of the failures which occurred during the S & L crisis of the late ’80s.
Is this a widely held conclusion, or is there a case to be made that the number of contemporaneous bank failures will rival or surpass that of the S & L crisis when it’s all said and done?
August 5th, 2009 at 1:46 pm
Barry: Got another favorable review at http://www.marketwatch.com/story/ritholtz-gets-to-the-roots-of-bailout-nation-2009-08-04
August 5th, 2009 at 1:50 pm
“Construction loans are structured with upfront reserves”
The way construction loans are structured always makes me think of the protagonist in Tom Wolfe’s “A Man in Full”, a real estate developer, that named his $2 million racehorse “First Draw”.
Even better is the mechanism whereby interest charges on the loan are paid by advances against the loan. It could take awhile before these dogs start howling. In the meantime, you can bet the developer’s new Mercedes came off the “upfront reserves”.
August 5th, 2009 at 1:51 pm
I work for a commercial RE developer in the NW. We have been hired by several banks (mostly local, one large national one) to help sort out failed projects (construction stalled, cost overruns, construction defects, no foreseeable market, unable to secure bridge/perm loans, etc.) they have provided construction loans on. Based upon our experience, I wholeheartedly agree with this post. There is a wave of doom coming in commercial real estate and it begins with these types of loans. Projects now defaulting were started at the peak of easy finance, developed to low low yields and suffered from high and increasing construction costs.
As Rikky says above, the banks are absolutely kicking the can down the road.
I’d add a few items to the list above:
-Like many of their assets, if banks actually revalued all their construction/CRE loans, they would be instantly insolvent.
-On for-sale residential projects (esp. condos), there is tremendous liability in taking ownership (through foreclosure), so banks have little to no leverage against borrowers.
-Banks have not been enforcing policy with regard to loan administration, so cost overruns have resulted in loans being drawn down much farther than construction progressed (which works when condos are selling and offices are leasing, as the borrower has cash flow to fund the cost overruns). That’s no longer the case and banks get stuck with the costs overruns to preserve whats left of the value in the project.
-For some smaller banks, they are bumping into their maximum exposure limits to single borrowers, so even if they wanted to put in more money to complete the projects, they can’t.
-Many of these loans are syndicated, so there is a logjam between all parties as to the best method to solve the problems (under capitalized banks want to sit around and hope for the best, rather than deal with problem).
-Appraisal/market study fraud, similar to SFR homes. Banks/borrowers used appraisals and market studies to underwrite projects based on projected (increasing) rents/sales prices, not comps or gasp, declining rates.
August 5th, 2009 at 1:53 pm
Also add that construction loans are IO, while perm financing is now an amortizing world. Increase in debt service is a shock, if they can even get permanent financing.
August 5th, 2009 at 2:09 pm
drey,
CR has pointed out the number of bank failure will be much less, but has also pointed out that banks today are also much larger in size and have more branches than in earlier days:
“Of course the number of banks isn’t the only measure. Many banks today have more branches, and far more assets and deposits. ”
http://www.calculatedriskblog.com/2009/07/fdic-bank-failures-update.html
August 5th, 2009 at 2:12 pm
Whats this? Reality? Who needs that shit anymore?!
Theres a new paradigm at work here and its called…
“Just buy the KBE and the IYR, all will be fine.”
August 5th, 2009 at 2:42 pm
Thanks, jr, for that link. And thanks, heditor, for that insightful post.
August 5th, 2009 at 2:58 pm
Extend and pretend baby! And then hand the bill to the taxpayers and all their descendants, until the generation down the road finally defaults and and curses our names, writing us into the history books as one of the most selfish, irresponsible and immoral eras to ever come down the pike (oops, slipped into a rant)
Oh yeah, BKX is up 3+% today. Nothing to see here.
August 5th, 2009 at 3:27 pm
My oh my, my FAZ has just gotten destroyed these past three months. I keep holding on believing reality will once again set-in, but no luck. Do I hold or do I fold?
My FXP has actually gotten hit even worse….. China, the market that keeps on going up and up and up…….
August 5th, 2009 at 3:53 pm
@jdamon33:
I’d wait until National Day (October 1) before thinking about FXP.
August 5th, 2009 at 4:22 pm
jdamon-
the problem is that you are up against a money printing machine and tacit agreement between the the Fed/Treasury and the market makers to reflate asset prices-
tough odds- SKF is now $29- ( a 2X finance inverse)- its high was over $300- tough to compete agsinst the program trading and the creation of money at will
August 5th, 2009 at 4:36 pm
There is only one way for this market to go and that is up, up and up! Who cares about CRE, just another reason to crash the dollar…and we all know that a weak dollar is great for the stock market. Don’t we? Sell your bonds jump into the stock market where nominal gains can be made hand over fist.
September 8th, 2009 at 5:50 pm
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