Will Commercial Loan Losses Hurt Regional Banks?

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Regional banks have varying degrees of exposure to commercial loans. At the end of 2008, the percentage of commercial loans in loan portfolios was 65% for BB&T (BBT), 77% for Comerica (CMA), and 63.5% for Fulton Financial (FULT), while PNC's (PNC) and Marshall & Ilsley's (MI) portfolios were both around 56.5% commercial, according to data that CapitalIQ provided to Oja. While the banks themselves report lower percentages of commercial exposure, CapitalIQ regards as commercial loans many loans that the banks hold for investment, as well as portions of what the banks categorize under specialized lending and revolving credit.

Although commercial real estate loans have performed fairly well thus far in the downturn, the weakening economy and lack of consumer demand is certain to adversely impact commercial properties, which in turn will hurt the quality of those commercial loans, says Tom Kersting, an analyst at Edward D. Jones in St. Louis.

Pressure on smaller commercial owners

With law firms and other businesses cutting back workforce and giving up rented office space when leases expire, vacancies in office buildings are sure to rise. And new tenants most likely will pay lower rents than the former tenants were paying, says Stan Ross, chairman of the Lusk Center for Real Estate at the University of Southern California in Los Angeles. He estimates that 15% of all office space across the U.S. is currently vacant. "We can live with 10% to 12%, but we start really feeling it at 15% to 18%," he says. "And we could get [to 18%]."

Vacancies pose less of a problem for larger owners, who typically can devote cash flow from other kinds of properties to service loan payments to banks, says Ross. "We've seen some of that."

A bigger issue than commercial borrowers' ability to make their annual amortizations is how they will make payments on loans that come due in full by the end of this year. In such an illiquid credit market, many of these borrowers have already had loans default as a result of debt covenants being triggered by other defaults. Banks will be more inclined to extend maturities or modify loan agreements for companies they view as good bets by virtue of their long track records. But less trusted companies likely will be required to sell off some assets or cut operating costs to pay down a substantial portion of the loans, says Ross.

He estimates that banks will choose to extend or modify loans for roughly 75% of the borrowers. "The banks understand that if a shopping center is empty, it's not a question of poor management, it's a question of being impacted by poor economic times," he says.

For the other 25% of the borrowers, banks can take back the assets. They can then use government programs, such as the Treasury Dept.'s Public-Private Investment Program, to sell them—or hold assets they consider good until the market returns.

Stress tests could prompt mergers

But that 25% is enough to cause a lot of credit deterioration in banks' commercial loan portfolios, says Oja at S&P. Total charge-offs for bad loans are now around 2%, up dramatically from lows in 2006, he says. The Federal Deposit Insurance Corp.'s latest quarterly survey showed net charge-offs for all of 2008 of 1.28% for all 8,300 U.S. banks that the regulator guarantees. But fourth-quarter charge-offs reached 1.92%. "It's the trend that has hurt banks a lot," says Oja.

Mounting charge-offs will further threaten already low equity capital ratios for most of these banks. Once the results of the FDIC's stress tests on the banks are made public by the end of April, and certain banks have been shown to be undercapitalized, the government will have to decide which ones it will force to close or merge with stronger banks—and which are worth putting more federal money into.

The missing piece to the commercial lending puzzle that's critical is whether—and in what form—securitization will return, says Ross. "We had a lot of [commercial mortgage-backed] securitization, and that's typically how banks [were able to hand off the loans]." he says. "To survive in real estate, you need an exit. I teach that to all my students."

There will be some problems with banks whose loan portfolios are too heavily concentrated in a particular asset class, such as strip shopping centers, or in certain locations, such as Florida. But overall, Ross says he doesn't expect further deterioration in commercial loans to destroy the banks that made these loans.

And despite the recent rally in bank shares, investors aren't likely to be surprised by how badly commercial loans perform this year, says Kersting at Edward Jones. "It's priced into the stocks at this point," he says.

Bogoslaw is a reporter for BusinessWeek's Investing channel.