Ongoing problems in the U.S. economy continue to manifest themselves in new ways. TheStreet .com, an Internet-based financial news service, tabulated a list of banks with high exposure to losses on construction loans. Six of the top 20 are in the Twin Cities metro area.
The list highlights a long-standing phenomenon in U.S. banking: We have a few very large banks and numerous small, community-based banks. Such small banks are thought to be more responsive to the credit needs of their communities than large national banks based in financial centers like New York, San Francisco or Charlotte, N.C. But many of them are vulnerable when specific sectors like farming, property development or construction go south.
This was clear 25 years ago. There were then 14,000 commercial banks in the United States. Canada, with about one-tenth of the population of the United States, had 14 banks.
More than 12,000 of the U.S. banks were small, state-chartered institutions that operated in one community outside of large population centers. Many were in farming areas and had loan portfolios dominated by agricultural lending.
All of the Canadian banks were large banks, almost all with branches across several provinces. All had diversified portfolios of loans to large corporations, medium and small businesses, farmers and consumers.
U.S. agriculture experienced a boom following the devaluation of the dollar in the early 1970s. Land prices soared. When the Reagan-Volcker era of high interest rates hit, farmers suffered a double whammy. The cost of servicing farm loans soared. High interest rates increased the value of the dollar and priced U.S. farm products out of world markets.
Hundreds of thousands of farms went bankrupt. Many more underwent severe financial restructuring. Ag lenders had to write off billions in bad loans. Hundreds of banks went broke and were liquidated by regulators or sold to healthier banks.
Canadian farmers had financial problems too, but they were not as severe. As in the U.S., many ag loans in Canada went bad and had to be written off. But no Canadian bank went broke because of farm-loan losses. They all were diversified across enough sectors that a rough patch in farming did not threaten their solvency.
So far, banks’ problems with construction and property-development lending remain much smaller than those with farm lending 25 years ago. Some observers believe, however, that construction loans already listed as nonperforming – 90 or more days past due – are the tip of an iceberg and that many more such bad loans will be disclosed in coming months.
Managers of banks on the list emphasize some important points: At most banks, construction loans remain a small portion of total loans. One St. Paul-based bank, for example, said that all its construction loans come to only 12 percent of total assets.
Moreover, not every loan listed as nonperforming will be a 100 percent loss for the bank. Lenders generally have some security interest in the projects they finance. Foreclosing on this collateral may take time, but will yield considerable amounts for the banks. Furthermore, banks in the region generally remain well capitalized.
While this is all true, details are illuminating. The bank with only 12 percent of its assets in construction has bad loans equaling 3.8 percent of assets. For a bank with $268 million in assets, this would amount to about $10 million in bad loans. The bank may remain healthy but some of its customers from the construction industry obviously are very troubled.
Second, the 1980s ag crisis showed how what seems safe for any one individual loan may not be when troubles affect a whole sector.
Most farm loans made prior to 1982 were well collateralized, at least on paper. If any single loan went bad for some reason, the lender could foreclose and sell the collateral for more than the amount owed. But when hundreds of farms in one country were going broke, the market value of land and machinery dropped so much that their sale did not cover outstanding loan balances. Lenders had to write off enormous losses.
In the same way, if one construction project goes belly up, the collateral will cover the loan. But if dozens of construction projects are all going belly up at the same time, the fire-sale value of unsold houses and strip malls may cover only a fraction of the loan amounts they secured.
Don’t go away, this story may be back in the news in coming months.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.