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How Banks Will Fare in a Commerical Real Estate Crash


The regional ones will provide a window into the CRE market.

The markets have witnessed the damage from banks with significant exposure to residential and consumer loan markets. But how bad will the commercial real estate crash hurt? Upcoming earnings from some smaller, regional banks will likely give investors that answer.

This week, banks with large commercial real estate (CRE) exposure that are turning in results include First Niagara Financial Group (FNFG) and National Penn Bancshares (NPBC). On Monday, PrivateBancorp (PVTB) reported results that underwhelmed the Street. The stock closed down almost 37% as EPS undershot expectations.

CRE fundamentals have dramatically weakened across major property segments and markets, note analysts at Deutsche Bank. And, since banks have $1 trillion of core commercial real estate loans sitting on their books, according to the FDIC, this understandably has some of our central bankers a bit antsy.

"More pain likely lies ahead for this sector and for those banks with heavy commercial real estate exposure," New York Fed President Bill Dudley said in a recent speech.

There's also evidence to suggest that financial institutions are inadequately protected against potential losses on commercial real estate loans.

The Wall Street Journal reported that banks with heavy exposure to such loans set aside $0.38 in reserves during the second quarter for every $1 in bad loans. That's a sharp decline, reported the Wall Street Journal, from the $1.58 in reserves for every $1 in bad loans from the beginning of 2007.

The number of bank failures continues to rise. In fact, regulators shut down seven more regional banks last Friday, which now brings the tally for the year to 106.

To put that in historical perspective: There have been more bank failures this year than in the past 15 years combined, notes David Rosenberg of Gluskin Sheff.

Dennis Gartman, editor of The Gartman Letter, worries that the number of banks on the FDIC "watch" list has been growing. In the beginning of the year, he emphasizes, there were 250 banks on the list. Now there are 416.

Little wonder then that banks aren't as easygoing these days about making loans.

For the week ending October 14, outstanding bank credit shrank $27 billion, the eighteenth consecutive fall-off, bringing the cumulative contraction to a record $400 billion. That, Rosenberg writes, is a 15% plunge at an annual rate.

A concern is whether the commercial real estate bust will prove to be a repeat of the scene that played out with residential loans. Matthew Anderson, a partner at research firm Foresight Analytics, thinks it will.

Anderson tells us that the total delinquency rate on commercial mortgages rose to an estimated 4.7% in the third quarter, up from 4.1% in the second quarter, and more than double the 2.1% in the third quarter of 2008.

The 4.7% delinquency rate is well below the 8% delinquency rate in the third quarter of 1991, Anderson tells Minyanville, but it's worrisome, he says, in light of a weak economy, constrained credit availability, and high volume of commercial mortgages coming due the next several years.

"By the end of next year, the delinquency rate will hit 7.5% for commercial mortgages," Anderson predicts.

His shop projects 700 banks ultimately take a dirt nap.

Other analysts, like Gerard Cassidy of RBC, are more optimistic. He turned bullish on the small regional banks in May 2009, as he bets on the economy picking up speed.

However, even Cassidy tells investors to sharp shoot carefully for places to commit capital in this space.

"Those banks with excess exposure to construction lending, to non-residential real estate, will have real serious problems," he says.

This leaves the analyst less than enthusiastic, he says, on banks such as The South Financial Group (TSFG).

David Darst of FTN is still finding opportunity in this sector, looking for banks with stringent underwriting standards and solid management teams.

He's telling his clients to buy Signature Bank (SBNY).

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