Stress Tests And Commercial Real Estate Loans

The leaks surrounding the bank stress tests continues this evening. The WSJ is reporting that 10 of the 19 banks that underwent the test will be required to raise more capital.

The Journal didn’t have any definitive list, just more of the same names being bandied about. Despite all of Warren Buffett’s praise this weekend, it still looks like Wells is on the list though the article indicates that discussions are centered around whether it might be allowed to earn its way out as opposed to raising new capital.

All of the leaks are likely meant to diffuse the impact of the actual announcement. There may be a small flurry of activity when they finally pull away the vails but I think that most of the impact has already been discounted. The real test will come when the chosen few have to actually try and raise some money. I truly wonder if anyone in their right mind would dump any meaningful amount of money into one of them.

A separate but related article in the Journal delves a bit into the growing problem of banks’ commercial real estate exposure. This issue goes far beyond the 19 banks that were subject to the stress test. It truly goes to the heart of the regional and community banks across the country.

While bank regulators aren’t immediately applying the stress-test criteria to small and midsize institutions, banks with high commercial real-estate exposures are drawing greater scrutiny from regulators. Nearly 3,000 banks and thrifts are estimated to have commercial real-estate loan portfolios that exceeded 300% of their total risk-based capital, according to Foresight. Regulators consider the 300% threshold as a red flag, although it doesn’t necessarily mean all those banks are in danger of failing. Risk-based capital is a cushion that banks can dig into to cover losses.

While the failure of a single small bank is unlikely to cause systemic damage to the nation’s financial system, such institutions could have a big impact as a whole. Banks with commercial real-estate loan portfolios exceeding 300% of their total risk-based capital have total assets of about $2 trillion, compared with $2.3 trillion in assets at¬†Bank of America¬†Corp.

This truly is the elephant in the room. While it doesn’t threaten the solvency of the system it does represent a significant challenge for the FDIC and a likelihood that the government is going to have to pony up quite a lot of money to resolve these institutions. The FDIC has already this year seized several small and one fairly large institutions that it was not able to sell to another bank. This results in a larger cost to the agency than they incur when a bank buys the deposits from them.

In my opinion, the economy can’t recover quickly enough to limit much of the damage that’s likely to occur. The assumptions underlying many of the deals were too aggressive and the leverage too great thus the hits the banks would have to take to work out the loans is probably more than they can tolerate.

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