Loans threaten Minnesota community banks

For much of the past two years, Minnesota's community banks have seemed to escape the credit crisis engulfing the nation's largest banks.

Until now.

Dozens of Minnesota banks have entered the new year on shaky footing, hobbled with millions of dollars of commercial real estate loans going sour at an alarming pace. Several analysts predict that some community banks could fail in the state this year, as the slump that began in the housing market spreads to business loans backed by land and buildings.

"Any bank that has a sizable book of commercial real estate loans could have serious problems in 2009," predicted Jamie Peters, a bank analyst at Morningstar in Chicago.

Across the state, banks are beginning to feel the impact of loans they made to borrowers during the real estate boom, when property values went nowhere but up. The delinquency rate on commercial mortgages and construction loans made by Minnesota banks jumped 84 percent from the third quarter of 2007 to the same period in 2008, according to Foresight Analytics, a real estate research firm in Oakland, Calif. As of the third quarter of last year, 5.7 percent of commercial real estate loans in Minnesota were more than 30 days past due, up from 3.1 percent a year ago, according to Foresight Analytics.

Officials with the Minnesota Department of Commerce, which regulates 429 state-chartered banks and credit unions in Minnesota, acknowledged the problem and said they are concerned. The department's watch list of banks it considers in "less than satisfactory" condition has nearly doubled over the past 18 months to 50, from 26 in June 2007. A handful of those banks are at risk of possible failure, say Commerce Department officials, though they declined to identify them.

In contrast with past economic downturns, many of the problem loans are showing up at Twin Cities metropolitan-area banks, as opposed to banks in small towns and rural areas, said Kevin Murphy, deputy director for financial institutions for the Commerce Department. "We've had a booming, consumer-oriented economy for many years here in the metro area," he said. "And the merry-go-round has stopped. Not everyone is finding a seat when the music stops."

The fallout could ripple through the state's entire economy, analysts said. As the economic slump deepens, and more commercial real estate loans go into default, banks will be under increased pressure to dump bad real estate loans and to curtail new lending as a way to preserve capital, analysts said. Many Minnesota banks dipped into their cash earnings in 2008 to shore up their reserves against loan losses.

Already, local real estate developers say they have noticed banks tightening credit standards on land and development loans. They're asking for additional collateral and demanding quicker repayment.

"A bank will never tell you that they're not doing loans," said Richard Lewandowski, head of Edina Development Corp., a real estate development firm that has struggled recently to raise financing for projects. But developers "know that every one of them is reducing their exposure to real estate."

Amid the financial turmoil last year, it was widely assumed that many community banks had steered clear of the excesses that got bigger banks and thrifts into trouble and led to a $700 billion bailout program.

But it was community banks that spearheaded much of the real estate overbuilding, say analysts, and the bad loans are now starting to turn sour as the economic decline accelerates.

Last week, in an apparent recognition that the financial crisis was spreading beyond the giants on Wall Street, President-elect Barack Obama said he will ask his Treasury Department to direct more money to community banks.

"The community banks were taking risks that other banks weren't willing to take," said Tony Plath, a finance professor at the University of North Carolina at Charlotte.

Overextended

As of last year's third quarter, nearly 30 percent of all banks in Minnesota -- or 133 banks -- had commercial mortgages and construction loans exceeding four times their core capital, a level regulators consider excessive, according to Foresight Analytics. Core capital includes a bank's common stock and retained earnings, and is considered a key indicator of a bank's ability to absorb losses. While such a ratio doesn't mean a bank is in danger of failing, it is cause for concern, analysts say.

Even more jarring, 86 banks in Minnesota had commercial real estate loan delinquency rates of more than 10 percent as of the third quarter, according to Foresight Analytics. And 28 of those banks had delinquency rates in excess of 20 percent. By comparison, the national delinquency rate on commercial real estate loans is just 4.9 percent. Analysts consider a delinquency rate of more than 5 percent on a book of loans to be troubling.

"With real estate exposure like that, the probability is high that a number of Minnesota banks will not survive the year," said Plath. "The young banks that haven't been through a recession will be in particular trouble."

Nationwide, the financial industry is experiencing its largest number of bank failures since the third quarter of 1993. In the third quarter of last year, 73 financial institutions were absorbed in mergers and nine failed, according to the Federal Deposit Insurance Corp. (FDIC) Among the failures was Washington Mutual Bank, a savings and loan with $307 billion in assets and the largest insured institution to fail in FDIC history.

'Murphy, deputy director at the state Commerce Department, added that much of the weakness in community bank portfolios in the state is confined to construction and development loans, not business loans secured by commercial real estate. He cautioned against drawing hasty conclusions about a bank's health by focusing on one indicator, noting that many banks with a sizable exposure to real estate as a percentage of their capital are "excellent banks," he said.

"If they're all good loans, then who cares? It's not a problem," he said. "But if a bank has four or five big loans ... and they all go bad, that could have catastrophic results."

Collateral 'just isn't there'

Still, delinquency rates on commercial real estate loans have surpassed levels of 1994, at the end of the last recession and on the heels of the savings-and-loan debacle. And evidence is building that businesses, and not just developers, had overpaid for properties based on future income assumptions that have not materialized.

"If you think losses were bad in 2008, just wait," said Jennifer Thompson, an analyst at Portales Partners in New York. "The problem is that land is arguably worth almost nothing. There's no demand for it. ... So when a business runs into trouble, the collateral just isn't there."

At Brickwell Community Bank in Woodbury, commercial real estate loans outstanding totaled more than eight times its core capital as of the third quarter of last year, according to Foresight Analytics.

And delinquencies within the bank's commercial loan portfolio rose to 10.1 percent, more than twice the national average. The bank posted a $2 million loss in the third quarter of last year, largely because it had to increase its reserves against future losses.

Brickwell has stayed away from construction and development loans to home builders, but it's still affected because some borrowers were businesses that sold supplies to builders or contractors, said Ivar Peterson, president and part owner of Brickwell, which focuses on Dakota, Ramsey and Washington counties.

"In this environment, there are a lot of things that keep bankers up at night," Peterson said. "But my biggest worry is the inability of my borrowers to repay their debts caused from the downturn of the economy. ... We're not in the business of owning any real estate."

Chris Serres • 612-673-4308