Noah Wilcox's family has owned and operated Grand Rapids State Bank since 1920 and, as he watched colleagues and rivals plunge into Minnesota's hot real estate market over the past decade, he recalled a comment a friend in the business once made: "Real estate is the cocaine of the banking business."
Today, even as the world's biggest banks show signs of recovery, many of the community banks that anchor the nation's Main Streets are paying the price for over-indulging on housing, retail and office projects.
In Minnesota, regulators have seized and closed two banks since 2008 and have ordered 16 others to clean up their balance sheets. Another 65 of the state's 430 banks and thrifts are on a secret watch list, and state banking officials expect more to fail as they are pulled down by bad real estate loans.
Minnesota ranks fifth nationally, with 50, or 12 percent, of its banks carrying particularly high levels of dead real estate loans, according to an analysis done for the Star Tribune by Foresight Analytics, a financial research firm in Oakland, Calif. Only Florida, Georgia, Illinois and California have more banks at such levels.
Joe Witt, CEO of the Minnesota Bankers Association, a state trade group, said the percentage of Minnesota's stressed banks is not out of line given the high number of banks in the state, growth in the metro area during the boom and the flurry of new bank formations.
But some bankers and industry watchers disagree.
"That's inordinately high for a marketplace that's supposedly more rural and more conservative," said Jeff Judy, a former banker and Bloomington-based consultant to the industry.
Foresight estimates that up to 19 Minnesota banks could fail in the next two to three years. Federal deposit insurance will protect most bank customers if that happens, but the mounting pile of bad commercial real estate debt at community banks is taking a quiet toll on the state and national economy. Small businesses that depend on these front-line institutions are finding it tougher, if not impossible, to get loans and lines of credit they need to expand or ride out the recession.
"We've got enough problems as it is," said Andy Winton, chair of the finance department at Carlson School of Management. "It's going to make it that much harder for the economy to recover."
Getting high on profits
Many Minnesota bankers have spent the past two years relearning a painful lesson: real estate loans can wreak sudden havoc on a bank.
Bank consultant Robert Viering, principal of River Point Group Inc. in Monticello, had that lesson drilled into him when he was a regional credit officer at the former Norwest Bank. A credit manual, circa 1990, warned him and his colleagues: "The pivotal issue in CRE lending is knowing when to stop. Restraint must be initiated by bankers because historically borrowers have been unable to recognize the warning signs. Commercial real estate lending should not be viewed as the cornerstone of a loan portfolio."
With more than 100 years in banking, BankCherokee should have known better. But by the end of 2006, the bank's portfolio of commercial real estate loans reached five times its total capital.
"We had it figured out," said Heidi Gesell, president of BankCherokee. "We'd been doing it for a number of years and had not experienced losses."
Now, BankCherokee is sitting on $15.1 million in bad real estate loans and is one of the state's 20 banks warned by regulators in recent years to raise money and clean up its finances.
Steve Gilmer, president of State Bank of Delano, also was hooked on real estate loans -- for building homes and developing land both in the metro area and outstate.
"We thought we were diversifying," Gilmer said. The bank is struggling with nearly $7 million in bad commercial real estate loans -- equal to more than 6 percent of its assets. That makes it among the state's 50 worst for relying on commercial real estate.
"This is a lot different than anything I've ever seen before," Gilmer said.
Many bankers say they turned to commercial real estate loans out of necessity. Auto makers had captured car buyers with zero percent financing. Countrywide Financial and a host of now-infamous mortgage companies were hoovering up home loans. Big banks such as Wells Fargo and U.S. Bank were stealing chunks of small business lending. Even the Farm Credit System, some banks complained, was hogging the rural loan market.
Real estate lending was lucrative. In 2005, a bank could reap $100,000 up front in fees for a $10 million deal. Then there was the interest -- typically a few percentage points above the prime interest rate, the base rate banks charge their best customers.
The math made it simple. It was the best -- and only, some argued -- game in town.
'Hindsight is 20/20'
When it came to gambling on rising real estate values, no one rolled the dice as often as Mainstreet Bank in Forest Lake. A mid-sized bank with eight branches and assets now of about $500 million, Mainstreet was created in 2001 by Minneapolis businessman and veteran real estate financier John Blomquist when he merged The County Bank and Southview Bank.
Mainstreet Bank is not actually on Main Street but on the side of Hwy. 61, a wide commercial strip south of Forest Lake's original downtown, flanked by a clinic and a Moto Mart gas station. Inside the new two-story brick building is the expected row of teller windows, each decorated with a miniature watering can on a red and white gingham cloth.
It's the kind of cozy, small-town touch that seems at odds with Mainstreet's turbocharged real estate lending. The bank did it all: loans for raw land, for developers working on large subdivisions, for contractors building a few houses or a suburban office building.
Its lending tactics were aggressive, though not atypical for development and construction lending: making high loan-to-value loans, accepting land as equity down payment in deals, making second mortgages and structuring loans to cover the interest payments so borrowers didn't have to pay interest for a certain period of time.
Bank management declined repeated requests for interviews but said through a spokeswoman that its loans were within regulatory guidelines and that the loan-to-value relationship only became an issue after the housing market crashed.
Many of Mainstreet's loans were parceled out to a variety of other lenders eager to get in on the real estate action but not large enough to handle them on their own. Sometimes the bank rented a school bus to drive out-of-town bankers around to different projects for which it was trying to drum up interest.
"Every loan that Mainstreet did was backed by real estate," said a former loan officer at the bank who didn't want his name used because he still works in the industry. "No one would look at anything any other way."
For a while, the strategy worked. The bank was expanding, opening about a branch a year, including a new building on Hennepin Avenue near Minneapolis' Uptown.
In 2006, Mainstreet had a return on equity of 20 percent, well beyond the 12 percent national average. At the time, its load of commercial real state loans was seven times its total capital. Only a few dozen banks in the country made more commercial mortgages relative to their size, according to Foresight Analytics.
Ron Stratton, who headed a company focused on construction loans, said if you were a builder needing more than $10 million for a deal, aside from the area's largest banks -- Wells Fargo, U.S. Bancorp and M&I Bank -- there were fewer than 10 banks or specialty construction lenders in town you could go to. His firm, Meridian Construction Capital Group, and Mainstreet were two of them and often competed.
Developer Gary Laurent went to both when he was looking for money in 2005 to buy more than 150 acres of farmland on the western fringe of the Twin Cities. Laurent, a former mayor of Shakopee, wanted to build two subdivisions in rural Corcoran, with a population of 6,000 and no sewer system, including a large luxury housing development called Hedgestone.
Stratton, concerned about the cost of the new sewer system, wanted a significant down payment. Mainstreet, along with other banks it recruited to help mitigate its risks, lent $20.7 million to Laurent, with the land serving as both collateral and a 20 percent down payment.
The housing market slammed shut before Laurent broke ground.
"It's that old story: Hindsight is 20/20," said Laurent, who defaulted. "We're both caught in circumstances that neither of us would like to be in."
Herbie Wensmann went to Mainstreet to finance a major project in Prior Lake. In 2005, at the height of home-building, Mainstreet packaged two loans totaling about $32 million for Wensmann's Jeffers Waterfront, an expansive development abutting The Wilds Golf Club.
Jeffers Waterfront remains half-built. Some streets in the 330-acre scenic development lead nowhere. The neighborhoods are pocked by empty houses and ghost lots with mailboxes. Mainstreet is suing Wensmann's companies to recover $23 million.
Wensmann, now 80, declined to be interviewed for the story.
Diane Wipf, who lives in Jeffers Waterfront, said she has been trying to sell her townhouse to find more space for her family. She's asking $229,000 -- less than she paid for it in 2007. It will "take a miracle" to sell it, she said.
"We have gotten so many homes with lock boxes on them it is unbelievable; just on our little row here there is five or six now," Wipf said. "There's foreclosures all over. I think it's impacted the whole atmosphere around here."
The crash after the high
Effects of the commercial real estate meltdown ripple far beyond sectors in the obvious line of fire. Banks are more likely to call in loans or credit lines, even ones that don't seem troublesome. And they're less likely to make new loans.
"There's going to be tighter credit for everybody ... not just for speculative commercial development loans," said state economist Tom Stinson.
Even before regulators seized Horizon Bank in Pine City last month, customers felt the pullback.
One business owner, who asked not to be named because he still banks there, said the bank this spring cut off several lines of credit he used to help run his businesses, which include a landscaping operation. He'd never been late on a payment, he said, but Horizon told him it couldn't renew certain loans because it had to conserve capital. So far, he has been able to make ends meet and hasn't needed the extra credit.
"Thank God I've been busy enough," he said.
For those seeking financing now, the process can be excruciating.
Businessman Steven Berg estimates that nearly a dozen banks turned him down for a $265,000 loan to buy a building -- an historic brick firehouse in south Minneapolis -- for his company, the seven-year-old Yarn Garage, now in Rosemount.
It was the first time the 48-year-old Berg had applied for a business loan, he said, and the process was surprising and humbling. His top-tier credit score of 780, lack of debt, profitable business with sales approaching $500,000 and extensive experience in clothing design, from stints at Munsingwear to Versace, seemed to count for nothing, he said. He recalled going to five banks in one day, filling out stacks of paperwork, only to collect rejections.
Most of the banks wanted $100,000 down for the loan, about $40,000 more than Berg said he could handle. Some banks rejected him, he said, because of his personal bankruptcy in the mid 1990s. A few banks flat out told him that they just weren't doing commercial real estate loans, period. One simply ignored him.
"I finally called them and their answer was, 'Oh, you were serious?'"
He ended up finding a bank through his real estate agent, whose lake cabin is next to an employee of tiny VisionBank in St. Louis Park -- and with backing of a Small Business Administration program to help entrepreneurs buy fixed assets such as real estate and equipment.
"Particularly now with [commercial real estate] cratering, banks are very nervous," said Alex Blum, president of Minnesota Business Finance Corp., a nonprofit that helps coordinate the loans, which enable a borrower to put as little as 10 percent down to get a low-interest, 20-year fixed-rate loan. "They're all coming to us now."
Berg, for one, is grateful. Standing in the doorway of his new firehouse wearing a sweater he crafted from a fiber he made with fireweed he harvested from some ditches and an old Willie Nelson eight-track tape, among other things, he described finally getting his loan: "Heaven."
The situation is expected to get worse before it gets better.
Foresight Analytics estimates that the nation's 8,000 community banks will suffer losses of $60 billion related to commercial real estate in the next two to three years, and that about 713 banks across the country will fail. Under that scenario, about 19 banks in Minnesota will fail and commercial real estate losses could total more than $2 billion.
Experts say troubled community banks won't rebound until the commercial real estate markets do, and no two crystal balls forecast the same recovery for that. Even Congress is looking for insight, holding a hearing this month on the crisis.
Some area industry watchers report scattered bright spots even now, such as activity in Twin Cities-area suburban industrial centers. But for the most part, they don't think the problems will be resolved until 2010 to 2012.
Two things must happen, say experts. One: The secondary market for commercial real estate loans -- where institutional investors such as pension funds buy bonds backed by big bundles of commercial mortgages -- must thaw. The market is a critical lubricant for financing real estate and getting demand moving again, and it has been all but frozen since last fall.
"Our world is very tied to job growth," said Whitney Peyton, senior managing director of commercial real estate brokerage CB Richard Ellis in Minnesota. "When you think about it, it's filling industrial buildings, it's filling office buildings, it's filling retail buildings with people who are buying stuff."
And that won't happen quickly, cautioned Stinson, the state economist. Minnesota lagged in job growth for years after the 2001 recession. The state's unemployment rate now is 8.4 percent -- a 26-year high. The state has 60,000 fewer jobs than it did when the recession began at the end of 2007, Stinson said, and it probably won't recover those, let alone grow new ones, until 2011.
The result, he said, is that for those community banks in trouble with commercial real estate, "it's going to be a long time to resolve."
Jennifer Bjorhus • 612-673-4683