Sam Chandan on the State of the Banks

For a majority of the nation’s banks, more stable economic and financial market conditions than those that prevailed during the

For a majority of the nation’s banks, more stable economic and financial market conditions than those that prevailed during the recession are supporting a return to healthy profits and a modest increase in net new lending. Following seven quarters of improving profitability, the F.D.I.C. reports that banks posted their highest earnings since the beginning of the financial crisis in Q1’11. The share of unprofitable banks has fallen as income has edged up, from 19.3 percent in Q4’10 to 15.4 percent in the most recent reporting period.

Even though broad financial-activities employment growth has been weak, and in spite of uncertainties related to the implementation of Dodd-Frank, employment among regulated banks has expanded by 3.2 percent over the past year, increasing net payrolls by more than 65,000 jobs.

Commercial Real Estate Default Rate Flat
Loans in default across all sectors, a key measure of the banking system’s health, fell by $17 billion in Q1’11, dropping 4.7 percent from the previous quarter.

The default rate on commercial real estate and multifamily loans—including loans 90 days or more delinquent and loans in nonaccrual status—was essentially unchanged at 4.2 percent, 24 basis points below its cyclical high of 4.42 percent in Q3’10. The results are consistent with my model projections last quarter that banks’ commercial real estate distress was nearing a plateau across most institutions.

While commercial real estate default rates were unchanged in Q1’11, the overall statistics mask a 12 basis point drop in the multifamily default rate, to 3.62 percent. Consistent with momentum in multifamily property fundamentals, including rising rents and occupancy rates and strengthening investment activity, the default rate on banks’ multifamily mortgages is now 105 basis points below its Q3’10 peak of 4.67 percent, recovering faster than other loans in other property sectors and well ahead of construction loans.

Matching the weak outlook for development activity outside of the multifamily arena and a few C.B.D. office markets, the default rate for construction and development loans remained exceptionally high in Q1’11 at just under 16 percent. That compares unfavorably with a cyclical low default rate of just 0.38 percent measured in Q4’05. The weight of nonperforming construction loans is especially heavy for regional and large community banks, where they account for 8 percent of the dollar volume of all balance sheet loans and where commercial, multifamily and construction combined account for 42.5 percent of all lending.

Banks Narrowing Exposure to Commercial Real Estate
Even as commercial real estate credit conditions improve, the impact of nonperforming construction loans, a complex regulatory environment and competition among lenders for relatively lower-risk lending opportunities are leading banks to narrow their exposure to the sector.

Combined commercial real estate and multifamily loan balances peaked at $1.307 trillion in Q3’09 and have since fallen by $28.4 billion. Construction lending, characterized by much shorter duration loans, has fallen precipitously. Peaking in Q1’08 at $631.8 billion, construction loan balances have since fallen by more than 50 percent, to $295.5 billion as of Q1’11.

Banks may seek to increase their loan originations for stabilized properties in the coming quarters, but will face stiff challenges from other lenders seeking to extend credit for core assets, particularly in major coastal markets.

Outlook: Challenging for Smaller Lenders; New York Banks Fare Better
With improvements in lending and investment trends concentrated in a relatively small number of coastal markets, the current data confirm that the outlook remains challenging for smaller lenders and lenders in geographically localized markets. Large community and regional banks account for almost half of all banks’ commercial real estate and construction loans outstanding.

Moving more slowly than their national counterparts in clearing their balance sheets, they hold 62 percent of all real-estate owned (REO) as of Q1’11.

New York-based banks outperformed the national benchmarks, with a smaller share of loans in default across the commercial real estate, multifamily and construction pools. The default rate for commercial real estate loans held by New York banks declined to 2.44 percent in Q1’11, down from 2.69 percent in Q4’10 and 3.06 percent a year earlier.  New York’s multifamily default rate is 2.02 percent, essentially unchanged from 1.99 percent in Q4’10 and down from 2.49 percent a year earlier.

Consistent with the observable correlation between loan performance and banks lending activity, New York’s lower default rates coincide with an expansion of banks’ commercial real estate balance sheets. Bucking the national trend and supported by stronger loan demand in and around New York City, New York banks increased their commercial real estate balances to $51.5 billion ($86.3 billion including multifamily loans), up from $49.6 billion in Q4’10 and $47.6 billion a year earlier.

Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. Sam Chandan on the State of the Banks