US alarmed over banks' commercial property loans

Fears of new credit crisis caused by risky commercial property lending by banks

The Federal Reserve has been beefing up its examination of US banks, fearing that profligate lending to commercial property developers could ultimately prove as damaging to the financial system as the subprime mortgage debacle.

An internal presentation given to bank examiners warned that many institutions were being slow to admit their losses on commercial real estate. The author, a property expert at the Fed, predicted that those losses could reach 45 per cent next year.

Revelations about the Fed's alarming internal presentation stoked the debate over whether the credit crisis is truly over. Bearish commentators have long looked to the commercial property market as the "next shoe to drop", potentially dragging the banking system into a new round of retrenchment, which could make future loans harder to come by and tip the economy back into a deep recession

Bulls, however, argue that the market is already well aware of the difficulties property developers are having in filling their retail and office space and the heightened risk of their defaulting on mortgages. Banks may indeed have been slow to account for the losses, but financial markets have already priced them in, bulls say.

Many US banks are holding back on accounting for the expected spike in defaults, according to the Fed presentation, because executives are in "capital preservation" mode. Admitting losses means admitting that a bank's capital cushion has eroded.

"Banks will be slow to recognise the severity of the loss – just as they were in residential," the presentation's author, KC Conway, told Fed bank examiners. Mr Conway is a property expert at the Fed in Atlanta, who is part of the central bank's Rapid Response programme to spread information internally about potential problem areas.

Many property developments which received bank loans in the final years of the boom have mortgages coming due for refinancing over the next 18 months, but the collapse of the securitisation market – where banks typically sold packages of mortgages to other investors – has meant banks are much less willing to extend loans on the similar terms, if at all. At the same time, property values have fallen in many areas of the US, as vacancy rates rise.

Nationwide, office rents fell 8.5 per cent in the past three months, compared with the same period a year ago, the steepest year-over-year decline in 14 years, according to a report by the research firm Reis Inc, released yesterday. But even that was not enough to attract more tenants. The vacancy rate rose 0.6 percentage points to 16.5 per cent, up from 14.2 per cent a year ago.

"We have to look back to 1995 to observe a similar time period when office property landlords were under such pressure," said Victor Calanog, director of research at Reis. "We have yet to observe clear, systematic evidence that the office market is bottoming out."