Tuesday, August 11, 2009

Waiting for the Other Shoe to Drop


According to a recently published report by a Congressional Oversight Panel reviewing the effectiveness of the Troubled Asset Relief Program (TARP), many banks remain vulnerable due to questionable commercial loans still held on their balance sheets. This is a looming problem for community and smaller banking institutions. Smaller banks are being adversely effected by the the rise of commercial loan defaults. Many community banks have large loan exposures to shopping malls and other small businesses hard hit by the recession.

The report states, "Owners of shopping malls, hotels and offices have been defaulting on their loans at an alarming rate, and the commercial real estate market isn't expected to hit bottom for three more years, industry experts have warned. Delinquency rates on commercial loans have doubled in the past year to 7 percent as more companies downsize and retailers close their doors, according to the Federal Reserve.

The commercial real estate market's fortunes are tied closely to the economy, especially unemployment, which registered 9.4 percent last month. As people lose their jobs, or have their hours reduced, they cut back on spending, which hurts retailers, and take fewer trips, affecting hotels."

Defaults in sub prime and other residential mortgages precipitated last years banking and credit crisis. The TARP program succeeded in stabilizing a banking system that was teetering on collapse. The $700bn infusion into the banking system appears to have buttressed depleted capital ratios and severely stressed balance sheets of large banking institutions. But many banks are still carrying troubled assets on their balance sheets. Commercial Mortgage Backed Securities (CMBS) values are tied to the cash flows generated by renters and lessors of the underlying mortgaged properties. As occupancy rates of commercial properties fall cash flows dissipate. The market value of these securities plummets creating a distressed condition. This places additional strain on the banks balance sheet driving capital ratios lower and places a banks liquidity and ability to lend at risk.

The TALF (Term Asset Backed Loan Facility) was instituted in March to extend $200bn in credit to buy side financial institutions to purchase troubled assets and remove them from banks balance sheets. So far only $30bn has been allocated through the program. Clearly banks balance sheets remain at risk due to their continued high exposure to this asset class.

A strong economic recovery will address this problem. A prolonged recession will resurrect the banking and credit crisis we experienced last autumn. It would appear that TARP II may be a necessity if more private sector investors don't step up to the plate and participate in TALF.

Risk: CMBS, commercial real estate, banks, credit risk

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