Banks about to face the real estate music

According to a story in the Wall Street Journal, the second phase of financial pain from the real estate bust is about to begin: whereas phase one was focused on the 'demand' side (i.e., homebuyers & mortgages), phase two will be centered on the 'supply' side (i.e., banks forced to mark their real estate collateral to current pricing). As Ivy Zelman concludes, "...this period of procrastination is nearly over."

Federal regulators warned Thursday that banking-industry turmoil would continue as financial institutions come to terms with piles of bad loans they made to finance the construction of homes and condominiums.

Until now, most of the damage to banks from the housing crisis has come from homeowners defaulting on their mortgages. But amid a dismal spring sales season for new homes, loans to home and condo builders are looking increasingly shaky. Banks have begun to dump them at what will likely be steep discounts, setting the stage for billions of dollars in fresh losses...

The surprisingly gloomy outlook is at odds with the sentiment of investors, who appear to have moved on from worrying about the health of the financial system to obsessing about gasoline prices and consumer spending. The Dow Jones Industrial Average rose 213.97 points, or 1.7%, on Thursday on the back of surprisingly strong retail-sales data.

The health of the economy is heavily dependent on the willingness of banks and other financial institutions to lend to consumers and businesses. Many banks have already taken substantial losses, and either will have to pare their lending or raise new capital to rebuild their safety nets. The Federal Reserve and Treasury Department have been pressing banks to raise capital so as not to further reduce lending.

Banks with swelling portfolios of troubled loans tied to land and housing are struggling to unload some of their real-estate debt. IndyMac Bancorp Inc., a Pasadena, Calif., lender, is trying to sell $540 million in loans made to finance land purchases and housing construction projects. Winning bids on many of the loans were, on average, about 60 cents on the dollar, according to people familiar with the matter. But some winning bids were only about 20 cents on the dollar...

The sales are a response to a growing problem: Home builders are falling behind on loan payments, and the value of the land and housing developments that serve as loan collateral is plummeting. Over the next five years, U.S. banks could "charge off" as bad debt between 10% and 26% of their loans tied to residential construction and land assets, which would amount to about $65 billion to $165 billion, according to a report sent to clients Thursday by housing research firm Zelman & Associates. That compares with charge-offs of about 10% of construction-related bank assets, totaling $31.6 billion, when adjusted for inflation, during the last housing downturn in the late 1980s and early 1990s. In 2007 and the first quarter of this year, banks wrote down just 0.7% of such assets, according to Zelman...

The prospect of a new wave of losses worries federal regulators, given the large proportion of loans to housing developers held by many banks and thrifts. The problems are worse at small banks that can't easily absorb losses, and at banks with big exposure in states hit hard by the housing crisis. Banks in Arizona have 36% of their total loans tied to construction and development. In Georgia that number is 34%, and in North Carolina it's 28%. Zelman said construction and development loans, as a percentage of total loans, are at their highest levels since at least 1975.

IndyMac is trying to sell debt backed by a grab bag of assets, including partially built subdivisions, condo buildings and large parcels of raw land covered in sagebrush in parts of California, where the housing crisis is acute, according to people familiar with the offering.

Selling real-estate loans could help larger lenders like IndyMac shore up their balance sheets. But such sales, by setting a market value for distressed real-estate loans, could trigger problems at smaller banks with real-estate exposure, which might have a difficult time absorbing such losses...

Real-estate lenders had been hoping for a decent spring sales season for new homes, which would have helped builders stay current on their loans. But the selling season has been a bust. The rate of foreclosures on homeowners hit a record, as did the rate at which they fell behind on their mortgage payments. In the first quarter, 6.35% of mortgages were at least 30 days delinquent, not including those already in foreclosure, a rise of 1.51 percentage points from the year-earlier period.

"We've seen a real change in the market," says Ricardo Chance, a managing director at KPMG Corporate Finance LLC, who is helping troubled builders restructure their businesses. "Finally the banks are capitulating and saying, 'Let's mark to market and flush this all out.' The market is going to get worse. We don't want to hold on to this stuff."