Small Banks, Tight Credit
Reliance on Souring Development Loans Is Leading To a Cash Crunch, Limiting Funds for Other Businesses

By Binyamin Appelbaum and David Cho
Washington Post Staff Writers
Wednesday, August 27, 2008

Late loan payments and defaults by commercial and residential developers have soared to the highest levels since the early 1990s, threatening the health of some small banks, regulators said yesterday.

The delinquency rate on construction and development loans hit 8.1 percent at the end of June, the highest rate for any category of bank loans, according to new data from the Federal Deposit Insurance Corp. The rate has more than tripled from 2.4 percent at the end of June last year.

The missed payments are forcing banks to hoard money against possible losses and to tighten lending standards. Some chastened banks have even curtailed lending to new customers in order to conserve available funds for existing customers.

Small banks are hardest hit. Many concentrated in construction and development lending during the real estate boom, and they have less financial padding to absorb losses. Regulators said they had added 27 names to a list of troubled institutions in the second quarter, a 30 percent increase, largely because of problems with development loans.

Nine banks have failed this year, none in the Washington region.

Abigail Adams National Bancorp, a small lender headquartered in the District, yesterday suspended dividend payments, saying it wanted to save cash for other needs, including potential loan losses. The company already holds more capital than required by regulators.

The downturn that began with homeowner defaults has now spread through developers and their banks to reach businesses as far removed from suburban foreclosures as a shoe store in Columbia Heights.

Kassie Rempel, owner and founder of the boutique online retailer SimplySoles, went to the Bethesda-based Eagle Bank three months ago for a loan to build her first store, in Columbia Heights in Northwest Washington. Despite growing sales that topped $2 million last year, bank officials required Rempel to personally guarantee the loan. They told her that because of credit conditions, the practice has become standard across banks, she said.

"It gave me pause, but not enough to not proceed with the paperwork," said Rempel, who has been operating her online and catalogue business from her basement in Mount Pleasant.

"I'm breathing a sigh of relief that I applied and was approved three months ago, versus today, because I don't see on the immediate horizon any good news for the credit markets," she said.

A spokesman for Eagle Bank said it would not comment on specific cases.

The rise in delinquent development loans follows a spike in home foreclosures that is unprecedented since the Great Depression.

The delinquency rate for mortgage loans that sit on bank balance sheets is relatively low. Most mortgage loans are made by mortgage companies and sold to investors. Overall, about 8.8 percent of home mortgages were delinquent or in foreclosure as of June, according to the Mortgage Bankers Association.

Delinquency rates on credit cards, home equity and other consumer loans continue to climb but remain lower. Mortgage loans for commercial properties and other loans to businesses have been relatively unaffected.

Many small banks focused on construction lending because it was one of the few areas where they could compete with larger banks. In other areas, large banks used their scale to offer prices and products that small banks couldn't match, from free checking to lower rates on mortgages.

But construction lending was an area where smaller banks could compete by cultivating relationships with developers and embracing risk. And during the real estate boom, it was immensely profitable, leading, among other things, to the founding of many new banks, some of which appeared to be functioning essentially as real estate investment clubs.

Now the tide appears to be turning.

The profit margins of small banks that focused on construction lending shrank below the margins for other small banks in the first quarter of 2008 for the first time since the real estate boom began, according to an analysis by the Office of the Comptroller of the Currency.

Just as larger banks have struggled with defaults on loans to homeowners, smaller banks are now struggling with defaults on loans to home builders.

"We are starting to see the onset of a second round of effects primarily concentrated in residential and commercial development lending that affects more institutions and probably will play out over a longer period of time," FDIC officials said during a news conference yesterday.

A list of troubled banks kept by federal regulators included 117 names at the end of June, up from 90 institutions at the end of March. Those troubled institutions had total assets of $78.3 billion, up from $26.3 billion in March. The June numbers include some banks that have since failed, including IndyMac Bancorp, which had assets of $32 billion.

Further increasing the pressure on banks, FDIC officials confirmed that they will discuss in early October an increase in the insurance premium banks are required to pay on deposits to replenish the insurance fund after the expenses of recent failures.

Regulators and industry officials emphasized that the vast majority of banks remain in strong health. James Chessen, chief economist at the American Bankers Association, noted that total lending volume rose in the second quarter.

"The industry as a whole remains well-positioned to meet the credit needs of local communities," Chessen said.

Federal regulators warned banks in late 2006 to avoid too much concentration in construction and development lending. Almost half the banks in Virginia and 40 percent of the banks in Maryland now have concentrations of such loans in excess of the standard suggested by regulators. Nationally, about a quarter of institutions are above that threshold.

Some bankers say the concern is hard to address. Small banks now exist to make real estate loans, and by nature they rise and fall with the local economy.

"It's not an unfair concern, but I don't know how one really gets around it. We're located here, and this is our market," said John Shroads Jr., chief loan officer at Adams National Bank. "Your fortunes are tied to the place where you operate."

Adams National is the main subsidiary of Abigail Adams, which suspended its dividend yesterday. The holding company also owns a bank in Richmond. It is majority-owned and -operated by women, and it focuses on serving female- and minority-owned businesses.

The company most recently paid a quarterly dividend of 12.5 cents per share in June, and investors expected another payment in September. But the company said this morning that its board of directors had voted to suspend the payments. The company will save about $433,000 each quarter.

"Current economic conditions require prudent management and conservation of capital," said chief executive Jeanne Hubbard.

Banks are cutting back most dramatically on the business that burned them: development lending.

Caruso Homes of Crofton filed for bankruptcy protection after cost-cutting failed to shore up its financial health. Others, such as Seville Homes in Virginia, have lacked the resources to finish some of the homes they started, which has left customers out in the cold.

James Williams, executive vice president of the Northern Virginia Building Industry Association, said banks are hurting builders by tightening lending standards unnecessarily, such as requiring larger down payments or an assurance that homes will sell faster, allowing the loan to be repaid more quickly.

The new requirements feed a vicious cycle, he said. Builders can't borrow money, so their businesses struggle. That, in turn, makes it harder for them to meet their payments on outstanding loans.

"It's the action of the banks, not the performance of the builders," Williams said. "The builders are performing okay in general, but what the banks have done is changed the rules."

But the lending drought could have an upside for the industry in the long run by giving builders time to sell off the excess inventory of homes, office space and storefronts.

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