Small banks may be exposed to nearly $300 billion in bad construction loans granted to local builders and developers according to a new report by the Wall Street Journal. The report estimates that more than 150 local banks could fail under the weight of the defaults.
Construction loans are dicey propositions in the crashing housing market as builders who bet on repaying loans with sold properties may be unable to repay the debt obligations on the existing projects. Some projects are probably already abandoned and others will sell for pennies on the dollar leaving developers insolvent.
Further, because banks often allow developers to hold off on interest payments during construction the true ability of the developer to repay is often not known until it is too late.
More on the small bank crisis from Market Watch:
Small banks have some $280 billion of outstanding construction loans and analysts have predicted that as many as 150 smaller banks could fail in coming years after betting heavily on construction loans, The Wall Street Journal reported.
The practice of allowing real estate developers to delay paying construction-loan interest has raised alarms with regulators concerned that smaller banks are masking potential problem loans, the paper said.
Increasingly popular during the building boom of the last decade, many of these loans allowed banks to calculate the interest that would be paid on the loan overall and then set aside that amount in “interest reserves,” essentially allowing the banks to pay themselves until the property becomes profitable or the loan is paid off.
The loan can then be marked as a performing loan even if the project if it is financing is failing, a practice that concerns regulators, the report said.
But the tanking housing market means many of these projects may not be built — or even financed — leaving banks, and their investors, holding the bag.
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