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Small banks could take construction loan hit

By MarketWatch

Last update: 8:10 a.m. EDT June 25, 2008

NEW YORK (MarketWatch) -- Small banks could be greatly exposed to billions of dollars of outstanding construction loans to home builders and developers, a published report said Wednesday.

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.

As a result, this month the Federal Deposit Insurance Corp. instructed its bank supervisors to pay particular attention to banks that may not be as forthcoming about their trickiest loans, because they have been counting on the interest reserve to cover the initial loan payments.

"You don't want to have a false sense of security because the interest reserve is paying the loan," Steve Fritts, the FDIC's associate director for risk management and exam oversight, told the paper. "You need to look to the credit fundamentals of the project."

The FDIC sent cease-and-desist orders to some banks requiring them to revamp how they use interest reserves, including Arizona's Towne Bank and HomeTown Bank and Integrity Bank, both in the metropolitan Atlanta area, the report said.