Banks’ Commercial Mortgage Default Rates Fell–Now What?

The rate of growth in banks’ defaulted loan balances had slowed considerably in the first three quarters of 2010, declining for the first time in Q410. The $573 million increase in the default balance in Q310 was just a fraction of the $7.2 billion spike in Q209, when default balances were rising at their fastest pace. In Q410, the default balance fell by almost $1 billion, and now stands at $45.8 billion.

The drop in the rate and balance of defaulted loans comes on the heels of 17 consecutive quarterly increases in the former. At the low point in defaults, in Q1 and Q2 of 2006, the default rate was just 0.58 percent. By comparison, the current default rate is just shy of its record high of 4.55 percent, reported in 1992.

And so while the new results can be greeted with cautious optimism, it is clear that legacy challenges have yet to abate for many institutions.

As banks have worked through only a subset of these loans–including delinquencies, there are $57 billion in problem loans on bank balance sheets–the potential for significant additional losses remains a key feature of the marketplace, particularly in secondary and tertiary markets, where recovery rates on liquidated exposures remain relatively weak.

While the commercial default rate declined on the margin, the multifamily default rate fell sharply between the third and fourth quarters, from 4.67 percent to 3.74 percent. The record-setting improvement in the multifamily loan metric coincides with increasingly broad-based improvements in the sector’s cash flow fundamentals, leading early gains in for other property types.

Over the course of the downturn, the increase in the default rate for multifamily mortgages had been more dramatic than for commercial real estate generally. At its peak in Q310, the multifamily default rate was nearly 20 times higher than the 0.24 percent default rate measured in early 2005. The improvement raises hopes that the locus of bank stress may be shifting away from new defaults and toward challenges related to unwinding distress, especially in cases where related property fundamentals are firming.

The weight of unresolved distress is manifest in greater regulatory and supervisory oversight when making new loans, as well as adjustments in lending standards and many banks’ willingness to extend new credit in the sector.

As a result of these shifts, banks have been drawing down their exposure to commercial real estate, making new loans at a slower pace than that at which maturities, amortization and distress have removed exposure from their balance sheets.

The latest data suggest that the decline in bank balances is beginning to moderate, though it lags behind other capital groups, where lending may now be increasing. In Q410, total commercial real estate mortgage balances fell by $2.1 billion, a smaller decline than in past quarters. For the year, balances fell by $20.5 billion. Multifamily balances increased slightly over the year, by $2 billion.

Default rates are highest at the largest institutions (those with $10 billion or more in assets), where the concentrations in commercial real estate are lowest and the capacity to absorb related losses benefits from diversification. At smaller institutions (those with less than $1 billion in assets) default rates are generally lower.

For example, at banks with between $100 million and $1 billion in assets, the commercial mortgage default rate was 3.42 percent in Q410, lower than the average across all bank lenders.

But concentrations in commercial real estate, multifamily lending and construction lending remain much higher at smaller institutions. Combined with the lagging recovery in values in secondary and tertiary markets, where these banks dominate lending activity, the greater concentration still implies a much more limited capacity to manage related losses.

Increases in lending activities of large institutional lenders, including life companies, have resulted in an improvement in credit availability in many of the largest and most liquid metropolitan areas and for the highest-quality properties. This trend will see further support from an increase in securitization activity.

But outside of the major metros-including New York, Washington, D.C., and San Francisco, among a select few others-transaction activity and bank credit remain relatively constrained.

The decline in bank-held commercial mortgage defaults suggests that the sector’s contribution to bank distress may be nearing a plateau. Nonetheless, banks still face serious challenges in drawing down their default and real-estate-owned balances, and in working toward a normalization of credit in the markets where bank lending is most critical for the recovery.

schandan@rcanalytics.com

Sam Chandan, Ph.D., is global chief economist of Real Capital Analytics and an adjunct professor at the Wharton School.