First Bank, a firm headquartered in St. Louis, sounds like a real basket case: loan charge offs in the latest quarter were up 202% and profits were down 90%, to just $2.5 million from $25 million a year earlier. Its parent, First Banks, Inc., also disclosed that profits were overstated by $11.1 million over three years due to irregularities in its mortgage division.
Non-peforming loans were so common that 25 banks chartered in the region and surveyed by the Business Times reported that cumulative increases in NPLs were up 165% vs the year prior and profits were down more than 35%.
According the the Business Times, bankers there expect it to get worse before it gets better. “I expect the first quarter trend showing greater charge offs to continue through most of 2008″, said Mike Flavin, President if the Business Bank of St. Louis.
Falling home prices remain at the center of the problem as these regional banks, which were basically forced out of big real estate and corporate loan syndicates by the ravenous and much cheaper CDO, CLO and CMBS markets, wound up heavily exposed to local housing markets with risky loans to small, local developers.
Not only have these banks been getting burned by loans to developers, but high yielding small loans to rehabbers have also turned south. “The rehabbing business has been difficult,” said Rick Bagy, President of the First National Bank of St. Louis. “Everyone went into the rehab business in the last 10 years – doctors, lawyers, housewives – because it was easy money.”
And punctuating that point was still another article relating the story of Triad Bank, yet another local lender, that was foreclosing on a local rehabber and seeking up to $1 million in the foreclosure suit. These are big numbers for small local banks and one of the major reasons why the FDIC, OCC and other regulators are stepping up their supervision of local and regional banks and their lending practices.
Forget worrying only about commercial mortgages, there are a number of Mortgage REITs out there, as many of you know, that bought and originated Trust Preferred’s as a way of diversifying out of real estate. Many of these TruPs were covenant-lite and therefore poster children of the credit bubble: easy money just didn’t get any easier. This was because these particular REITs were turning around and issuing CDOs secured by the TruPs, which was the ultimate OPM game. For those of you who don’t know what OPM is, there is a book entitled OPM that was written about a leasing company of the same name. It is great reading, and illustrative of what happens when a lender’s interests and a borrower’s interests are no longer aligned.
No earnings after issuance? No problem! Busted tangible net worth covenants? Why bother to calculate it, pay that mob of lawyers to get it right in the docs and then monitor it all for compliance? Let’s just leave that pesky provision out of the deal, shall we? After all, it’s not our money, hey? We’re just in it to collect management fees, so it’s really no problem if you don’t pay us back.
Among the many concerns now facing the banks that coughed up TruPs as fast as the lawyers could replace the ink cartridges on their printers are strong recessionary pressures within the US economy, outsized exposure to residential construction loans and home equity loans, and reduced short-term profitability. Significantly, these are not isolated problems at one or two thrifts, or just one or two wayward mortgage lenders (e.g., IMB). It is spread throughout the country, and it is particularly bad in the Southeast and West, two of the hottest housing markets in 2005 and 2006.
Fitch Ratings, evidencing this increasing pressure, has been notified of the deferral of TruPs payments at 11 banks and the complete default of one since September 2007. These 12 banks issued US$644.5m in aggregate TruPs and subordinated debt through 46 Fitch-rated CDOs. “Further bank deferral and default activity is likely, given current economic conditions,” says Fitch senior director Nathan Flanders.
Near-term wholesale defaults appear unlikely, but the breadth of the problem is the issue, as evidenced by my anecdotal reading of just one midwestern business journal on my way through an airport. I’m not sure that anyone could have seen it all coming, except that the lack of covenants should have been a tip off: without covenants, there is no way to declare a technical default and get access to assets before it’s too late.
As a result of the observed and expected collateral deterioration underlying bank TruPs, Fitch has revised both its rating and asset performance outlook on US bank TruPs CDOs from stable to negative. This should be no wonder, since by the time they are able to declare a monetary default, holders of the TruPs will be practically last in line for any recovery.
Fitch is also currently reviewing bank TruPs CDOs with deferral and/or default exposure or other high-risk exposure and expects to place materially affected transactions on rating watch negative in the near future. “The magnitude of underlying collateral currently in deferral or default will likely be the most significant determining factor in Fitch’s analysis,” adds Flanders.
Not wanting to get caught with its blinders on, Fitch says that its deliberations on ratings will also give consideration to individual exposures that Fitch believes will create increased risk, such as banks facing heightened regulatory scrutiny, banks which have recently reduced or eliminated dividends on common equity, or those with an above average level of exposure to high risk real estate. Given what’s been happening in the market, this would seem to include just about everybody.
Additionally, Moody’s has downgraded 53 tranches issued by 10 CDOs with significant exposure to residential mortgage REIT Trust Preferred Securities (Trups) and homebuilder securities. It said that the rating actions were prompted by continued credit deterioration and defaults in the residential mortgage REIT and homebuilder sectors.
Four of the affected CDO series include Attentus CDO (series I to III), Kodiak CDO (series I), Taberna Preferred Funding (series II to VII) and Trapeza CDO (series X). Moody’s said that these CDOs have significant exposure to these sectors, ranging from approximately 25% to 50% of their aggregate portfolio balances. The rating actions also reflect uncertainties over final workout values, which are expected to be low (hence my rant on covenants before).
Not surprisingly, Moody’s outlook for REIT TruP CDOs is also negative for 2008. The Taberna series were essentially issued by RAS, since it made its ill-fated purchase of Taberna and is now stuck with the mess. I don’t mean to imply that a few isolated downgrades of these CDOs will be a huge problem for REITs like RAS. However, taken cumulatively with other problems, these downgrades – and the trouble they signify for the underlying TruPs collateral – could be the tipping point for those in the REIT menagerie that are struggling with a whole smorgasbord of other problems. These would include forced liquidations of assets, subsequent trouble satisfying IRS REIT income requirements and general head scratching in the board room when it comes to declaring dividends after all the defaulted scrip has been siezed or sold off.
Always looking for ways to have fun in this abysmal market, I have actually written about one such REIT in this very article. Long time readers may have noticed that having fun has not included kicking those that are down and out, but this is too important, as there is real money to be made with the survivors. Some of the more troubled REITs may also survive, but probably not as REITs, and definitely not with those head scratching dividends.
For a clue, look no further than the first letter of each paragraph.
Click here for an updated list of Mortgage REITS”, including current yields.
Update: Please take a look at the WSJ article which appeared today (Wednesday, June 25th) entitled “Small Banks Face a Looming Hit From Builders’ Interest-Reserve Loans“. The article contends that small banks are more heavily exposed to construction & development loans than bigger superregional and money center banks, and that the FDIC and OCC are examining in loans in asset-level detail to determine their performance status.
Apparently, some of these banks are using the interest reserve escrow accounts to maintain “current” status on loans secured by assets that are anything but. The article says that banking analysts worry that 150 small banks could fail in the next “few years” because of big bets on these construction loans. The FDIC has issued “cease and desist” orders to banks ranging from National City (subject of another, earlier WSJ article) to HomeTown Bank of Villa Rica, GA.
Please don’t bet the “ranch” on AFN; it seems that many of their TruPs obligors may have already done so.