“There are likely many more very small builders and developers in distress”

From the Wall Street Jounal:

Loan Spree to Come Back Against Small Banks
By DAVID ENRICH
July 17, 2007; Page A12

Falling home prices are about to take a big bite out of many midsize banks’ profits.

Until recently, banks were eagerly doling out loans to real-estate developers looking to capitalize on soaring home prices. Today, as housing markets cool rapidly, banks are starting to reappraise the collateral behind those loans, often finding that land and property values have deteriorated, forcing the lenders to take painful write-downs that are taxing earnings.

“Going in and reassessing the collateral is going to be the key for everybody in the next 12 to 18 months,” says Gerard Cassidy, a bank analyst at RBC Capital Markets. “It’s going to take a pound of flesh off of the lenders.”

Some sizable Midwestern banks — including Huntington Bancshares Inc. and Citizens Republic Bancorp Inc. — already are warning about the declining value of their real-estate construction loans. Their rolls may grow as a slew of regional banks around the U.S. report second-quarter earnings this week.
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Banks have been like “a kid in a candy store” when it comes to construction lending, gladly financing even speculative projects, says Mike Castleman, president of Metrostudy, a Houston research and consulting firm that advises banks and home builders.

While some banks have been scaling back on construction loans, they still represent regional banks’ fastest-growing type of loan, according to a June study by Atlanta research firm FIG Partners LLC.

Home and land values have been sliding for more than a year, but thanks to a common but rarely scrutinized type of bank loan, many smaller developers are only now beginning to come under financial pressure.

When a bank lends to a developer, it also typically issues an “interest-reserve” loan that covers the monthly interest payments that the developer owes on the primary loan. The interest reserves generally are meant to last about 18 to 24 months — covering the period from when construction begins until the project is complete and cash starts flowing from sales of the new homes.

Bankers and analysts say the interest-reserve loans have masked underlying weakness in banks’ portfolios of construction loans.

Developers are just now depleting the interest reserves on loans that were made two years ago at the peak of the housing market. As they struggle to sell newly completed properties at a profit, more builders are falling behind on their loan payments. This forces the lender to write down the loan’s value to reflect its odds of getting repaid and, in the event of a default, the amount the bank can realistically hope to recoup through seizing land or property.

“The numbers keep going lower and lower,” says Terry McEvoy, an analyst with Oppenheimer & Co. “That’s really the core of the problem for many of these companies.”