Bad Construction Loans Weigh on Banks
Mortgages aren't the only kind of exposure banks and thrifts have to falling housing prices; in addition to financing the purchase of homes, they may also finance their construction. And unlike regular mortgages, which can be sold to investors, thereby freeing up capital to make more loans, construction loans are kept on a bank's books.
Bad construction loans were a significant factor in TheStreet.com Ratings' decision to downgrade the financial strength ratings of a number of banks and thrifts last month. With the meltdown down in residential real estate, many financial institutions that specialize in construction lending have been feeling the heat as small construction companies go belly up.
Construction lending can be a tricky business. Typically, a lender disburses funds to the general contractor in several installments, called "draws," as various stages of construction are completed. One of the ways a lender manages the credit risk on these loans is by making periodic site inspections to confirm the construction is proceeding before issuing subsequent draws.
For larger projects -- and a sample of smaller projects -- prudent institutions also do quick title searches at certain points during the construction process to make sure the general contractor is paying its subcontractors. That's because a subcontractor that hasn't been paid may place a lien on the property.Construction companies typically rely on a constant flow of new projects to keep their businesses viable, and the housing market slowdown has put many of them out of business. When this happens, problems tend to spiral, since switching to a new builder midstream usually adds to construction costs, which may require more financing than the borrower can afford. Problems can be further compounded for a bank that has concentrated its construction lending to borrowers using one or two local builders. That's what happened to Coast Bank of Florida, a subsidiary of Coast Financial Holdings (CFHI), which announced in January that there were problems with 482 construction loans it had made to individuals who had contracted with the same builder. Investors who follow TheStreet.com Ratings would have had some idea of the risks to holding this stock, since we had downgraded it twice during the previous 12 months. The bank's financial strength rating was cut to a D (weak) in April 2006 and subsequently lowered even further to D- in December of last year. The industry's first-quarter results revealed that construction lending was a problem area for other institutions, too. So we decided to take a look at the 20 banks and thrifts with the biggest concentration of nonperforming construction loans. A nonperforming loan is one with payments past due by 90 days or more. It turns out that exposure to troubled construction loans is a good indicator of overall financial health, as 16 of these institutions have financial strength ratings in the D range or lower.
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