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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.

Looking at the list, it is clear that institutions with high exposure to nonperforming construction loans also have poor overall asset quality. The most alarming statistic is the ratio of nonperforming assets to core capital and loan loss reserves. All of the listed institutions have a much higher level of capital exposure to problem assets than the national aggregate of banks and thrifts.

The second table includes commonly used asset quality ratios. It also lists the concentration of assets in construction loans that are past due between 30 to 89 days. These loans are still considered performing, and are not included in any of the asset quality or capital exposure rations. But they provide a possible indicator of a further decline in asset quality.

Leading the list in terms of asset concentration in nonperforming construction loans is First National Bank of Brookfield, Ill., which is rated D- based on financial results for the quarter ended March 31, 2007. The institution reported that nonperforming loans (mainly commercial construction loans) reached $23.5 million, or 7.73% of total assets and 84% of its core capital and loan loss reserves. This means the institution's solvency would be threatened if it were forced to charge off the majority of the nonperforming loans.

Nonperforming construction loans represent a smaller percentage of assets at Douglass National Bank of Kansas City, Mo. -- just 2.9% as of March 31. But the institution's ratio of nonperforming loans to core capital and loan loss reserves was much higher than First National's, at 201.62%. Total nonperforming assets, including other kinds of loans, comprised 15% of total assets and the institution was considered significantly undercapitalized per regulatory guidelines.

We have rated the company E- (very weak) since December of last year, not just because of the large number of bad construction loans, but because it has repeatedly reported net losses, poor asset quality and the low level of capital. Due to various management problems, the bank has been operating under a formal agreement with the Comptroller of the Currency since March 2006.

Macomb Community Bank, a subsidiary of Capitol Bancorp (CBC), is one of two banks on the list held by a publicly traded holding company. As of March 31, Macomb's reported nonperforming construction loans comprised 3.90% of total assets. The institution's ratio of nonperforming loans to core capital and loan loss reserves was 62.63%. Macomb Community, which is rated D-, has reported net losses in three of the past five quarters. These losses reflect elevated provisions for loan loss reserves and, more recently, a narrowing net interest margin.

The two largest institutions on the list are both based in Florida. Florida Community Bank, of Immokalee, has $994 million in assets and a D- rating. As of March 31, the institution reported $47.9 million in nonperforming construction loans, or 4.82% of total assets and 43.65% of core capital and loan loss reserves.

As for Coast Bank of Florida, the second-largest institution on the list, its credit commitments for the troubled loans disclosed back in January amounted to $110 million, which would have been roughly 10% of the institution's assets had the loans been fully funded.

This is a textbook case of what can go wrong if a bank's construction portfolio is overly concentrated in loans tied to one builder. In its announcement, the holding company stated that some subcontractors had not been paid by the builder, and had placed liens on the homes.

While it is not uncommon for subcontractors to place these liens even if they expect to be paid, it is a major problem in this case, since the homeowners could wind up paying twice for the same work. This is why it is so important for banks to be diligent in not allowing draws without performing site inspections for all loans and reviewing documents for at least a sample of loans, to prove the subcontractors were paid.

In the week following Coast Financial's announcement, its stock price dropped more than 50%.

TheStreet.Com Ratings provides an easy way for a depositor or investor to monitor the financial strength of any U.S. bank or savings and loan. You can quickly look up an institution's financial strength rating using TheStreet.com Ratings Screener , which is now updated with ratings based on March 31, 2007, data.

Our ratings don't just help depositors determine whether their money is in a safe haven; they can also help investors. Some bank- and thrift-holding companies have several bank and/or thrift subsidiaries. The holding companies' consolidated financial statements may not tell the whole tale, if there are operating problems with just one of its subsidiary institutions. A problem affecting one of the subsidiary institutions, even a small one, can have a serious impact on a holding company and its stock. Our ratings often reflect an underlying problem months before a holding company announces bad news.

Philip van Doorn joined TSC Ratings as a banking analyst in February 2007. He has a varied background, with a B.S. degree in business administration from Long Island University. He previously worked as a loan operations officer with Riverside National Bank in Fort Pierce, Fla. Before that he was a credit analyst, monitoring banks and thrifts at the Federal Home Loan Bank of New York.

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