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. ...