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Banks Hit by More Construction Loan Woes

'Subcontractor risk' becomes a major issue.

As the housing crisis unfolds, banks are continuing to suffer from increases in nonperforming construction loans.

Back in July, Ratings discussed the special risks associated with construction lending, and listed the 20 banks with the

highest asset concentration in problem construction loans, based on March 2007 financial reports.

A construction loan is really a credit line, with the lender doling out money to purchase the lot and pay the general contractor as construction is completed. Close scrutiny by the lender is required, to make sure construction proceeds as agreed.

A major worry is "subcontractor risk," since a subcontractor can place a lien on the property at any time. If neither the borrower nor the lender have proof that the general contractor paid a subcontractor for completed work, the subcontractor's lien will probably not be lifted. This has played a major role in Coast Bank's construction loan difficulties, described below.

In the second quarter, overall construction loan quality continued to decline. Looking at an updated list of 20 banks with the most exposure to problem construction loans, it is clear that the situation has gotten critical for some institutions:

Highest Asset Concentration in Nonperforming Construction Loans

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The following shows an alarming level of overall exposure to problem loans for most of the listed institutions:

Overall Asset Quality and Capital Exposure

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Amboy National Bank of Old Bridge, N.J., is the largest institution on the list. The bank's problem assets doubled during the second quarter, with a ratio of adjusted nonperforming assets of 6.19%, as of June 30. Problem loans were split between residential and commercial construction loans and permanent mortgages. All of the nonperforming loans were categorized as nonaccrual, meaning the bank didn't expect principal repayment.

Amboy's rating is now a D- (weak financial strength), being downgraded twice from a C (fair financial strength) back in December 2006. The downgrade reflects the sharp decline in asset quality and low reserve coverage. This being said, there's no denying that Amboy National Bank has been a stellar earnings performer over the past several years, with five years of returns on average assets exceeding 3% and returns on average equity exceeding 35% through 2006. The institution's high efficiency and revenue should enable it to reserve sufficiently over the next few quarters, and assume a healthier profile.

Coast Bank of Florida (held by

Coast Financial Holdings


made news back in January, when it announced problems with 482 construction loans to individuals who had contracted with the same failed builder, Construction Compliance, Inc., to build homes for investment purposes. As of June 30, these loans amounted to $61.8 million, or 8.33% of the bank's total assets. In its second-quarter 10-Q filing, Coast Financial said it was pursuing foreclosure on loans where the borrowers were not meeting their obligations. The company also said it would vigorously defend against a lawsuit from 129 of the borrowers.

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The institution's rating remains an E- (very weak financial strength) and it was undercapitalized per regulatory guidelines as of June 30. In May, the FDIC and the Florida Office of Financial Regulation issued a cease-and-desist order requiring Coast Bank to stop expanding and maintain a core capital leverage ratio of at least 7.50% by November 2007.

On Aug. 6, Coast Financial entered into a merger agreement with First Banks, Inc., a privately held holding company based in Hazelwood, Mo., with $10 billion in assets. Under the agreement, Coast Financial would be acquired for $22.1 million or $3.40 a share, subject to conditions that may affect the price. This represents a $6.5 million premium to Coast's shareholders, based on the holding company's Oct. 12 closing share price of $2.44. In the second quarter 10-Q filing, Coast Financial expressed doubt that it could continue to operate if the merger failed to close, as expected, in the fourth quarter.

Veteran Florida banker Tramm Hudson, who was hired as a special adviser by Coast Financial back in February, said "we are working diligently to complete the merger in the fourth quarter, and are very confident that our shareholders will approve the merger agreement."

Bankfirst, of Sioux Falls, S.D., had the worst overall asset quality on the list, with adjusted nonperforming assets comprising 12.58% of total assets as of June 30, shooting up from 4.99% the previous quarter.

The institution reported a net loss of $8.6 million for the quarter, as it made a large addition to its loan loss reserves. With reserves covering just 24.54% of adjusted nonperforming loans, Bankfirst faces several quarters of earnings pressure, unless asset quality quickly recovers.

Another institution with a sharp second-quarter rise in nonperformers was First Florida Bank, one of 39 institutions held by

Synovus Financial Corp.

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. First Florida's adjusted ratio of nonperforming assets was 6.91% as of June 30, increasing from 2.38% the previous quarter.

The institution is still rated a B-, mainly due to the deep pockets of its holding company. Nonaccruing residential construction loans made up most of the problem loans. With relatively low reserves, First Florida probably faces a few quarters of deflated earnings, with elevated loan loss reserve provisions.

The continuing housing crisis may cause more construction companies to suffer and banks to feel the pain. As always, it is a good idea to monitor the

Financial Strength Rating of the bank or thrift that holds your deposits.

While you might be comfortably under the FDIC's insurance limits, if you or someone you know are running a business, nonprofit organization or managing municipal accounts, it is quite possible to lose money when a bank fails, as we recently saw with

two recent bank failures.

Philip W. van Doorn joined Ratings Inc., in February 2007. He is the senior analyst responsible for assigning financial strength ratings to banks and savings and loan institutions. He also comments on industry and regulatory trends. Mr. van Doorn has fifteen years experience, having served as a loan operations officer at Riverside National Bank in Fort Pierce, Florida, and as a credit analyst at the Federal Home Loan Bank of New York, where he monitored banks in New York, New Jersey and Puerto Rico. Mr. van Doorn has additional experience in the mutual fund and computer software industries. He holds a Bachelor of Science in business administration from Long Island University.