Falling property prices fuel new wave of bank woes

The economic downturn’s second shoe is starting to drop on banks.

Falling prices for commercial real
estate are forcing them to write off an increasing number of troubled business loans, a trend that’s suppressing bank
earnings and likely will continue for many quarters.

Lenders are struggling with the problem. So are borrowers
and regulators.

“It will be at least a couple of years before the problems are worked out. It’s hard
to envision a quick turnaround,” said John Reed, president of Chicago-based David A. Noyes and Co.’s Investment
Banking Group.

“If this were a baseball game, we’re maybe in the fifth inning. What we don’t
know is if it’s going to be a 10- or 12-inning game.”

The second and third quarters were brutal for
Indiana banks. Compared with the same periods a year ago, many suffered as profits shrank or swung into substantial losses.
Much of the red ink stemmed from banks’ acknowledging their loan woes by ratcheting up provisions for loan losses.

The root of the commercial real estate problem is all too familiar for homeowners around the country who are now
underwater on their mortgage loans. In the recession, business properties have similarly lost market value, leading to some
outright loan defaults and far more technical breaches of loan covenants—even if the borrower is current on monthly
payments.

Nervous banks often are responding by playing hardball with the borrower rather than trying to work
out problems, said Henry Efroymson, an Ice Miller LLP partner who serves as chairman of the firm’s Bankruptcy and Creditor/Debtor
Disputes Practices Group.

“The slump in values, that’s really a curve ball to lenders. They don’t
know how to deal with the fact that their collateral base for the credit dramatically dropped in value in a very short period
of time,” Efroymson said.

Efroymson

“The answer in my experience has been not to try to work with the real estate borrower
to figure out a way to keep them alive and ensure that the loan is performing. The answer has been to abandon the borrower
and to move the credit or liquidate the credit.”

Banks that seize collateral often end up faced with unpleasant
options. They can try to sell an under-occupied building into a weak market, or they can hold onto it, potentially for years,
waiting for values to rebound.

Working through either scenario saps management’s time and energy, which
would normally be focused on booking new loans, Reed said.

On the other hand, bank executives fear
they’ll fare even worse if they cut a struggling borrower too much slack.

“In a strong, vibrant
economy, [a banker] might say, ‘We’ll let it ride for a while. I know you’re good for it,’”
Reed said. “But now at some fairly early point, a good banker will say, ‘Hey, Buddy, you have your woes. But I
can’t take a risk on getting burned on this thing.’”

Local business lending is bread-and-butter
banking, not the sort of exotic, risky high finance associated with last year’s Wall Street investment bank meltdown.
That’s why it’s a big problem for all banks, big or small, and even the most conservative.

And just
one bad bet can be devastating. Take tiny Cambridge City-based Wayne Bank and Trust, which has just $148 million in assets.
It recently filed a $2.4 million loan-collection lawsuit against Beilouny Luxury Properties LLC, whose bet on Mass Ave-area
condos soured when the residential market tanked.

Other banks, such as Muncie’s First Merchants Corp.,
are experiencing a rash of problems.

Until a year ago, First Merchants regularly booked quarterly profit of $6
million or more like clockwork. But in the last four quarters, its provision for loan losses has shot up. In the second quarter,
First Merchants booked a $59 million loan-loss provision and a $29.7 million net loss. The third quarter was somewhat better,
with a $24.2 million loan loss provision and a $6.4 million net loss.

First Merchants didn’t respond to
IBJ’s requests for comment. But in a Nov. 3 conference call with analysts, Chief Financial Officer Mark Hardwick
pointed out the bank’s allowance for loan losses has increased 308 percent during the last seven quarters.

First Merchants now has $87 million set aside against potentially souring loans, or 2.54 percent of its portfolio. It used
to be just $28.2 million, or less than 1 percent of the bank’s loans.

John Martin, First Merchants’
chief credit officer, said the bank’s commercial mortgage portfolio accounted for 21 percent of loan charge-offs.

“We are paying particular attention to this sector by closely tracking vacancy in our commercial real estate
portfolio,” he said.

Columbus-based Indiana Community Bancorp, which suffered a $2.1 million third-quarter
loss, is re-evaluating every commercial relationship, CEO John Keach Jr. said.

Keach said the bank is writing
down projects to their current market value, and sometimes requesting additional funds from the borrower. The bank, which
provided financing to condominium developers, is particularly concerned about a glut of condos south of Indianapolis.

“One thing we remind ourselves, the relationships we have for the most part at one time were very good projects,
and we certainly are working with customers we’ve enjoyed a long relationship with, realizing we all are in this economic
time together,” he said.

“I do think a majority of the banks are working hard at recognizing the
risk in their loan portfolios, preparing for us not to come out of recession as soon as some think we might.”

In the third quarter, The National Bank of Indianapolis Corp. suffered a $208,000 loss and recorded a $3.96 million
provision for loan losses. That compared with a profit of $1.64 million and a $1.8 million loan loss provision in the same
period a year ago.

Maurer

CEO Morris Maurer said the bank experienced an unusual misstep, attributable primarily to a single, troubled
commercial real estate loan he wouldn’t identify.

“I’d call that a rare mistake from a very
experienced lending team,” he said. “Banking is a business where, if you’re right 99 percent of the time,
you’re not very good. You have to be right almost all the time.”

If anything, community banks may
be more willing to work out problems than their bigger brethren, Ice Miller’s Efroymson said. The larger banks see as
many or more underwater business loans as community banks but don’t break out Indiana-specific results.

To help steer bankers through these treacherous times, the Federal Deposit Insurance Corp., the Federal Reserve and the Office
of the Comptroller of the Currency issued new guidance last month on how to prudently handle commercial real estate loan workouts.

The guidance attempts to quell bankers’ concerns that regulators won’t let them hold troubled commercial
real estate loans on their books. It also encourages banks to make new loans, even though doing so carries risks.

“Financial institutions that implement prudent loan workout arrangements after performing comprehensive reviews of
borrowers’ financial conditions will not be subject to criticism for engaging in these efforts, even if the restructured
loans have weaknesses,” the regulators’ release read.•