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Elizabeth Warren Warns About Commercial Real Estate Crisis, 'Downward Spiral' For Small Businesses, Local Banks

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Even as the economy shows signs of recovery, a government watchdog is warning that another financial crisis is coming round the bend -- and that the Treasury Department and financial regulators are not prepared to deal with it.

"There is a commercial real estate crisis on the horizon, and there are no easy solutions to the risks commercial real estate may pose to the financial system and the public," says a report issued Thursday by the Congressional Oversight Panel, the bailout watchdog led by Harvard Law professor and middle-class advocate Elizabeth Warren.

"The Panel is concerned that until Treasury and bank supervisors take coordinated action to address forthrightly and transparently the state of the commercial real estate markets -- and the potential impact that a breakdown in those markets could have on local communities, small businesses, and individuals -- the financial crisis will not end."

Over the next five years, about $1.4 trillion in commercial real estate loans will reach the end of their terms and require new financing. Nearly half are "underwater," meaning the borrower owes more than the property is worth. Commercial property values have fallen more than 40 percent nationally since their 2007 peak. Vacancy rates are up and rents are down, further driving down the value of these properties.

When the reckoning comes, it could threaten everyone from banks and pension funds to renters and small businesses -- and small banks could be particularly vulnerable.

Warren warned against government inaction.

"When commercial properties fail, the result is a downward spiral of economic contraction; job losses; deteriorating store fronts, office buildings and apartments; and the failure of the banks serving those communities," she said. "These are the same small banks that provide loans to the small businesses that create jobs and boost productivity. If hundreds more community banks go under the effect could be to dump sand in the gears of our economic recovery.

"We need to start now before the system is on the brink of collapse to work out a plan."

The report's exhaustive description of the coming crisis isn't new. What's new is its conclusion, based on the panel's review and conversations with Treasury officials, that the U.S. government is unprepared.

It "strongly urges Treasury to put a plan in place now to deal with the coming crisis," Warren told reporters Wednesday during a conference call.

The report spells out why:

In a recent speech, Dennis Lockhart, president of the Federal Reserve Bank of Atlanta...spoke about the "potential of a self-reinforcing negative feedback loop" involving bank lending, small business employment, and commercial real estate values. Lockhart noted that small businesses tend to rely heavily on smaller financial banks as a source of credit. He further noted that smaller financial institutions tend to have a larger-than-average concentration in commercial real estate lending. Lastly, he noted that banks with the highest levels of exposure to commercial real estate loans account for almost 40 percent of all small business loans.

What this means is that a small bank that does not make many loans -- perhaps because it is hoarding capital to offset future losses in the value of its commercial real estate portfolio -- can feed a vicious cycle that does additional damage to the bank itself. The lack of lending may mean that small businesses that rely on the bank as a source of credit will be forced to shut their doors. This drives up vacancy rates on commercial real estate in the local region, which puts more downward pressure on real estate prices. And those falling prices can lead to additional write-downs in the bank's commercial real estate portfolio.

Because commercial real estate loans typically have three- to five-year terms, those loans are constantly being refinanced. The problem is that loans made at the height of the boom -- 2005 to 2007 -- were based on inflated values during a time of easy money, and now they're coming up on the end of their terms.

"There was a big commercial real estate bubble, and it has to come down," Warren said. "And that means there will be losses to be borne by investors and banks."

The report notes that $770 billion (53 percent) of commercial mortgages maturing from 2010 to 2014 are underwater. More than 60 percent of mortgages maturing in 2012 and 2013 are underwater. Many of these loans are likely to default, and the losses could cause more small- and medium-sized banks to collapse.

The nation's 20 biggest banks -- those with at least $100 billion in assets -- have an average commercial real estate exposure equal to 79 percent of their total risk-based capital, according to the report. For the nation's roughly 7,000 community banks -- those with less than $10 billion in assets -- the average commercial real estate exposure equals 288 percent of total risk-based capital.

So the average community bank has about $3 in commercial real estate loans for every $1 set aside to cover possible losses.

The panel calls for regulators to perform on small banks the kind of "stress tests" that were conducted last year on the nation's 19 biggest bank holding companies to assess their health if the economy deteriorated.

But in a sign of the government's unpreparedness, Warren notes that last year's stress tests were overly limited. "Concerns over commercial real estate are very real," Warren said. "The largest loan losses are projected for 2011 and beyond, but the stress tests conducted on big Wall Street banks last year examined their stability only through 2010."

There are more than 10,100 troubled commercial properties worth more than $205 billion across the U.S., according to Real Capital Analytics. The report notes that banks alone could experience losses nearing $300 billion.

The Treasury Department declined to comment on the report. However, a spokeswoman pointed to Treasury Secretary Timothy Geithner's remarks during a September hearing before the panel.

In discussing smaller banks and their exposure to commercial real estate, Geithner said they account for a small share of the nation's banking system, "so we are probably likely as a country to be able to manage through and withstand those remaining pressures."

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