Congressional Oversight Panel has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.

The worst bet in real estate today:

Construction loans

By Paul Wiseman, USA TODAY

The biggest bank killer around isn't some exotic derivative investment concocted by Wall Street's financial alchemists. It's the plain old construction loan, Main Street banks' bread and butter for decades.

Deutsche Bank has called them "without doubt, the riskiest commercial real estate loan product." The Congressional Oversight Panel, a financial watchdog, has warned that construction loans have deteriorated faster and inflicted bigger losses on banks than any other real estate loans.

And the worst may be yet to come. Banks, adopting a desperation strategy known as "extend and pretend" or "delay and pray," have been reluctant to admit defeat, repossess half-completed housing developments and strip malls — and dump them on a depressed market at a big loss. "There probably are many loans out there that are in worse shape than reflected on lenders' books," says Chicago construction lawyer Joshua Glazov.

Even so, the numbers are already grim:

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•Across the banking system, nearly 17% of construction loans were non-current — at least 90 days past due or otherwise in trouble — at the end of March, a record level and a stark contrast to less than 5.5% for all loans, according to the latest numbers available from the Federal Deposit Insurance Corp. For construction loans on one- to four-family residences, the percentage of bad loans is even worse: nearly 23%.

"Construction loans are experiencing the biggest problems with vacancy or cash-flow issues, have the highest likelihood of default, and have higher loss severity rates than other commercial real estate loans," the Congressional Oversight Panel, tasked with overseeing the federal bailout fund, reported earlier this year.

•The 10% of banks that had the highest concentration of construction loans at the end of 2007 account for more than half of the 274 banks that have failed between then and Aug. 6, according to an analysis for USA TODAY by SNL Financial in Charlottesville, Va.

•Even the banks that have survived despite holding high concentrations of construction loans remain vulnerable. Their average "Texas ratio" — which measures their bad loans as a percentage of their capital and reserves against loan losses — stood at 101% on June 30, up from 90% three months earlier, SNL found. Anything over 100% signals that a bank is in danger of failing. For construction-loan-heavy banks, the median Texas ratio — which weeds out the worst cases — was still high, at 62%.

"It's been a bloodbath out here," says bank consultant Tod Little of BNK Advisors in Las Vegas.

Developers typically take out short-term, adjustable-rate loans to buy and develop property. The bank releases money in increments — as the developer needs it — and puts some of the proceeds in a reserve from which the builder makes interest payments before the project starts generating revenue. After the project is completed — and tenants have moved in and started paying rent — the developer takes out a longer-term mortgage to pay off the construction loan.

'Cocaine' for banks

Many small and midsize banks, eager for growth, grew addicted to construction loans during the housing boom. "Construction lending is really the cocaine of the banking industry," says veteran banker Rollo Ingram. "They're easy to do. They're big-dollar loans that can bulk up a balance sheet. And there are always developers who want loans."

Construction loans — officially labeled "acquisition, development and construction" loans — surged more than 150% between the first quarters of 2003 and 2008, when they peaked at $631.8 billion. (Overall loans rose just 55% during the same period.) If a bank said no to a construction loan, "The developer could just go down the street," says Brandon, Fla., bank consultant Jon Campbell.

And some of the people getting loans during the real estate frenzy of the mid-2000s were amateurs, says Boston bank consultant David Brown: "They were contractors who got the bug and felt they could make a living at being a developer."  Link to complete article