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While everyone is watching the House-Senate conference committee work through the 2,000-page financial reform bill, one of the most significant developments for community banks took place in the House on a different bill — the Small Business Lending Fund Act of 2010 (H.R. 5297). This is the bill that would create a $30 billion fund to help banks make small business loans.

Much more important than the main bill, however, is an amendment the House approved by voice vote to allow banks with fewer than $10 billion in assets to amortize losses or write-downs on commercial real estate loans over a 10-year period. I have written about the need for such a thing. U.S. Rep. Ed Perlmutter of Colorado authored the amendment. Read the details here.

The House passed the bill, with the Perlmutter amendment, on Thursday, by a vote of 241-182. The Senate is expected to consider the bill after the Independence Day recess. I hope they move on it quickly and this bill gets signed into law by Labor Day.

About a year ago, I wrote this editorial for NorthWestern Financial Review magazine explaining the need to give community bankers more time to write off losses in their commercial real estate loan portfolio. “Until real estate market activity returns to pre-recession levels, bank regulators should suspend the mark-to-market rules for real estate non-performing assets and allow banks to amortize the losses over a period of up to 10 years,” I wrote. This is not a new idea. Regulators did something similar in the 1980s when the banking industry was slogging its way through a crisis in agriculture.

Kevin Funnell, who runs Bank Lawyer’s Blog, recently has been writing about the idea. Check out this post, and this follow-up. Then, on Monday, he posted this about efforts by two U.S. Representatives from Colorado to put the idea into law. It is great to see this idea gaining momentum.

The mark-to-market purists who oppose the idea need to weigh the value of strict adherence to a particular valuation theory with the impact of real world consequences. Forcing banks to take big losses immediately on OREO property is an enormous drain on capital, which makes it much harder for these banks to lend, which further makes it harder for these banks to turn a profit. Give banks time to absorb losses and most of them will come through; force them to write off losses immediately, and in many cases you risk sinking the ship. And I ask, for what? Allegiance to a valuation theory that really isn’t appropriate for community banks anyway? This is ridiculous and lawmakers can easily solve the problem. 

This is an issue we will follow at this blog. The truth is, this idea will do more good to help community banks than anything currently in the regulatory reform bills passed by the House and under consideration in the Senate. The best thing that could happen would be for this concept to be folded into the financial reform bill.

Commercial real estate, liquidity and capital are the main near-term problems facing community banks, said Federal Reserve Board Governor Daniel Tarullo in New York last week. Speaking April 8 at the New York Community Bankers Conference, Tarullo also called loan concentration and net interest margin major problems for community bankers in the longer term.

“Coping with CRE problems will not be easy. I expect these problems to be with us for some time to come,” he said. Solutions will require bankers to rethink credit administration practices, and force them to expand their loan work-out capability. He commented that the task is complicated by the large volume of properties on the market.

Saying that many banks have relied heavily on noncore funding sources, Tarullo said bankers will have to come up with new contingency funding plans to bolster their liquidity. “Additionally, capital planning will need to be strengthened across all institutions,” he said, noting that high capital cushions are likely to become the norm.

Although many banks will survive the challenges, Tarullo said the industry cannot expect to emerge unscathed. “These immediate financial challenges will, I am afraid, overwhelm quite a number of community banks this year,” he said.

Furthermore, Tarullo said, bankers will need to avoid high concentrations of any single loan type. A move toward loan portfolio diversification will prove difficult for some banks, and will likely lead to lower returns for nearly all banks.

Finally, Tarullo commented on the shrinking net interest margin. “Despite all the emphasis on noninterest revenues in recent years, community banks have continued to rely heavily on spread income,” he said. He further noted that the “aggregate net intrest margin for banks with assets of $10 billion or less has tightened considerably.” Compressing by more than 70 basis points over the last 10 years, the net interest margin for those banks is now 3.63 percent. “As a result, it becomes more difficult for community banks to cover their overhead, pressuring their earnings and their ability to support capital needs fron internal sources,” Tarullo said.

The speech, in which Tarullo also discusses the Fed’s so-called “exit strategy,” can be read here.

In a speech last month to bankers gathered in Florida, Comptroller John Dugan said most of the bank failures in the last 18 months have been the result of:

• Excessive concentrations in commercial real estate lending, especially construction and development lending; and/or
• Excessive reliance on non-core funding, especially brokered deposits, to fund rapid growth, especially in CRE lending.

So you can bet there will be rules coming to reduce the banking industry’s commercial real estate lending and its access to non-core funding. Dugan listed the following things that we “know” about excessive commercial real estate lending:

• We know from experience from the late 1980s and the early 1990s, and from the current period, that a significant concentration in CRE lending leaves banks vulnerable to an economic downturn – and the higher the concentration, the more vulnerable the bank.
• We know that a robust economy will mask unsound underwriting for a period of time.
• We know that rapid loan growth, and particularly a rapid build up of CRE loans, is likely to overwhelm risk management controls.
• We know that there is a level of CRE concentration that even the most sophisticated control systems cannot protect from a serious economic downturn.
• We know that banks that build concentrations in CRE are more likely to rely on non-core and/or high interest funding.
• We know that banks, in response to market pressures, have increased their CRE concentrations significantly in recent years; CRE loans now account for well over one-third of the loan book on average at commercial banks, and for about half of loans at banks in the $500 million to $2 billion asset range.
• And we know that significant CRE concentrations in economic downturns can lead to an increase in problem banks, an increase in bank failures, loss of jobs, loss of incomes, loss to communities, loss to the deposit insurance fund, and higher costs for all banks, even those that do not have CRE concentrations.

Dugan said regulators should consider a variety of options for mitigating the risk posed by excessive commercial real estate lending, including increased capital requirements, a “more granular approach” to defining concentrations since not all CRE is the same, minimum underwriting standards, and more stringent requirements for loans funded chiefly with non-core money. He also said that new banks should be subject to even greater controls.

Dugan’s comments don’t bode well for many community banks, where real estate lending is a key source of business. Take away consumer credit, auto loans and ag loans, and what else is there besides loans secured by real estate? Sure, small business lending is important, but so many of those loans are secured by commercial real estate.

Here is what would really be helpful. Rather than solely tightening the rules on commercial real estate lending, why not work at the same time to eliminate the advantages that Farm Credit System lenders and credit unions have over traditional banks? The positive effect of leveling the competitive playing field would off-set some of the negative effect of limiting banks’ ability to make loans secured by real estate.

Anyone who works with numbers knows they can be deceiving. I have to call the Minneapolis-based Star Tribune on some numbers they ran in their Jan. 11 edition. Here is the online version of the article the newspaper ran about high concentrations of commercial real estate loans at some Minnesota banks. The print edition of the newspaper included a list of 17 banks that it says have commercial real estate loan concentrations equaling more than 400 percent of capital. The list does not appear online.

No. 14 on the list is Central Bank of Stillwater. It caught my eye because my colleague Tony Telschow and I just spent quite a bit of time researching this bank, which experienced phenomenal growth in 2009. When you receive your January edition of NorthWestern Financial Review in a day or two, you will see that we have named the management team at the bank — Owner John Morrison, Chairman Kurt Weise and President Larry Albert — our Bankers of the Year.

The Star Tribune article implies that high concentrations of real estate loans put these banks on shaky financial ground. But in the case of Central Bank, the numbers are misleading. A substantial portion of the real estate loans currently on the books at Central Bank came from failed bank acquisitions. Virtually all of those loans come with an 80 percent loss-share agreement with the FDIC. That means they pose little risk to the bank. Should a million dollar loan go bad, the FDIC will pick up $800,000 of the loss. Central Bank would never have acquired these assets had they not come with the FDIC loss-share agreement.

The article makes it sound as if these banks exercised poor judgment but in the case of Central Bank acquiring these assets was a savvy move. With the loss-share agreement in place, the bank picks up an investment with little down-side potential and tremendous up-side potential.

Data by itself never tells the whole story. You have to look beyond the numbers. To get a more complete story about Central Bank, be sure to read our January edition of NorthWestern Financial Review.

The president of the Atlanta Fed said companies with fewer than 50 employees have been responsible for about 45 percent of the job cuts in this recession, a change from the 2001 recession when small business accounted for 9 percent of the overall job cuts.  Now small business job creation may be constrained in the nascent recovery as a result of “small banks’ impaired ability to support the small business sector,” said Fed President Dennis Lockhart.

“Small firms’ reliance on banks with heavy CRE exposure is substantial. Banks with the highest CRE exposure (CRE loan books that are more than three times their tier 1 capital) account for almost 40 percent of all small business loans.”

Banks with less than $10 billion in assets “carry almost half of total CRE loans,” Lockhart said.

But while CRE is “very worrisome” in parts of the banking industry, Lockhart does not see it as a broad risk to the financial system. “As the recovery develops. the CRE problem will be a headwind, not a show stopper, in my view.”

Lockhart’s remarks were prepared for a meeting of the Urban Land Institute.

On average, commercial real estate values will fall by 40 percent from their 2007 peaks before hitting bottom in 2010, according to the annual Emerging Trends in Real Estate survey, which was released this afternoon. This Reuters writeup on the PricewaterhouseCoopers/Urban Land Institute survey indicates that retail and office developments are being hit the hardest, as consumers cut spending amid job losses. Apartment developments will recover first, due to increased demand from “a growing population of men and women in their 20s.”