Financial Update (Third Quarter 2007)

Real Estate Could Pose Challenges for Some Banks

sixth district mapOverall the banking industry remains in good shape, but real estate problems could pose challenges for some banking institutions, according to Brian Bowling, an officer in the Atlanta Fed's bank supervision division.

"The reversal of a long run in housing appreciation and the sharp corrections in real estate markets in parts of the Southeast substantially changed the region’s banking environment in 2006, and those pressures have continued in 2007," Bowling said. Nevertheless, bank earnings have held up, capital levels remain ample, and loan problems have been contained.

Slowing markets, margin squeeze loom
Industry conditions, however, mean financial institutions in the region are likely to face greater challenges in the near future. "While capital levels and profitability indicators are good now, the continued slowdown in real estate markets in general, and in the subprime loan market in particular, point to potential problems ahead as declines in credit quality are manifested in higher loan loss provisions, and slower home sales result in less demand for construction financing from banks," Bowling said. "Competitive pricing is expected to add additional pressure to profitability margins."

Looking ahead, Bowling said some institutions could see fewer opportunities to make commercial real estate loans. He also said some commercial and retail borrowers could be constrained by higher interest rates and tighter underwriting standards.

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These real estate–related issues are particularly notable in the Southeast as many banks rely on real estate development and related loan growth, which has slowed along with the housing sector.

What heats up cools down
Commercial and industrial lending by Southeast banks increased in 2006, partly fueled by mergers and acquisitions and businesses refinancing to extend maturities to take advantage of low long-term interest rates, according to Bowling. By early 2007, however, demand for commercial and industrial loans in the region had cooled.

Nationwide, commercial and industrial concerns were borrowing less from banks because of borrowers' increased use of internally generated funds and decreased needs to finance investment in plant or equipment, as well as a shift in customer borrowing to nonbank sources of credit, according to the Federal Reserve Board's July 2007 Senior Loan Officer Opinion Survey on Bank Lending Practices.

Despite some challenging circumstances currently, the Southeast remains a fertile market for de novo, or start-up, banks, and the longer-term outlook for banks in the region is favorable, Bowling said. At the end of the first quarter of 2007, the Atlanta Fed's region was home to 28 percent, 142 of 507, of the nation's de novo banks that had been open for less than three years. Among banks started during the first five months of 2007, 19 of 71, or 27 percent, are in the Atlanta Fed's district. Bowling attributes this development in part to continued strong population growth across the Southeast relative to other regions of the country.

September 4, 2007