A.M. Best Report: High Levels of Commercial Real Estate and Construction Loans in U.S. Banks Pose Powerful Risk to Earnings.

OLDWICK, N.J. -- Among the significant findings in U.S. bank 2005 filings was the continued climb in the most volatile segment of real estate financing. The industry's commercial real estate loans increased by 9.5% in 2005, continuing the trends of the past several years' growth rates of 10.3% in 2004 and 8.7% in 2003. Similarly, growth in construction and development loans registered 9.8% in 2005, 10.5% in 2004 and 9.3% in 2003. As a percentage of total net loans, commercial real estate loans still remained around 15.2% to 15.6% in the past four years. However, construction and development loans have been inching steadily upward to 6.7% of total net loans in 2005, compared with 5.6% in 2004, 5.1% in 2003 and 4.9% in 2002. U.S. bank regulators have responded to these trends by proposing in January 2006 new guidance on commercial real estate (CRE) exposure, according to a special report published by A.M. Best Co.

With a plethora of anecdotal evidence pointing to a softening commercial real estate market, the potential adverse impact of increasing exposure by banks in this segment is not just on asset values, but also on earnings and capital levels. The concentration in the industry's real estate income is the most alarming element. Total real estate income, consisting of all gross interest income and fees, jumped 30.4% in dollar terms from 2004 to 2005, accounting for a staggering 42.3% of total banking revenues. Total banking revenues is defined as all noninterest income and net interest income, rather than gross interest income, because in the event of a loss in real estate income, banks still would have to carry the funding cost of the troubled loan assets, i.e., the related interest expense. Loss of revenues is assumed to result from nonaccruing loans, besides the loan impairment arising from full resolution or termination of actual loan facilities which are charged off against capital. The industry's capital levels grew proportionally to total asset growth during the past several years, but tangible capital (equity plus reserves less goodwill and intangible assets) was lagging asset growth in 2005. At year end 2005, the ratio of CRE asset classes to tangible capital grew to 170.0% from 155.5% in 2004 and 152.9% in 2003.

While specific situations vary for each bank, when real estate market conditions turn downward, an aggregate increase in industry wide exposure like the current trend is likely to lead to an adverse impact on the industry at large. Under a stress scenario of a 25% decline from the year-end 2005 real estate income level), there would be a corresponding 10.6% decline in total banking revenues and a 37.3% hit to the industry's aggregate net operating income. Combined with a stress scenario of a 10% and 20% decline in the respective loan values of commercial real estate and construction and development, the industry might see a decline in capital levels for the first time in many years. The impact of declines in loan values on capital is assumed to be associated with actual charge-off of the impaired assets against capital.

The current state of the real estate market can be argued to have sounder fundamentals than the last real estate crisis. However, the trend toward increasing exposures by banks in these especially risky areas of construction lending and CRE, combined with a similar pattern of concentration in certain regions of the United States as during the last downturn, merit exploring the accompanying potential adverse impact on the industry's earnings, asset values and capital levels.

Best's Banking Center provides online access to data, special reports, analytical methodologies and news on the U.S. banking industry. For a complete overview, please visit www.ambest.com/banks.

A.M. Best Co., established in 1899, is the world's oldest and most authoritative insurance rating and information source. For more information, visit A.M. Best's Web site at www.ambest.com.