Leery lenders feeling exposed on speculative loans.

FEDERAL officials are worrying that as interest rates rise and the housing market cools, some banks are carrying a heavier concentration of real estate loans than in the 1980s, a sign that could spell trouble for some banks in Southern California.

Rising interest rates typically hammer banks that are top-heavy with residential real estate loans. Many banks have diversified into commercial loans as a critical source of earnings, only to find they are just as susceptible to rising interest rates.

"As interest rates go up, we could see some borrowers having trouble paying their loans, especially if the terms of the loan are at variable rates," said Steven Wollum, an analyst at insurance rating service A.M. Best Co.

Federal regulators have proposed setting new guidelines for real estate lenders because of the high concentration of commercial loans that could expose banks to unanticipated earnings volatility. The focus is on construction and development loans, in which the primary source of repayment is dependent on the sale or refinancing of a property.

A.M. Best recently reviewed regulatory findings of 8,900 U.S. banks and found that 22 percent have construction loan-to-total capital ratios--a key measure of lending activity--above 100 percent. Of those, 20 U.S. banks had total commercial lending-to-total capital exposure above 800 percent, with 14 of them based in California. Those with the highest concentrations included Pacific Premier Bank in Costa Mesa; Luther Burbank Savings in Santa Rosa, Malaga Bank in Palos Verdes Estates and Sonoma National Bank in Sonoma.

Randy Bowers, an executive vice president and chief lending officer at Malaga Bank, said regulators are particularly concerned about speculative construction lending. Energy costs are driving up the prices of raw materials, making it more expensive to build a project within budget, and then to sell a property a year from now, when the market is soft.

"Their concern is that the market will dry up for speculators who have constructed a building with the intention of selling it," he said.

Malaga Bank cut back on its construction lending in the past year but continues to have a strong portfolio of apartment loans. Bowers believes apartments are "a very safe product" because of supply-and-demand for housing in Los Angeles.

Too broad a brush?

Small banks tend to have a higher concentration of construction, multi-family and income-property loans. Many bankers have written in public comments to regulators that banks should not be painted with such a broad brush.

"Building an apartment building in Los Angeles is very different from building one in Texas or Cleveland," Bowers said. "They need to look at this on a case-by-case basis."

Bank supervisors are starting to track the growth and concentration of commercial real estate loans. They are also testing bank systems for proper risk and underwriting standards. The guidelines, which have not been formalized, are being proposed by four federal agencies: the Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Office of Thrift Supervision.

Though critics have been sounding the alarm on risky loans for several years, most of the issues have centered on mortgage lenders that have lured first-time homebuyers into interest-only and payment-option adjustable rate mortgages.

With interest-only loans, the minimum monthly mortgage payment is never enough to pay against the principal, or in some cases, to cover the costs of accrued interest. Many borrowers with poor credit histories and limited budgets have opted for these creative loans, because the teaser rates often are fixed for three to five years before becoming adjustable. Consumer watchdog groups have complained that many debt-heavy consumers are forced into a condition known as "negative amortization," owing more than the home is worth.watchdog groups have complained that many debt-heavy consumers are forced into a condition known as "negative amortization," owing more than the home is worth.

In March, Statewide Bancorp, based in Rancho Cucamonga, began offering 50-year home loans that would allow California residents to borrow over a much longer period.

Michael Perry, chief executive of IndyMac Bancorp, the seventh largest mortgage lenders in the U.S., said rising interest rates will probably squeeze speculators out of the market, forcing some defaults.

"Mortgage producers are struggling and we're clearly seeing the market for home resale and new purchases slow," Perry said. "That's likely going to continue, and the question is whether it's going to fall off the cliff--and nobody knows the answer to that."

Home sales in Southern California were at their slowest pace in six years in April, and for the first time in four years, prices appreciated at a single-digit rate.

The number of new and existing homes that changed hands in the five-county area fell 16 percent in April, according to Dataquick Information Systems. The median price paid for a home was $485,000 in Los Angeles, Riverside, San Diego, Ventura, San Bernardino and Orange County.

Boiling point?

Despite the concern about rising interest rates, Perry believes the U.S. economy will sustain a soft national landing primarily because of the growing importance of real estate to local economies.

"We're in for a few bumps in the road, for some turbulence over the next year or so, but I'm reasonably optimistic because I just don't see inflation out there," he said.

Another critical issue for banks is the overall cost of borrowing to fund loan growth.

When interest rates rise, many banks look to deposits as a cheaper way to fund growth.

Mike Dokmanovich, executive vice president and head of middle-market banking in Southern California for Comerica Bank, a unit of Detroit-based Comerica Inc., said recent rate hikes have had a "negligible" effect on commercial banks--but are likely to a have a big effect on bank customers.

"I think it's reaching a boiling point where it's causing concern with our customers, primarily with interest rates going up and not really working, so we have inflation," he said, adding that companies are likely to hold off on capital expenditures in anticipation of a slowdown.

"To me it's really a fear of future rate hikes, more so than where they are now," he said.

How Is the Federal Reserve Structured?

The Federal Reserve System is the nation's central bank. It was established by an Act of Congress in 1913 and consists of the Board of Governors in Washington, D.C., and twelve Federal Reserve District Banks. Congress structured the Fed to be independent within the government--that is, although the Fed is accountable to congress and law sets its goals, its conduct of monetary policy is insulated from day-to-day political pressures. This reflects the conviction that the people who control the country's money supply should be independent of the people who frame the government's spending decisions.

What makes the Fed independent? Three structural features give the Fed independence in its conduct of monetary policy: the appointment procedure for governors, the appointment procedure for reserve bank presidents and funding.

Appointment procedure for governors: The seven governors on the Federal Reserve Board are appointed by the President of the United States and confirmed by the Senate. Independence derives from a couple of factors: first, the appointments are staggered to reduce the chance that a single U.S. President could "load" the board with appointees; second, their terms of office are 14 years--much longer than elected officials' terms.

Appointment procedure for Reserve Bank presidents: The board of directors appoints each Reserve Bank president to a five-year term, subject to final approval by the board of governors. This procedure adds to independence because the directors of each reserve bank are not chosen by politicians but are selected to provide a cross-section of interests within the region, including those of depository institutions, non-financial businesses, labor, and the public.

Funding: The Fed is structured to be serf-sufficient in the sense that it meets its operating expenses primarily from the interest earnings on its portfolio of securities. Therefore, it is independent of Congressional decisions about appropriations.

How is the Fed "independent within the government"? Even though the Fed is independent of congressional appropriations and administrative control, it is ultimately accountable to congress and comes under government audit and review. Fed officials report regularly to the congress on monetary policy, regulatory policy, and a variety of other issues, and they meet with senior administration officials to discuss the Federal Reserve's and the federal government's economic programs. The Fed also reports to congress on its finances.

Who makes monetary policy? The Fed's FOMC (Federal Open Market Committee) has primary responsibility for conducting monetary policy. The FOMC meets in Washington eight times a year and has 12 members: the seven members of the board of governors, the president of the Federal Reserve Bank of New York, and four of the other reserve bank presidents, who serve in rotation. The remaining reserve bank presidents contribute to the committee's discussions and deliberations. In addition, the directors of each reserve bank contribute to monetary policy by making recommendations about the appropriate discount rate, which are subject to final approval by the governors.

Source: Federal Reserve Bank of San Francisco