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By Ronald Fink
Losses on commercial real estate may take a bigger toll on big banks' balance sheets than previously estimated, according to a the report issued last week by the Congressional Oversight Panel that oversees the Troubled Asset Relief Program.
The nation's four largest commercial banks have acknowledged that they will have to bring more commercial real estate assets onto their books as a result of a change in accounting rules for off-balance-sheet financing vehicles that takes effect this year. And bank regulators have said they would give the banks some leeway when setting capital reserves against losses that may result.
But the COP report suggests that an expected wave of foreclosures in commercial real estate this year may result in bigger losses than regulators expect.
According to the report, approximately $900 billion in assets will be brought back onto financial institutions' balance sheets. Of this amount, the four largest stress-tested banks will recognize approximately $454 billion. As disclosed in their public filings, Citigroup, Bank of America, J.P. Morgan Chase, and Wells Fargo will recognize additional assets of approximately $154 billion, $100 billion, $110 billion, and $48 billion, respectively.
Much of that represents commercial real estate loans that have been securitized through collateralized mortgage-backed securities.
The report noted that bank regulators have agreed to adjust capital reserve requirements so that losses on assets brought back onto balance sheets don't suddenly require banks to raise more equity.
But the authors warned that banks may suddenly be undercapitalized because losses on such assets may be larger than expected as a result of spreading foreclosures.
Because these assets were not previously reflected on banks' balance sheets, banks were not required to recognize any losses incurred from holding them. As a result, the report said, recognition of these new assets on an institution's balance sheet may result in an increase to loan loss reserves as well as additional losses from the write-down in values of investments in CMBS.
Commercial real estate whole loans "could also significantly affect the capital of a financial institution," the report stated.
"There is no 'check the box' formula for determining the appropriate level of loan losses," the authors continued, noting that it is based upon a high degree of judgment by management.
But they warned that regulators had to take steps to deal with that or risk a new round of financial instability.
"Because this account is based upon management's judgment, there is a high degree of risk that a financial institution's allowance for loan losses may be insufficient, especially in regard to the additional assets that will be recognized upon the adoption of these new accounting standards," the report said.
"The new accounting standards will force more accuracy in an institution's financial statements, but the increased accuracy will mean that the parlous state of commercial whole loans will be even clearer."
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