Small Banks Face a Looming Hit From Builders' Interest-Reserve Loans

Regulators are increasingly worried about a lending practice that allows real-estate developers to delay paying construction-loan interest but can mask problems at the banks that made the loans. Small banks, which are more exposed relative to bigger banks, have $280 billion of outstanding construction loans overall, mostly to condominium developers and home builders. When the loans were made, the banks calculated the interest that would be paid and put that money aside in "interest reserves." In essence, the banks pay themselves until the loan becomes due or the property generates cash flow. Regulators fear this practice can be abused to keep recording loans as performing even though the underlying real-estate projects are failing. This month, the Federal Deposit Insurance Corp. alerted its bank supervisors to be on the lookout for banks that haven't come clean about potentially problem loans. "You don't want to have a false sense of security because the interest reserve is paying the loan," Steve Fritts, the FDIC's associate director for risk management and exam oversight, said in an interview. "You need to look to the credit fundamentals of the project." The issue is gaining attention because the housing slump means many of the projects funded by construction loans either will never be completed, or won't get sold or rented. That means banks likely will see a sudden jump in the number of dud construction loans as interest reserves deplete. A warning that interest reserves might have disguised loan problems can pop up when a bank shows a relatively low percentage of delinquent construction loans in one quarter followed by a big jump in nonaccruing loans the following quarter. While there can be other reasons for this shift, one possible explanation is that interest reserves kept delinquencies low. However, once the well ran dry, troubled projects were immediately moved to the nonaccrual category, said Mr. Anderson. Meridian Bank in Phoenix is among the banks where nonaccrual rates have outpaced delinquencies. Only 6.4% of Meridian Bank's construction loans were delinquent in the fourth quarter of 2007, but its nonaccruing loans jumped to 30% in this year's first quarter. That jump was among the largest of banks with a sizable proportion of construction loans, according to FDIC data on more than 8,000 banks analyzed by The Wall Street Journal.