Fed, IRS try to limit problem loans in commercial real estate

WASHINGTON — The Federal Reserve is stepping up its scrutiny of commercial real estate loans at smaller banks, which have seen delinquency rates double in the past year.

At the same time, the IRS issued rules Tuesday designed to make it easier to refinance some commercial real estate loans, to try to curb the number of defaults.

Instead of reviewing individual banks, Fed examiners are comparing results across the industry to better assess broader risks, a Fed official said Wednesday. The official spoke on condition of anonymity because of the confidential nature of bank reviews.

Delinquency rates on commercial loans have doubled the past year to 7% as more companies downsize and retailers close, the Fed has said. Small and regional banks face the greatest risk of severe losses from commercial real-estate loans, which are contributing to a rising number of bank failures.

The Fed review is focused on roughly 800 regional and community banks, the official said. The Fed’s “stress” tests earlier this year on the 19 biggest banks in the country already examined their commercial real-estate loans.

Unlike the “stress” tests, results of the Fed’s examinations of smaller banks are not expected to be made public. The extra scrutiny of commercial real estate loans is being done through the normal supervisory process, the official said.

Based on the government’s “stress” tests results in May, Bank of America , Citigroup and Wells Fargo were among the 10 banks told they would have to boost capital by a total of $75 billion to cover potential losses.

Some of the lessons learned from those tests are being applied in examinations of smaller banks, the Fed official said. The biggest change in technique was the importance of analyzing results — risks and problems — industrywide, rather just at the company level.

Credit troubles have spread beyond the risky mortgage-backed securities that were at the heart of the financial turmoil that erupted two years ago and reached a crisis last fall.

Ninety-two banks have failed this year, according to the Federal Deposit Insurance Corp. Hundreds more are expected to collapse in the next few years largely because of problems with commercial real estate loans.

The new rules at the Internal Revenue Service isn’t directly related to banking. It would allow commercial loans that are part of investment pools known as Real Estate Mortgage Investment Conduits, or REMICs, to be refinanced without triggering tax penalties for investors.

The investment pools were designed to encourage mortgage-backed securities by offering tax benefits not typically available through other investment vehicles. However, under the old rules, investors could have lost those benefits if loans in the portfolio were restructured.

The new regulations come as Wall Street braces for a wave of defaults on commercial real estate loans. More than 90 U.S. banks have already failed this year. Hundreds more are expected to fail in the next few years largely because of souring loans for commercial real estate.

“These changes will affect lenders, borrowers, servicers, and sponsors of securitizations of mortgages in REMICs,” the new regulation says.

The changes will not affect commercial mortgage loans held by investment trusts or REITs. However, the Internal Revenue Service said Tuesday it is soliciting comments on possibly expanding the changes to other investment vehicles.

Concept Capital, a New York-based institutional broker, welcomed the changes but cautioned that they will not solve the commercial real estate crisis alone.

“We have all heard stories about commercial real estate loans that are performing now but cannot be refinanced because of the tax rules,” Concept Capital’s Washington Research Group said in a report issued after the regulations were released. “The IRS attempted to ease the tax code problem for these modifications.”

But, the report said, “We still question if there is enough financing available to deal with the wave of commercial real estate loans that must be refinanced by 2012.”