Bad real-estate loans stack up for smaller local banks

For much of 2007, as the rest of the country sank deeper and deeper into the housing slump, Western Washington and the rest of the Northwest seemed immune to the gloom. But economically, no region is an island, and in recent months the local housing markets have slowed dramatically.

Statewide, housing starts in February (the most recent data available) were running at a seasonally adjusted annual rate of 34,000 units, according to the Bank of Tokyo-Mitsubishi. That was actually a slight increase from January, but 37.2 percent below the level in February 2007.

With sales down, inventories piling up and homes sitting on the market longer, two groups feeling the pain are developers and the banks that fund them. Indeed, looking at regional banks is a good way to gauge the local fallout from the housing crunch.

Though much of the attention has focused on financial giants like Citigroup, Wachovia and Washington Mutual, many regional banks are heavily exposed to residential real estate.

For instance, construction and land-development loans make up 61 percent of the loan portfolio at Bremerton-based WSB Financial, parent of Westsound Bank. At First Financial Northwest of Renton, parent of First Savings Bank Northwest, virtually the entire billion-dollar loan portfolio is connected in some way to real estate.

S&L roots

Some of Western Washington's smaller banks, like First Financial, have their roots in the savings-and-loan industry, which historically has focused on home loans. For other banks, real-estate development has become more dominant as big national banks have picked off other lines of business.

Locally oriented developers who don't fit into big banks' standard loan grids often find it easier to borrow from local banks, said Bill Conerly, a business consultant in suburban Portland and former economist for Bank of America.

"The small banks have an inherently higher cost structure, but they have the ability to make case-by-case lending decisions and do more careful credit analysis," Conerly said. "The big banks are more likely to say it either fits into our box or it doesn't."

For several years, that specialization proved quite profitable. Smaller regional banks often posted growth rates and earnings per share that superbanks would have envied.

But now, with home sales slowing, the regionals are seeing more developers fall behind on their loans, and are setting aside larger sums for expected future loan losses.

And because of their size, they can be hurt when just a few large borrowers run into trouble. Earlier this month, for instance, Everett-based Cascade Financial, parent of Cascade Bank, said nonperforming loans in the first quarter will increase by about $16 million, due mainly to just two unidentified borrowers.

In one instance, Cascade lent $11.2 million to "a well established Pierce County-based residential real-estate builder" to buy 46 lots and build 12 homes. But "sales in this development have not materialized as originally projected," the bank said. A $5.6 million balance remains on that loan.

The other customer, identified as "a well-established Snohomish County-based real estate developer," took out three loans totaling $11.6 million to buy two tracts totaling 466 acres, with the intention of building homes on them.

After the developer fell behind on the loans, he agreed to sell them; the sales have yet to close and the loans have been classed as nonperforming.

Cascade, which has about 35 percent of its loan portfolio in real-estate construction loans, said it will set aside $2.4 million in loan-loss provisions and charge off $1.5 million; it expects first-quarter earnings per share to fall to between 19 and 23 cents.

"Due to its large construction exposure, Cascade could see continued deterioration in credit quality, representing a head wind to earnings going forward," Ragen MacKenzie analyst Dustin Brumbaugh wrote to clients.

Covering losses

WSB last year set aside nearly $16 million to cover future loan losses, compared with $1.5 million in 2006 — more than a tenfold increase. A particular concern has been the difficulty many builders have had in replacing their WSB bridge loans — which typically are interest-only — with permanent financing.

In most cases, chief lending officer Charles Turner said in a statement, when the construction loans originally were made the borrowers "had commitments for takeout or permanent financing from national sources. Many of those permanent financing alternatives are no longer available, and consequently the risk in these construction loans has increased."

Sterling Financial of Spokane, which through a series of acquisitions has built itself into one of the Northwest's largest independent banks, has said it will set aside $35 million to $40 million for future loan losses. The higher provision reflects slower home sales, particularly in Boise, Idaho; Bend, Ore.; and Southern California.

"The subprime-related credit crunch is affecting builders and developers disproportionately in some of Sterling's smaller markets," Chief Executive Harold Gilkey said. Slower sales of properties "are beginning to affect the liquidity reserves of some borrowers in our core markets."

Sterling said it expects to report $200 million to $210 million in nonperforming assets when it reports first-quarter results, up 58 to 66 percent from the fourth quarter.

City Bank of Lynnwood has seen its nonperforming assets jump from $2.7 million in the first quarter of 2007 to $33.8 million at the end of last year, and to $56.6 million in the just-completed first quarter.

In its quarterly earnings report, the bank blamed the weakening residential sector and warned investors not to expect any improvement soon: "The slowdown in the housing market will remain particularly challenging and the bank expects higher loan delinquencies, nonaccruals and potential charge-offs to continue for the remainder of the year."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com