Of Banks and Band-Aids®: How Much Pain Lies Ahead?

At the end of the third quarter, the S&P 500 Index had risen almost 60 percent since its low on March 9, 2009.  A variety of indicators, including capital goods orders, vehicle and home sales have retreated from their downward trends and turned positive.  In the wake of the recent credit meltdown, the contracting U.S. economy appears to have turned the corner.  Or has it?

Without sounding too depressing a note, perhaps we shouldn’t be too quick to accept that the economy is completely out of the woods.  Why?  Three words: Commercial Real Estate.

According to Fortune magazine, real estate research firm, Foresight Analytics, estimates that banks should have booked losses on defaulted commercial real estate and construction loans to the tune of $110 billion.  To date, they have only booked about one-third of those losses.  This will put some of the smaller, regional and community banks (already on their knees) out of business, adding to the instability which has plagued the banking industry for months.  (As an aside, those who are customers of the giant banks need not fearthose institutions will be saved by the Troubled Asset Relief Program (TARP).

There is no doubt that these unrecognized commercial real estate losses must be documented at some point, and they will inevitably have a negative effect on our economy.  The more taxing questions are: (1) when will banks be forced to recognize the losses, and (2) will the economy react as drastically as it did in 2007-2008?

There are two ways to approach this problem: The loss write-down problem is a little like removing a BandAid®. The first option is to pull off the BandAid® in a single, quick rip, forcing banks to book the losses in one painful event. Of course, this method is going to sting at first, but the pain subsides after a short period and you are ultimately glad that the whole unpleasant business is over quickly.  The second option is to remove the BandAid® by slowly peeling it away from the skin. This would allow banks to book the losses in smaller increments over a longer period of time. It may seem like a good idea at the outset, but it ends up hurting more in the long-run.

So which option will President Obama and his advisors choose?  It appears as though they have chosen the latter of the two.  A couple of days ago, Federal Bank regulators issued guidelines allowing banks to keep loans on their books as “performing” even if the underlying property values have fallen below the loan amount.  This guideline allows banks to put off until some future date the pain of recognizing these losses.

Nobody knows how frequently, or in what amount, the banks will decide to book these losses.  The only thing we do know, with some degree of certainty, is that the loss recognition will most likely make for a rocky economy over the next couple of quarters.


Michael Carpenter, J.D., CPA

Michael is the professional consultant for Steve Finerty and Linda Pietroburgo.

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