by Calculated Risk on 6/10/2008 12:37:00 PM

There is a growing concern that interest reserves are masking problems with Construction & Development (C&D) and Commercial Real Estate (CRE) loans. In their Summer 2008 Supervisory Insights released today, the FDIC provides a primer on interest reserves.

Interest reserves are common for new construction projects. Basically the lender loans the developer enough to build the project, and then loans the developer the interest payment each month during the development phase.

Although potentially beneficial to the lender and the borrower, the use of interest reserves carries certain risks. Of particular concern is the possibility that an interest reserve could mask problems with a borrower’s willingness and ability to repay the debt consistent with the terms and conditions of the loan obligation. For example, a project that is not completed in a timely manner or falters once completed may appear to perform if the interest reserve keeps the troubled loan current. This is a much different scenario from most credit transactions in which cash flow problems are eventually reflected in late or past-due payments and sometimes even in nonpayment. A loan with a bank-funded interest reserve would not exhibit these warning signs.

With little potential for monetary default during the interest reserve period, some lenders may delay recognizing and evaluating the financial risks in a troubled ADC loan. In some cases, lenders may extend, renew, or restructure the term of certain ADC loans, providing additional interest reserves to keep the credit facility current. As a result, the true financial condition of the project may not be apparent and developing problems may not be addressed in a timely manner. Consequently, a bank may end up with a matured ADC loan where the interest reserve has been fully advanced, and the borrower’s financial condition has deteriorated. In addition, the project may not be complete, its sale or lease-up may not be sufficient to ensure timely repayment of the debt, or the value of the collateral may have declined, exposing the lender to increasing credit losses.
emphasis added

This happens every down cycle. The interest reserves are masking the problems with C&D loans - usually because of the inability of the developer to sell or lease the developed property - and suddenly the noncurrent loans at financial institutions increase dramatically. This has just started happening:

[The acquisition, development, and construction] loan segment almost tripled, from $231 billion to more than $600 billion, and grew from 9 percent to 13 percent of total real estate loans from 2001 to 2007. Delinquency rates for the ADC portfolio were historically low during much of this time. However, credit quality began to show signs of weakening in 2006 as the level of noncurrent ADC loans began to rise. By year-end 2007, noncurrent loans had reached 3.15 percent—the highest level in more than 10 years—and more than triple the rate for other commercial real estate loans.

A rapid rise in noncurrent ADC loans, combined with the heavy concentration at certain institutions of CRE and C&D loans, will probably be the main reason for a large number of bank failures over the next couple of years.

As an aside, the FDIC argues interest reserves "might not be appropriate" for certain transactions, including:

Loans secured by income-producing rental properties (residential or commercial) that should be amortizing.

It was just yesterday that we discussed the interest reserve in Lehman's investment in Archstone-Smith. If Lehman was regulated by the FDIC that structure would probably be considered too risky and inappropriate.