Danger Ahead for Small Banks

The small banks that do much of the lending to small business face a crisis in the near future that could force thousands of them to cut back on loans.

That's the finding of a panel created by Congress to oversee the Troubled Asset Relief Program, or TARP, the Wall Street Journal reports. The panel found that losses on commercial loans could force nearly 3,000 of the 8,000 or so U.S. banks to jerk the reins on their lending activity to cover losses from commercial loans.

"The banks that are on the front lines of small-business lending are about to get hit by a tidal wave of commercial-loan failures," Harvard University law professor Elizabeth Warren, head of the panel, told the Wall Street Journal. The panel's findings are to be released today.

Loans made for shopping centers, offices, hotels and apartments pose the danger ahead, and loans for residential real estate development that have gone sour continue to drag on small banks.

And small banks have been paying the price, with 181 failing since January 2008, and 16 failing so far this year. The panel estimates 2,988 small lenders have exposure to commercial loans at least 300 percent of their capital, or construction and land loans above 100 percent of capital.

Don’t look for that trend to slow down, said Joshua Siegel, managing principal of Stone Castle Partners LLC, a firm that invests in small and mid-sized banks. There are still about 1,000 banks under financial pressure and anywhere from 500-800 will fail, Siegel and his colleagues expect.

“Borrowers that are creditworthy aren’t borrowing,” Siegel said. “There aren’t enough creditworthy people. Just because you want a loan doesn’t mean you’re entitled to one. “They’re still making loans but there aren’t enough loans that they’re comfortable with.”

And there are plenty of troublesome loans already on the small banks' books, the panel found.

From 2010-2014, some $1.4 trillion commercial real estate loans will reach the end of their terms, Bloomberg reports. In nearly half of those loans, borrowers owe more than the property is worth.

Without improvement in economic conditions "hundreds" of banks could fail. Siegel and his colleagues expect 500-800 bank failures before all is said and done.

Of course, if the economy and employment rebounds, the predictions of so many small bank failures may not come true. But most experts expect a slow climb away from high unemployment rates and slow growths, despite some recent encouraging signs.

The Obama administration is looking to offset the losses and spur small business lending by steering $30 billion in TARP funds toward small banks. But the Wall Street Journal points out that's just 4.3 percent of the $700 billion in small business loans held by banks and savings institutions.