A Long Shadow Over Small Banks

As the nation's largest financial institutions scramble to pay back their bailout money, some regional banks may be on the government dole until at least 2011. Lending for offices, malls, hotels, and similar properties averages more than a third of loans at 35 of the biggest regional players with federal funds, according to an analysis by Bloomberg BusinessWeek . By comparison, such debt averages 9.5% of loans at Citigroup (C) and Wells Fargo (WFC). And with defaults at a 16-year high and rising, the worst may be yet to come.

Unlike their bigger brethren, regional banks didn't diversify much into areas such as selling stocks and bonds. Instead, the smaller institutions—which typically operate in several communities or states, and don't have a national or international presence—found themselves lured by the potential riches of commercial real estate. "Regional banks basically became real estate banks," says Jeff Davis, an analyst at FTN Equity Capital Markets, an equity research firm. Among the group of regional banks in the analysis, seven have more than half their loans in commercial real estate, including Zions Bancorporation (ZION), headquartered in Salt Lake City, and Synovus Financial in Columbus, Ga. A spokesman for Zions says the losses will be "extremely manageable."

Now the loans are souring as vacancies rise and prices plummet. Portland (Ore.) lender Umpqua Holdings sank $3.4 million, according to local paper Bend Bulletin, into the Shire, a development where the artificial thatched-roof homes are modeled on the hobbit community in the Lord of the Rings trilogy. The developer defaulted in July. Umpqua CEO Raymond Davis said that while the bank did not experience a "significant loss" on the Shire, its real estate portfolio was "showing signs of weakness."

Profits are suffering. Synovus, which has two-thirds of its loans in commercial property and construction, has posted five straight quarterly losses. The lender is projected to lose money for all of 2010. One of the bank's failures: a $220 million loan to Sea Island, a Georgia real estate developer that fell behind on its payments. Last month, co-lender Wells Fargo took over the deed to Sea Island's 3,000-acre Frederica community on St. Simons Island. "We let our percentages [in commercial real estate] get higher than we normally have," says Kevin Howard, Synovus' chief credit officer. "We got out of whack...trying to keep up with the herd." Another eight banks with more than 30% of their loans in commercial real estate aren't expected to show a profit next year.

Until the regional banks are on better financial footing, the government likely will have a say in their affairs. When considering whether to let banks repay the bailout funds, the U.S. is looking at profits and capital, among other things. Big banks, which have more revenue streams, may have an edge. If Citigroup and Wells Fargo join JPMorgan Chase (JPM) and Bank of America in returning their bailout funds, they'll be free to press their advantage in markets they already dominate, such as consumer lending. Regional firms with federal aid may also look less attractive to investors, since those banks won't be able to declare dividends or stock repurchases without seeking the feds' approval.

It may take awhile for regional players to get out from under the government. Unpaid commercial real estate loans, which stood at 3.4% in the third quarter, may reach 5.3% in two years, estimates Real Estate Econometrics, a property research firm in New York. "The commercial real estate problem is looming," says William Bartmann, CEO of Bartmann Enterprises, a debt advisory firm. "We can see that it's coming. It just hasn't shown up yet."

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