by Slash, TheMarketTraders.com, 08.18.2010 

It looks like construction loans will be the next big hit for the banking and real estate sector.  

USA Today is reporting that construction loans are "The worst bet in real estate:

• Across the banking system, nearly 17% of construction loans were non-current — at least 90 days past due or otherwise in trouble — at the end of March, a record level and a stark contrast to less than 5.5% for all loans, according to the latest numbers available from the Federal Deposit Insurance Corp. For construction loans on one- to four-family residences, the percentage of bad loans is even worse: nearly 23%.
• "Construction loans are experiencing the biggest problems with vacancy or cash-flow issues, have the highest likelihood of default, and have higher loss severity rates than other commercial real estate loans," the Congressional Oversight Panel, tasked with overseeing the federal bailout fund, reported earlier this year.
• The 10% of banks that had the highest concentration of construction loans at the end of 2007 account for more than half of the 274 banks that have failed between then and Aug. 6, according to an analysis for USA TODAY by SNL Financial in Charlottesville, Va.
• Even the banks that have survived despite holding high concentrations of construction loans remain vulnerable. Their average "Texas ratio" — which measures their bad loans as a percentage of their capital and reserves against loan losses — stood at 101% on June 30, up from 90% three months earlier, SNL found. Anything over 100% signals that a bank is in danger of failing. For construction-loan-heavy banks, the median Texas ratio — which weeds out the worst cases — was still high, at 62%.

"It's been a bloodbath out here," says bank consultant Tod Little of BNK Advisors in Las Vegas."

The article goes on to correctly point out how construction loans work.  A developer applies for a construction loan from the bank at a high interest rate.  These loans were deemed safe because the real estate was used as collateral.  The monies are held by the bank  and distributed as needed.  As the project is finished and and tennants are placed, the developer refinances the loand (usually with a bigger bank) and repays the higher interest construction loan.  The developer then moves onto the next project.  

We happen to have a contact that is one of the largest residential developer in the midwest.   He has dozens upon dozens of loans taken out in small  community banks for his construction projects.  In the past, he was typically granted a fifteen to thirty day grace period against his due date to make payments.  This is no longer the case.  In fact, money is so tight that the banks are calling for early repayment.  The developer can also no longer refinance his current properties that are at or near completion because there are NO TENANTS. 

This is a big problem for the smaller community banks.  One of the reasons why they can offer better interest rates on deposits is due to the fact that they have loaned excessively to real estate developers. 

If you have money in a community bank, you have been warned.