Small Banks Face a Looming Hit From Builders’ Interest-Reserve Loans

Regulators are increasingly worried about a lending practice that allows real-estate developers to delay paying construction-loan interest but can mask problems at the banks that made the loans.

Small banks, which are more exposed relative to bigger banks, have $280 billion of outstanding construction loans overall, mostly to condominium developers and home builders. When the loans were made, the banks calculated the interest that would be paid and put that money aside in “interest reserves.” In essence, the banks pay themselves until the loan becomes due or the property generates cash flow.

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Regulators fear this practice can be abused to keep recording loans as performing even though the underlying real-estate projects are failing.

This month, the Federal Deposit Insurance Corp. alerted its bank supervisors to be on the lookout for banks that haven’t come clean about potentially problem loans. “You don’t want to have a false sense of security because the interest reserve is paying the loan,” Steve Fritts, the FDIC’s associate director for risk management and exam oversight, said in an interview. “You need to look to the credit fundamentals of the project.”

As an indication of regulators’ concerns about construction lending, the FDIC in recent months has hit some banks — including Towne Bank of Arizona, HomeTown Bank, of Villa Rica, Ga., and Integrity Bank, of Alpharetta, Ga., — with cease-and-desist orders requiring, among other things, that they overhaul how they use interest reserves. Analysts have warned that some 150 small banks could fail in the next few years because of their big bets on construction loans.