Construction-Loan Growth Is a House of Cards

 | Jun 23, 2014 | 12:00 PM EDT
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This week will bring the reports on both new and existing-home sales, and there is one group of businesspeople who will be keeping a sharp eye on the numbers. Banks have been sticking their collective toe back into the construction-loan market: In the first quarter, construction-loan volume reached its highest level in 25 quarters amid a renewed willingness to take on higher levels of risk among some lenders. So if the housing market doesn't deliver on the hopes for a strong recovery, it could become a problem for some of those firms.

This increase in lending has come just as Fannie Mae has lowered its 2014 housing-market forecast, with new targets for a small decrease in the total number of homes sold this year. This comes after a more hopeful start to the year, when the firm had expected a strong climb. Freddie Mac has likewise changed its outlook to project a decline in home sales. The Mortgage Bankers Association suggests a year-over-year decline of more than 4%, as well as a decline in total mortgage applications.

So far, among the banks that have been growing their portfolio of mortgage loans, most are the bigger operations. In fact, almost all of this growth has taken place at banks holding more than $5 billion in assets: Among the leaders in such lending growth have been U.S. Bancorp (USB), JPMorgan Chase (JPM) and United Bankshares (UBSI). Texas Capital Bancshares (TCBI) had pulled back from construction lending during the recession, but the bank is now back in a big way, and its construction-lending portfolio has grown in the double digits for five quarters in row.

While construction lending remains well below the peak levels reached back in 2008, some industry observers still feel this is still a less than wonderful time for the housing market. At the Ira Sohn Conference earlier this year, Jeffrey Gundlach made a compelling case for a decline in home sales and building activity. He pointed out that first-time buyers have gone on strike as a result of a weak economy that is not creating the type of higher-paying jobs that make home ownership possible.

A significant percentage of home sales have been all-cash purchases, which suggests investment buying as opposed to individuals buying new homes for their own use. I have suspected for some time that all the hedge-fund and investment buying has pushed home prices higher than they rationally should be. Much of that buying has been in the lower and middle segments of the market, as they are part of rental-home portfolios. I believe this activity has pushed prices too high, too quickly, and that this has prevented the market from recovering at a reasonable pace. As a result, potential first-time home buyers cannot currently afford to purchase.

The other obstacle facing the lower end of the market is that even qualified first-time buyers are simply not very interested in buying. They do not feel comfortable enough about the economy and the future to jump into the large commitment. Folks are also delaying getting married and starting a family for longer than previous generations. A 25-year-old today has already seen their parents deal with two massive stock-market collapses and a real-estate collapse, and it seems they just do not feel all that confident about their economic future.

Every quarter, when I'm reviewing my Trade of the Decade -- small banks -- one of the first things I look at is the percentage of construction loans and the performance thereof. Right now, I'd prefer to see a shrinking percentage of construction loans. I will make occasional exceptions for some names, such as Charter Financial (CHFN), that have a large percentage (e.g., 17%) of the portfolio in this segment, if they are doing an outstanding underwriting job and have very little nonperforming or delinquent loans. Most of the time, though, I want very little exposure to construction lending in my bank-stock portfolio.

For the most part, the rise in construction lending has taken place at the larger banks. The community banks have actually been shrinking their exposure to construction lending. They seem to have learned their lesson from the housing-and-credit crisis, but it appears their big brothers have much shorter memories.

I really do not believe the housing recovery will be very strong this year. For that reason, I am avoiding construction-loan risk as much I am able.

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