Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 30, 1992

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Statement by John P. LaWare, Member, Board of Governors of the Federal Reserve System, before the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 30, 1992 I am pleased to have this opportunity to discuss the Federal Reserve's supervision of bank lending on commercial real estate and the international coordination of supervisory efforts, in general. As requested, I will also provide an assessment of commercial real estate markets throughout the United States and describe steps we have taken to alert examiners about potential risks.

In brief, conditions within the U.S. banking system generally appear to be improving and, for some institutions, to be improving in significant ways. This progress flows from several sources, including a general stabilizing of commercial real estate markets, albeit at a relatively depressed level in all too many cases. Nevertheless, problem real estate credits remain a principal concern to major bank lenders throughout the United States and also, of course, to the supervisory agencies. It is important to learn from past events, and steps are being taken by both banks and the agencies to prevent the recurrence of problems of the scope we have experienced in recent years.

IMPORTANCE OF COMMERCIAL REAL ESTATE LENDING

Although real estate lending has always been important to U.S. commercial banks, it became even more critical to the industry during the past decade, as all loans secured by real estate increased from 14.5 percent of total commercial bank assets at the end of 1980 to nearly one-quarter of the industry's assets at the end of 1991. Currently, loans secured by real estate represent the largest asset class held by banks today and at $850 billion exceed the volume of commercial and industrial loans by more than $330 billion. In absolute terms, real estate loans have accounted for more than one-half of the industry's loan growth since 1980.

This growth in real estate lending includes substantial increases in home mortgages as well as commercial real estate loans, but it is the latter, of course, that has mainly presented the problems to the banking industry. Commercial real estate lending has also been the fastest growing real estate segment, as loans outstanding nearly quadrupled during the 1980s. This lending, combined with that provided by thrift institutions, fueled a dramatic expansion in commercial real estate building nationwide that has left markets in most cities throughout the United States significantly overbuilt.

To understand conditions today, it is helpful to consider views commonly held during much of the 1980s when most of the excess construction occurred. Over that period, contractors and lenders alike seemed to believe that nearly all real estate projects would prove profitable, for a long time. That view was supported by experiences in which properties were generally worth more by the time they were completed than all the costs included in their construction. Even banks that held problem real estate investment trust (REIT) loans in the mid-1970s had seen those problems largely disappear as rising inflation rates gave real estate values a boost. Although inflation rates had declined since then, many developers and lenders still felt that real estate values would continue to increase.

These expectations, as well as favorable tax treatment accorded by 1982 legislation and the general ebullience of the economy, encouraged many builders to expand their activities. At the same time, thrift institutions looking for added revenues to offset other problems, banks experiencing a loss of customers to other lenders and to the open market, and foreign …