Another Banking Disaster Looming on the Horizon

It turns out that a lot of banks, particularly smaller ones, look likely to get hammered by construction loans that allow developers to delay making payments.

They are called interest reserve loans, and they may be one of the next bubbles to pop:"

In essence, the banks pay themselves until the loan becomes due or the property generates cash flow."

That's a scary quote, and what it means is that a loan can continue to be reported as a "performing" loan, even though payments are not being made and the underlying property is not selling.

Sounds awfully familiar. A financial instrument predicated on the idea that property prices always go up, and never go down.

The good news is that the small banks seem to be a bit more proactive in recognizing and addressing the problem:

More banks are starting to change how they use interest reserves. Integrity Bank has stopped using interest reserves on loans used only for purchasing land without immediate plans for construction and loans on projects that have been delayed or abandoned. David Edwards, who joined Integrity in December as chief credit officer as part of a management shake-up at the bank late last year, said: "There is nothing wrong with the use of interest reserves. It depends on whether the borrower has hard cash [put up front], and whether the project is active or not."

Towne Bank, of Mesa, Ariz., has eliminated funding interest reserves. "Realistically, you never know whether a borrower can keep the loan current if you are the one who's making the payment," Patrick Patrick, who became chief executive of the bank in February.

HomeTown Bank, also ordered to change interest-reserves practices early this year, now is part of SunTrust Banks Inc., of Atlanta. A spokesman declined to comment.