In this week's Digital Dirt, Big Builder discusses the banks and the rebalance of power that's occurring as the large withdrawal of financing in the industry has amplified current difficulties for many builders.

Until earlier this year, it seemed the banks were almost in denial, despite the fact that public builders were writing off their equity. Logic dictates that if land deflation is prevalent on the public builders' balance sheets as they take write-downs and impair assets, then the same loans with the neighboring private that's being funded by a bank would also be negatively affected.

But it took a catalyst to crystallize the picture, and that came in March when the banking industry saw the number of non-performing loans in the space almost quadruple in 4Q2007 from the same period a year earlier. "The accruals are rising, the non-performing loans are increasing, and [banks have] got to recognize hits to their capital as a result of that," said Ivy Zelman of Zelman Associates. "We knew it would come; it was just a matter of when."

Today, the business of home building is in utter turmoil as money is being pulled from the space. To date, the much-discussed influx of private equity has been virtually nonexistent because of the persisting gap between ask and bid--although frontmen like Chris Mahowald of RSF Partners and John Peskin of Starwood Land both agree that the gap is finally starting to narrow.

And as the banking industry continues to lose faith, it is doing whatever it takes to get out of real estate.

It's not just that banks are shutting builders down completely and pushing them into insolvency; there is also a shift in tolerance that is manifesting itself through a move to secured lines that were previously unsecured, or a substantial increase in borrowing costs as a result of a higher risk rating. In many cases, it doesn't necessarily indicate insolvency, but the consequences can ultimately become dire.

Mick Pattinson, president and co-owner of Carlsbad, Calif.-based Barratt American, knows that first hand.

He thought he had built equity in a long-term banking relationship with Bank of America. His company had a $125 million credit facility with the lender, of which $100 million was available when the bank informed Pattinson seven months ago that it would not renew two of his lines of credit. Then BofA promptly reappraised properties not yet due for appraisal.

"We are a 28-year customer of Bank of America, and the guys we have borrowed over a billion dollars from will no longer return our phone calls," Pattinson said. "We were still profitable when the banks stopped funding us. We hadn't lost money; we hadn't broken covenants. We made $16 million in 2006, and we were making money in 2007, believe it or not. But it wasn't enough."

Today the company is virtually out of business from the standpoint of building and selling homes. And its inability to pay its bills has triggered more than 40 lawsuits filed mostly by subcontractors with liens against Barratt American's assets that guarantee payment for labor and materials. Pattinson is scurrying to secure bridge financing as a lifeline, collateralizing it against some unencumbered assets. All the while, he's looking offshore for partners to help recapitalize the company.

In the meantime, Pattinson wants to know how one of the economic engines of America can being abandonded, especially given the fact that the Federal Reserve has made over $400 billion available to banks.

"Home building is something like 11% or 13% of the national economy in normal times," Pattinson noted. "You can't wipe out an industry that big because you've lost faith in what's going on."

The American Banker's Association senior economist Keith Leggett confirmed that, yes, the banking industry does indeed have loanable funds, and that no, it won't be dispersing many of them into the industry anytime soon. Translation: There is more pain ahead.

"What you'll see is that lenders will continue to tighten as long as they see these markets under stress," Leggett said. "Though it's probably not encouraging, the good news is the banking industry does have capital. It does have loanable funds. Once a floor establishes in that market, I think the banking industry would be there to meet the capital needs. But I don't think there is that strong [of a] capital need out there. You don't have the demand. You have a huge inventory to work through first. That's a condition."

With demand weak and banks on the run, many builders are finding themselves unable to pay accelerated debt. Now banks are beginning to push reclaimed assets through the sausage grinder. Many of these larger banks have enough assets to create a pool, and already we are beginning to see these deals returning to the market. And this is likely to be just the beginning.

On Tuesday, June 13, an initial letter went out from Key Bank on a $935-million portfolio of reclaimed assets. Roughly 55% of the package is based in California, and among the bits and pieces are 50 lot deals and 21 land deals along with some inventory, commercial property, and even manufactured housing assets. Hard packages are expected to be out early next week, and interested acquirers have about three weeks to look at underwriting as final bids are due by June 12.

This portfolio follows closely a $630-million pool of assets offered by Indy Mac. Final bids closed earlier this month, and though no official word is out, sources with knowledge of the deal report that five or six bids were received for the total portfolio. Though one hesitates to use the term "groupthink," it seems there was some like-mindedness in the valuations because all bidders came in within a few percentage points of each other near the $150-$200 million range. But it appears as if Indy Mac isn't prepared to reset land values to that level quite yet. Word has it that Indy Mac will break up the portfolio in 18-plus separate escrows based on cherry-picking bids.

In the meantime, while the land valuation reset remains in relative limbo, the demise of some great companies and a lot of great talent from the industry is likely. "We are living to see a lot of things happening that we hoped never to see," said Pattinson.

During the past 10 to 15 years, the business of the banking industry has evolved to an originate-and-distribute model. But with those secondary markets shutting down, financing has regressed into a pre-1980 world where banks are being forced to the more expensive originate-and-hold model.

Leggett speculated that the turmoil in the financial markets may fundamentally change how the residential construction industry is financed. Whether that's a regression to the historical model or a new and improved way to carry the risk has yet to be determined.

The question today is: Will the banking crisis that exists for the home building industry have far-reaching repercussions that have not all unfolded yet?

There may be a lot more than builders going out of business. Just last week, the Northern California city of Vallejo voted to file for bankruptcy.

With the reduction of development impact fees and infrastructure costs funding the municipality, they are no longer sufficient to support city government costs. Experts say Vallejo's case will raise speculation about municipal bonds used to fund facility improvements since the promise of profitability will suddenly look poisonous to investors.

Will we see more domestic profits and earnings get re-patriated offshore as international companies see opportunity--plus a huge currency advantage--and domestic banks refuse to support their own domestic industry?

In the future, will builders--or banks--be prepared to finance much of the non-housing costs that they carry today? Will they have to work with government agencies to find new ways to finance infrastructure burdens and development fees?

What about financing land acquisitions? Some say that carrying A and D loans as builders go through a multi-year--sometimes decade-long--entitlement process likely won't work either.

Have banks thought through the long-term repercussions of the actions they are taking today, or are they exhibiting a knee-jerk reaction to regulatory pressures?

There is a lot to talk about.

E-mail me at with your insight on these issues.

In the meantime, here's more on what's happening in the trenches:

MYRTLE BEACH, S.C. Denmark Homes, which builds and develops in Raieh, N.C., as well as Myrtle Beach, filed for bankruptcy in late April and stopped building new homes as it awaits a court order to continue construction. In the meantime, two new Denmark communities on the Grand Strand are progressing despite the bankruptcy filing.

OKLAHOMA CITY, OKLA. According to a report from Forbes, Oklahoma City tops the list of recession-proof cities. The list, culled from the nation's 50 largest metropolitan areas, ranks the cities based on job growth, rising home values, and low unemployment amid a national economic downturn. In compiling its rankings, looked at unemployment and expected industrial growth data through February from the U.S. Bureau of Labor Statistics. It also surveyed home-price data from the National Association of Realtors and gross metropolitan product projections from the U.S. Conference of Mayors.

DALLAS, TEXAS About 500 acres in unincorporated Denton County is expected to be annexed into the city of Denton next month and eventually used to build a master planned, residential-heavy community. The Hills of Denton North, planned adjacent to the Hills of Denton, will make this combined development among the largest ever built in the city.

At least 10 builders accounting for more than 1,000 new-home starts in North Texas during the market's peak in 2006 have closed their doors in the DFW market. In 2006, those builders collectively accounted for 960 housing starts.