THE SUBPRIME-INDUCED TIGHTENING OF credit conditions in home mortgage markets now is being joined by tightening in credit markets where builders and developers raise funds—the markets for land acquisition, land development, and construction loans (AD&C). Some tightening in AD&C markets has been inevitable in view of the major downswing in home sales, the major upswing in inventories of unsold homes, and the associated weakening in prices of both homes and buildable land in many parts of the country. But the tightening process has been moderate, and we're not likely to face the kind of AD&C credit crunch that decimated the housing market in the early 1990s.
SOURCES OF CREDIT Large public home builders have access to AD&C credit through the capital markets. But most other builders and developers raise AD&C credit at depository institutions (commercial banks and thrift institutions). In fact, a quarterly NAHB survey of residential builders and developers shows that about 90 percent of these businesses rely on depositories for AD&C financing.
Depository institutions, of course, are subject to federal supervision and regulation. Indeed, tightening of regulatory constraints was a major factor in the AD&C credit crunch of the early 1990s. In the wake of that credit crunch, real estate lending rules were developed and implemented by the federal regulators, including limits on loan-to-value ratios for AD&C loans. These rules helped prevent the kind of collapse in lending standards that characterized major components of the home mortgage market during the recent housing boom. Thus, we're not likely to see the kind of snapback in lending standards that now characterizes the mortgage market.
FIRMING STANDARDS The major housing downswing naturally has had some adverse impact on the quality of AD&C loans held by depository institutions, illustrated by an upswing in the noncurrent proportion of construction loans at FDIC-insured institutions between mid-2006 and the third quarter of 2007. Even so, the noncurrent rate for the third quarter still was historically low and came to only one- seventh the peak rate registered in the early 1990s.
The regulators naturally have been warning depository institutions about deteriorating credit quality, and the institutions have been firming standards to some degree. Federal Reserve surveys of senior bank lending officers document this process. In October, about half the respondents said they had tightened credit standards on “commercial” real estate loans (including construction and land development loans) during the previous three months, but only 10 percent said the tightening was “considerable.” The balance of respondents held credit standards steady during the August to October period.
BUILDER REPORTS NAHB surveys of single-family builders show some deterioration in the availability of AD&C credit during the past year, but this deterioration hardly stacks up as a credit crunch. For example, 39 percent of respondents to a December survey said that the availability of single-family construction loans had deteriorated since mid-2007. The deterioration most commonly showed up as a reduction in allowable loan-to-value ratios.
We also surveyed builders about changing terms on land loans taken out during the past two years. About one-fifth of respondents said that they had been asked to pay down part of their loans because the value of the land had declined since loan origination. This response was most common among larger companies and in the West.
BEWARE LIBOR Most single-family construction loans are floating-rate arrangements, where the loan rate is tied to a short-term market index. In recent years, LIBOR has supplanted the prime rate in many loan contracts. However, LIBOR has been very volatile recently while the prime rate has moved down systematically with the federal funds rate (controlled by the Fed). In this environment, many builders have been shifting back to prime-based construction loans and that's a good lesson for most companies.
CHIEF ECONOMIST, NAHB WASHINGTON, D.C.