If there was a soundtrack to banking this summer, it sounded something like the theme from “Jaws” — tense, ominous and hinting at unknown dangers below the surface.

Even as tentative signs emerged that plunging home values might be nearing bottom, the recession and tighter credit increased the pressure on commercial real estate and the loans that back it. Those loans make up 20 percent to more than 50 percent of assets for most banks based in the Capital Region, and preparing for possible losses pushed some of those banks into the red in the first or second quarter.

Owners of commercial real estate are also nervous, particularly those with a loan due soon. Property values are down, tenants are bailing out or pushing for lower rents, and cash is scarce. Some investors are ready to cut their losses and hand the keys back to the bank, but many banks don’t want the properties on their books, let alone the headaches and costs of operating them until they find a buyer.

Unless there are regulatory changes that make it easier to clear problem loans off the books without a tsunami of commercial foreclosures, local players say, the problem could linger for years and even delay economic recovery.

“This affects everybody who borrowed money to buy, build or refinance (commercial real estate) in the past five years,” says John Frisch, managing partner with Cornish & Carey Commercial in Sacramento. “I think there are so many people in denial … that it’s going to make the problem worse.”

“Nobody’s moving very quickly because there’s no good solution for either side without an infusion of equity money, and the equity money is sitting on the sidelines until prices get lower,” says Michael Kvarme, a senior shareholder who handles real estate law for Weintraub Genshlea Chediak in Sacramento. “We’ve got this standoff taking place that, I think, is holding up the recovery. Somebody has to absorb those losses.”

The situation shows some marked parallels to conditions about two years ago in residential lending: falling values, increasing loan delinquencies and a certain amount of whistling past the graveyard through short-term modifications in hopes that economic recovery will clear up the problem without huge write-offs and foreclosures.

But there are key differences. The residential mortgage problems hit broadly while commercial mortgage woes vary considerably from bank to bank, project to project and area to area. Two banks might each have 40 percent of their assets tied up in commercial real estate loans but might have used different underwriting standards or targeted different types of property, leaving one in trouble and the other unscathed.

Still, the problem is looming and growing. By some estimates, delinquencies on commercial mortgages held by banks exceeded 4 percent in the second quarter, more than double a year earlier.

Many local banks have increased loan-loss reserves and taken control of commercial properties in default. A second-quarter loss at Community Business Bank in West Sacramento was almost entirely related to $1.8 million in charge offs for two commercial properties that declined in value.

American River Bankshares of Rancho Cordova posted its first quarterly loss in 25 years, largely because of cash set aside for potential loan losses. American River’s board suspended the company’s cash dividend, saying that economic challenges demanded that it build up capital and reserves now in the interest of long-term success.

Last month Golden Pacific Bancorp announced it was seeking to acquire and shore up Marysville-based Gold Country Bank, which had more than $5 million in foreclosed property on its books in the first quarter. The acquisition was pending regulatory approval at press time. Bankrate.com rankings, based on first-quarter data, showed Gold Country as the weakest bank of its size in California.

“We’ve got this standoff taking place that, I think, is holding up the recovery. Somebody has to absorb those losses.”

Michael Kvarme, shareholder, Weintraub Genshlea Chediak PC

These industry conditions have led analysts to offer more blunt assessments. “I don’t even think the banks know at this point how bad commercial real estate could be,” Edward Timmons, senior research analyst at Sterne Agee & Leach Inc., told The Wall Street Transcript as part of its Western Banks Report in July. “I think from here, we definitely get worse before we get better.”

“It will probably accelerate over the next 12 to 24 months,” says Steve Fleming, president and chief executive of River City Bank in Sacramento. River City anticipated problems and began building its loan-loss reserves in third-quarter 2008, but Fleming admits that the complicated broader picture makes forecasting difficult. Improvement is “far enough out that I can’t see the bottom at this time,” he says. “I guess I’m hopeful that it’s 12 to 24 months.”

As it did in housing, the rise of mortgage-backed securities put a lot of inexpensive money into the commercial real estate market early this decade. Easy money drove up prices and fueled competition among lenders, whether they used securities-backed financing or kept the loans in house, says Chauncey Swalwell, a partner and head of the Los Angeles real estate practice at Stroock & Stroock & Lavan LLP. The national law firm counts both lenders and equity investors among its clients.

“We had some clients where we put out a term sheet, and we’d have lenders bidding on it instead of the other way around … because it was so competitive,” Swalwell says. The easy money affected the lending standards even for banks and insurance companies that had taken a more conservative, relationship-based approach to underwriting in the past, he says. “During the run-up, a lot of these banks said, ‘We can’t compete with the Wall Street money (from mortgage-backed securities), but we can compete in our niche.’ But they still found themselves in that competitive environment and, in hindsight, maybe not pricing that risk appropriately.”

But that varies a lot from lender to lender. Roughly half of commercial real estate loans are for owner-occupied property, which tends to be less risky than office or retail space for lease, says James Chessen, chief economist with the American Bankers Association.

That’s partly why the Bank of Agriculture & Commerce in Stockton hasn’t had to foreclose on any properties and has only one bad loan, despite the fact that commercial real estate loans made up nearly 43 percent of its total asset value in the first quarter. Only one of the 23 banks headquartered in the Capital Region had a higher rate.

“We have concentrated very heavily on what we call owner-user properties, where the property is an integral part of the business,” such as a medical office owned by the doctor who practices there, says Ned Smull, executive vice president and chief lending officer.

Smull notes that BAC is family-owned and consistently used conservative underwriting standards during the boom, when some publicly traded banks might have been pressured by shareholders to relax standards to improve returns. He also points out that owner-user properties are more insulated from the changes in value that are squeezing the commercial property market. “Unless they go out of business, (the property is) like your home — you may have lost value on paper, but unless you sell it, you’re fine.”

And underlying property values are a huge problem, particularly for tenant-occupied offices or shopping centers emptied out by the economic downturn. If a loan for the property is coming due, it may no longer be worth enough to justify a new loan at the old amount, forcing the owners to bring cash or a new investor to the table to balance the scales. Some have been hit so hard that they’re in trouble even if the loan isn’t due.

“You’ve got a lot of properties out there that not only can’t service their debt, they can’t service their operating costs,” Swalwell says. Now most of the securities-backed financing is gone, and new private investors are biding their time while prices fall. “Where do you go to refinance a loan? Even in a normal market, let alone the one we have right now, it’s difficult to refinance a property that’s lost value.”

Some investors have worked with lenders on short-term fixes, “kicking the can down the road by a year,” Swalwell says, but now many aren’t sure how long recovery will take and are wary of putting up more cash with no end in sight. They’re ready to hand the keys over to the bank, but in many cases the banks don’t want them. “A lot of lenders don’t want to foreclose on the stuff” because the property has to be carried on the bank’s books and operating it for any remaining tenants is expensive.

“If the lender had to take the property back in every case, there’d be chaos.”

— Michael Heller, president, Heller Pacific Inc.

“There’s no good solution to this,” says Chessen, with the bankers association. “The best of all worlds is to try to keep those businesses in business.”

In some cases, that will mean digging cash out of savings. Gold River-based development company Heller Pacific Inc. locked in low-interest fixed-rate loans for many of its established properties several years ago, but President Michael Heller says he’s looking for additional money from savings or elsewhere to address the situation at a handful of properties with vacancies. Borrowers that can’t bring cash to the table should notify their lenders as soon as possible to talk about working things out. “If the lender had to take the property back in every case, there’d be chaos,” he says. “I can’t see how a rigid approach can work.”

Each bank faces a unique challenge depending on its portfolio, capital and the approach regulators take, says John DiMichele, president and chief executive of Community Business Bank. “The situation is going to take a few years to work through,” he says, but regulators demand a quick adjustment on a bank’s books to reflect reduced property values. That cuts into available capital and ultimately reduces lending. “We need to work harder to work through these (loans) without forcing all these properties into foreclosure.”

It would help if regulators would recognize that the widespread decline in property values demands a different approach, DiMichele says. “We need some additional breathing room, say over five years, and not mark these down all at once.” Under current rules, “banks are not in a position to do long-term workouts.”

“We’ve heard a lot of concerns about regulators forcing write-downs,” Chessen says.

But in some cases, writing off a bad loan may be exactly what’s needed, regulators say. “It was a bubble, and it deflated,” says a Federal Deposit Insurance Corp. official who spoke on background and was not authorized to speak to the media. Some banks may be hesitant to recognize losses because that would cut into earnings, the official says. “There are lots of creative ways that banks can work with a borrower, and I think they’re going to have to.” Some approaches, such as allowing banks to take an equity stake in a project, might be allowed with FDIC permission, but there hasn’t been a surge in applications for permission so far. Relaxing some of the rules would require an act of Congress.

Without a surge in those creative approaches or the economy, the commercial real estate lending market faces foreclosures, more pain on bank balance sheets and more falling prices. At some point, prices will fall enough that investors bring cash back to the market, as they have in the residential market.

“There is money out there, but I think on a general basis there’s a fear that we’re nowhere near the bottom yet,” Swalwell says. “I’m not whistling past the graveyard; I’m not guardedly optimistic. I’m just hoping we get to the bottom as quickly as possible.”

How does this all work?

The economic downturn, falling property values and tighter credit markets are combining to put the squeeze on commercial real estate loans. Tenant vacancies in an office building or shopping center can force the owner to rework a loan, or the debt might just be due. Here’s how the changes can force a borrower to cough up a lot of cash.

Values for commercial property are often based on expected cash flow from tenants plus the underlying value of the land and buildings. Let’s say five years ago an investor took out a loan on a shopping center valued at $1 million. At that time, a bank commonly would loan 70 to 75 percent of a property’s value, so the shopping center could support a loan of $750,000.

But time changes things. “For the most part, 25 to 50 percent of the value of commercial property has been lost since 2005,” says Steve Fleming, chief executive of River City Bank in Sacramento. Maybe an anchor tenant has filed bankruptcy and closed. Other stores, stung by the recession, have shut down, and remaining tenants may be pushing for rent reductions.

Whether the term is up or finances force the owner to revisit the loan, the shopping center needs a new loan in 2009. But now the property is only worth $750,000 — the full amount of the old loan. And standards are stricter now. In 2009, a bank is likely to loan no more than 65 percent of the value of a property. A 65 percent loan on a value of $750,000 is only $487,500.

“If that borrower’s loan is coming due today, they have to come up with an extra $260,000 to $270,000 to balance that loan,” Fleming says.

Many private investors who could bail out owners are waiting for prices to fall further, which leaves cash-poor borrowers in a bind.