US bank regulators warn on commercial real estate

* Regulators urge "prudent" commercial loan modifications

* Commercial real estate seen as trouble spot for banks

By Karey Wutkowski

WASHINGTON, Oct 30 (Reuters) - U.S regulators on Friday encouraged banks to modify troubled commercial real estate loans, which are seen as a looming danger spot for the banking industry.

The regulators issued guidance to financial institutions and said "prudent" loan workouts are often in the best interest of both the borrower and the bank itself.

"The financial regulators recognize that financial institutions face significant challenges when working with commercial real estate (CRE) borrowers that are experiencing diminished operating cash flows, depreciated collateral values, or prolonged sales and rental absorption periods," the policy statement said.

The guidance came from the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp and the Office of Thrift Supervision.

Community banks are being hit especially hard by the troubled CRE sector because many smaller banks built up heavy concentrations of commercial loans, viewing it as an area in which they could compete with larger banks.

FDIC Chairman Sheila Bair has said CRE exposure will increasingly be a driver of bank failures.

Last week, the tally of failures passed the 100-mark for the year and reached 106, the highest annual level since 1992.

That number is expected to continue rising as the banking industry continues to grapple with deteriorating loans on its books, many of which were extended during the credit heyday before the housing market bust.

The regulators' guidance said that while CRE borrowers may see their financial conditions deteriorate, many of them will continue to be creditworthy borrowers who can repay their debts.

Bank examiners will take a balanced approach and will not necessarily criticize institutions should the restructured CRE loans have weaknesses that result in an adverse credit classification, the regulators said.

As of June, commercial real estate loans totaled more than $1 trillion, or 14.2 percent of all loans and leases in the banking industry.

Prices for existing commercial properties have fallen 35 to 40 percent since peaking in 2007 and more declines are anticipated. Rising job losses and high vacancy rates also are weakening demand for commercial property. (Reporting by Karey Wutkowski, editing by Gerald E. McCormick)