Federal regulators warned Thursday that banking-industry turmoil would continue as financial institutions come to terms with piles of bad loans they made to finance the construction of homes and condominiums.

Until now, most of the damage to banks from the housing crisis has come from homeowners defaulting on their mortgages. But amid a dismal spring sales season for new homes, loans to home and condo builders are looking increasingly shaky. Banks have begun to dump them at what will likely be steep discounts, setting the stage for billions of dollars in fresh losses.

"As long as the housing market is on a downward path, as long as those prices continue to fall, I think there's a risk that the losses could continue to mount on a variety of loans," Federal Reserve Vice Chairman Donald Kohn told the Senate Banking Committee Thursday.

At the same hearing, Federal Deposit Insurance Corp. Chairman Sheila Bair said banks that aren't diversified, or those with high exposures to residential construction and development, are of particular concern. "That's where we are really seeing the delinquencies spike," she said.

The surprisingly gloomy outlook is at odds with the sentiment of investors, who appear to have moved on from worrying about the health of the financial system to obsessing about gasoline prices and consumer spending. The Dow Jones Industrial Average rose 213.97 points, or 1.7%, on Thursday on the back of surprisingly strong retail-sales data.

The health of the economy is heavily dependent on the willingness of banks and other financial institutions to lend to consumers and businesses. Many banks have already taken substantial losses, and either will have to pare their lending or raise new capital to rebuild their safety nets. The Federal Reserve and Treasury Department have been pressing banks to raise capital so as not to further reduce lending.

Banks with swelling portfolios of troubled loans tied to land and housing are struggling to unload some of their real-estate debt. IndyMac Bancorp Inc., a Pasadena, Calif., lender, is trying to sell $540 million in loans made to finance land purchases and housing construction projects. Winning bids on many of the loans were, on average, about 60 cents on the dollar, according to people familiar with the matter. But some winning bids were only about 20 cents on the dollar.

Cleveland-based KeyBank, a unit of KeyCorp., is trying to unload $935 million in loans tied to land and residential developments, while Wachovia Corp. is shopping a $350 million loan portfolio, according to two people who have seen the offerings. Representatives of the banks declined to comment.

The sales are a response to a growing problem: Home builders are falling behind on loan payments, and the value of the land and housing developments that serve as loan collateral is plummeting. Over the next five years, U.S. banks could "charge off" as bad debt between 10% and 26% of their loans tied to residential construction and land assets, which would amount to about $65 billion to $165 billion, according to a report sent to clients Thursday by housing research firm Zelman & Associates. That compares with charge-offs of about 10% of construction-related bank assets, totaling $31.6 billion, when adjusted for inflation, during the last housing downturn in the late 1980s and early 1990s. In 2007 and the first quarter of this year, banks wrote down just 0.7% of such assets, according to Zelman.

"We believe this period of procrastination is nearly over," says Ivy Zelman, chief executive of Zelman & Associates.

The prospect of a new wave of losses worries federal regulators, given the large proportion of loans to housing developers held by many banks and thrifts. The problems are worse at small banks that can't easily absorb losses, and at banks with big exposure in states hit hard by the housing crisis. Banks in Arizona have 36% of their total loans tied to construction and development. In Georgia that number is 34%, and in North Carolina it's 28%. Zelman said construction and development loans, as a percentage of total loans, are at their highest levels since at least 1975.

Grab Bag of Assets

IndyMac is trying to sell debt backed by a grab bag of assets, including partially built subdivisions, condo buildings and large parcels of raw land covered in sagebrush in parts of California, where the housing crisis is acute, according to people familiar with the offering.

Selling real-estate loans could help larger lenders like IndyMac shore up their balance sheets. But such sales, by setting a market value for distressed real-estate loans, could trigger problems at smaller banks with real-estate exposure, which might have a difficult time absorbing such losses.

Office of Thrift Supervision Director John Reich told Congress that the number of savings-and-loan associations at a heightened risk of failure jumped from 12 at the end of March to 17 today. Federal regulators have met privately with Treasury officials to discuss the potential fallout from a larger number of bank failures, people familiar with the matter said. Four banks have already failed this year, more than in the prior three years combined.

The FDIC's Ms. Bair said she would be "very surprised" if a large bank failed, but added that "we need to be prepared for all contingencies."

Federal regulators said they have increased scrutiny of banks with high concentrations of real-estate loans, with Comptroller of the Currency John Dugan saying a formal initiative is in place to review asset quality.

Signs of Improvement

At the same time, regulators praised the banking industry for raising capital and for building up reserves against losses. They added that some pockets of the credit markets were showing signs of improvement.

Over the last week, for example, direct lending by the Federal Reserve to investment banks and commercial banks declined, suggesting that credit strains across the industry were easing. Average daily borrowing by securities firms was $8.3 billion in the week ending Wednesday, down from $12.3 billion a week earlier, the Fed said Thursday.

Real-estate lenders had been hoping for a decent spring sales season for new homes, which would have helped builders stay current on their loans. But the selling season has been a bust. The rate of foreclosures on homeowners hit a record, as did the rate at which they fell behind on their mortgage payments. In the first quarter, 6.35% of mortgages were at least 30 days delinquent, not including those already in foreclosure, a rise of 1.51 percentage points from the year-earlier period.

"We've seen a real change in the market," says Ricardo Chance, a managing director at KPMG Corporate Finance LLC, who is helping troubled builders restructure their businesses. "Finally the banks are capitulating and saying, 'Let's mark to market and flush this all out.' The market is going to get worse. We don't want to hold on to this stuff."

The glut of foreclosed homes has made life hard for home builders. "I've been through three cycles, and this is the worst," says Mark Connal, a vice president at Michael Crews Development, a closely held Escondido, Calif., builder. "You can buy brand new homes for less than the cost of construction."

At the peak of the housing boom, during the second quarter of 2005, luxury-home builder Toll Brothers Inc. signed 3,120 contracts. In its latest quarter ended April 30, buyers signed just 929 contracts for new homes in the builder's 300 communities across the nation.

In Riverside County, Calif., where the housing market is dismal, developers are offering upgrades and services to move unsold homes. "They used to landscape the front yard," says Gloria Britt, of Prudential California Realty in Riverside. "Now they're doing the back, upgrading the patio, whatever the buyer asks for."

Write to Michael Corkery at michael.corkery@wsj.com, Jonathan Karp at jonathan.karp@wsj.com and Damian Paletta at damian.paletta@wsj.com

Kudos in line on inflation management

Floor Rates for NCR Realty may Rise 30%

Banks Toughen Terms on Loans

A Rising Number of Foreclosed Homes