The All Important Concentrations Policy

The general consensus appears to be that the housing market is on the way to recovery. Although there are still an abundance of distress properties on the market we are hearing from bankers that houses and even residential building lots are selling. Much of this is attributed to the federal government’s housing programs. However, the commercial real estate market is still suffering the effects of the economic recession. Last week the Bureau of Labor reported another 85,000 jobs were lost in December and kept the nations’ unemployment rate at double digits. This is bad news for CRE and the banking sector.

For the month of November the FDIC alone issued thirty-four formal cease and desist orders against banks. Of the thirty-four, twenty nine enforcement actions contained provisions related to “Concentrations of Credit” and order the bank to systematically reduce them. This is the issue that continues to plague the nations’ community banks. The condition of the CRE market is a major concern to top regulators. Several Federal Reserve governors have made recent speeches cautioning that the CRE market is still under major stress. In a speech on January 11, 2010, Atlanta Federal Reserve Bank President Dennis P. Lockhart stated that “the risk associated with commercial real estate is linked to banks, small business credit, jobs, and ultimately consumption. The overall commercial real estate debt in the financial system is smaller than residential, but it is disproportionately concentrated in small and regional banks.”

The FDIC risk examination manual states “concentrations generally are not inherently bad, but do add a dimension of risk which the management of the institution should consider when formulating plans and policies”. At this point in the time that appears to be a very big understatement. It is most likely that the lending policies in these institution’s do have a section for concentrations or quite possibly a stand- alone concentration policy but the field examiners have found it to be deficient.

If you find yourself at a bank with an enforcement action containing this provision whether the action is formal or informal, such as MOU or a Board Resolution, or if you are lucky enough to be employed by a healthy bank that wants to remain that way…..how do you write a Concentration Policy that will be considered adequate?

Here are some tips:

I – Opening Statement
Begin the policy with a definition of concentrations and an opening statement evidencing the commitment on the part of management and the board of directors to effectively manage the institution in a safe and sound manner. Acknowledge that concentrations of credit raise the risk level of the institution and require greater oversight and increased management processes.

For example: “We, the Board of Directors and Senior Management of Any Bank, strive to run this institution in a safe and sound manner while also providing an adequate return on equity and credit to our defined market. We recognize that credit concentrations have been inherent in our portfolio since the bank’s organization and that concentrations can also arise unintentionally. As such we have prepared and adopted this policy statement on Date. Concentrations are defined as a significantly large volume of economically related assets that an institution has advanced or committed to one person, entity, or affiliated group. Concentrations can also be any other group deemed important by the Bank.”

II – General Information
To begin the policy statement, describe the institution in general terms with a statement detailing its historical profile: such as the date opened, whether it has a parent holding company and affiliates, asset size, charter type, and the general philosophy of the senior management and board of directors.

For example, “The Bank of Any Town was organized as a denovo institution during 2008 and opened its doors for business on March 1, 2009, as an independent state non-member bank. Budgeted growth projections are on target with the bank’s total assets reaching $140 Million as of quarter end 2010. The Bank was formed by the directors to serve the retail banking and commercial and residential credit needs of the local community within Any Town County, Any State. Any Town County is a residential “bedroom” suburb of Any City and consists largely of residential subdivisions, strip shopping centers, a major shopping mall, office buildings housing businesses typically with fewer than 100 employees, and some small warehouse facilities. Deposit and loan products were tailored to fit the needs of this customer base”.

II – Products and Services Offered
For this section list the credit products the institution offers such as commercial real estate loans, commercial real estate construction, commercial and industrial loans, floor plan loans etc. Also be sure to list any credit related products related to deposit accounts, such as overdraft lines of credit, letters of credit, suspense assets, leases, repurchase agreements, as well as any other actual or contingent liability. This can be in list form and be sure to include the terms offered, such as residential mortgages with repayment terms up to 5 years based on a 30 year amortization with a balloon payment.

III – Concentration Identification and Limits
Concentrations can be clearly evident almost as soon as an institution opens. Typically senior management and the board of directors have contacts in a particular business, industry, and a certain geographic area. These relationships are often the impetus behind a new institution being formed and the growth, profitability, and ultimately the success of the institution can be attributed to them. These concentrations also form because the chief lending officer or other senior management official’s has expertise is a particular type of lending, or a certain geographic area, performs it well, and feels comfortable in this role. These concentrations are readily identifiable. However, concentrations can develop that are unintentional and can go undetected without proper mechanisms in place. Identifying concentrations of credit is ongoing function within any institution and it’s in every institution’s best interest to have mechanisms in place to identify these groups in the early stages especially before auditors and examiners discover them during a review or examination.

Open this section of the policy with a brief description of concentrations and define them for your institution in terms of dollar amounts and percentages for the group and in the aggregate.

Segments
The FDIC’s examination manual does not define a percentage for concentrations but Section 216 of the Comptroller’s Handbook states that a concentration exists if the credit in the form of direct, indirect, or contingent obligations exceeds 25 percent of the bank’s capital structure. However, the Handbook is dated March 1990 and it would be safe to say that lowering that threshold to 15 percent would be wise. Some suggestions for your segments:

1)Individual - Single developer/builder
2) Product Type
3)Geographic Distribution – by MSA, zip code, submarket
4) Underlying Collateral
5) Industry/Major Employer
6) Same Manufacturer’s Product –or if agricultural lender, by herd or crop

Concentrations are typically thought of in terms of a percentage of capital which is a very important analysis but what is even more important for a bank to do is break down and identify the most profitable product line or type. This segment is crucial to the bank for many reasons, some of which are to: sustain profitability; fund the loan loss reserve to ensure the ability to absorb losses in the entire loan portfolio; augment the capital base; and ultimately ensure the future viability of the institution.

Aggregate
The Interagency guidance on Concentrations in Commercial Real Estate Lending issued by the FDIC, OCC, and Federal Reserve System on December 6, 2006, defines the supervisory criteria as:
1) Total reported loans for construction, land development, and “other land” represents 100% or more of the institution’s total capital: or
(2)Total commercial real estate loans represent 300% or more of total capital and the outstanding balance have increased 50% or more during the prior 36 months.

The term “total capital” is defined as the total risk-based capital stated on Schedule RC-R Line 21.

Regulators received many negative public comment letters on the guidance threshold levels while in the proposal phase but history has clearly shown that concentrations are very dangerous for a bank. Steve Fritts, Associate Director of the FDIC’s Risk Management Policy Branch, said at the RMA Conference in November 2009 in Orlando Florida that “concentrations are bank killers”. With that in mind adopting more conservative limits, such as 150% which has appeared in public cease and desist orders, may be in your institution’s best interest.

IV – Mitigating Steps
The policy should clearly define what steps the bank can and should take if the concentration reports disclose that thresholds limits have been exceeded. Also included timeframes for which management must take action to reduce the concentration to within policy limits. Some suggestions include:
1)Participating out a portion or selling loan(s) to another lender;
2)Ceasing new loan originations or refinancing opportunities upon renewal;
3)Obtaining a government guarantee for all or a portion; and
4)Securing loan(s) with cash collateral;

V- Concentration Reporting and Frequency
This section should define the reports used to identify and monitor concentration limits. Reports can be derived from the bank’s core system, loan documentation system, excel spreadsheets, and any other software product installed in the bank. Hopefully banks are complying with the 2006 Guidance and performing stress testing on a portfolio level. If so, segmentation analysis performed for concentration analysis should be consistent with stress testing exercises. Also, periodic reports should be checked for accuracy by someone other than the preparer prior to being submitted to the board of directors. This person should clearly notate their review with date and signature.

Concentration analysis should be performed monthly and reported to and discussed with the board of directors with notation in the meeting minutes.

Don’t forget to present the policy to the board of directors and notate the approval in the meeting minutes.

What will 2010 hold for the banking industry?

Reports in various publications are conflicting as to the health of the real estate industry and its impact on the general economic recovery. An article in the LA Times says that “Commercial real estate will not cause another recession,” while a piece from Business Week states that, “Commercial real estate poses risk to U.S. recovery.” Who do we believe?

The facts are that bank loans dropped by 2.75% or $210 Billion during the third quarter of 2009. On an annualized basis this amounts to 11%. Real Capital Analytics (http://www.rcanalytics.com/) reported only $ 42 Billion in U.S. commercial-real estate transactions through November 2009, down from $136 Billion for the same time frame last year and $489 Billion in 2007. The chart below illustrates the decline in the national averages of sales price per square foot for the major commercial property types.

(Source: http://www.mbaa.org/NewsandMedia/MBANewsLink)

Bankers Reluctant to Refinance

The Federal Reserve’s most recent survey data of senior loan officers from October showed that banks are continuing to tighten standards on commercial real estate loans and appear reluctant to refinance maturing loans for construction and land development. Refinancing loans that are dependent on the rental income of the collateral property is also undesirable because of:

•  the decline in rental rates;
• a rise in vacancy rates;
• and higher capitalization rates,

...all factors which lower the value of the collateral property.

Adversely Classified Assets

It is highly probable that many of these assets have been adversely classified by the bank’s federal or state regulators. A review of recently issued and publicized cease and desist orders by the FDIC reveals that many if not all of these formal actions have provisions titled “Adversely Classified Assets”. These sections require bankers to reduce the bank’s risk exposure in each asset, or relationship, within a certain timeframe. 

• An FDIC cease and desist order consented to by the Bank of Ellijay in Ellijay, Georgia gave the bank 30 days to reduce loans in excess of $1Million which were classified Substandard or Doubtful in the Examination Report.

Reducing Risk Exposure
Reduce is often specifically defined as collecting, charging off, or improving the quality of the asset to warrant the removal of the classification.

A charge off of the loan balance negatively impacts the bank’s Allowance for Loan and Lease Losses and ultimately the capital base. No wonder why bankers are hesitant to offer refinancing.

Improving the quality of the asset is obviously the best option. Such efforts include the bank taking additional collateral, which often times comes in the form of a lien on the principal(s) residence. However, due to the decline in residential property values, this option can also be limited; and obtaining a substantial personal guarantee(s), is also difficult because many developers and investors never intend to repay a bank loan personally.

Outlook for 2010
Estimates vary, but range from an expected $1.3 - $1.4 billion of commercial mortgages that will mature by 2013 with approximately 65% of these credits failing to qualify for refinancing. All this still spells trouble for the banking industry. The FDIC’s troubled bank list totaled 552 as of September 30, 2009, but has surely climbed since that date. Look for large numbers of failures through the first two quarters of this year with a slow down towards the end of the third quarter.

C'mon! Give the Regulators a Break!

Much is being written in the press about the regulators, especially the FDIC, allowing banks to “extend and pretend” because of the October 30, 2009 “Policy Statement on Prudent Commercial Real Estate Loan Workouts.” Comments in online articles and blogs state, “Bank examiners have guidelines to follow when they review bank’s books, but none of the guidelines forces banks to ultimately resolve problem loans”
and, “Rather than foreclose, banks were guided to extend and amend loans.”

While the Youtube video on CRE posted below is hilarious, it accuses the FDIC of amnesty during bank examinations and I don’t see this being the case in any way.



The guidance that was released is simply a reiteration of policies that have been in effect for many years. Assistant examiners are taught these policies during training classes at the FDIC’s training facility in Virginia and while on the job from more seasoned examiners. The same is true for the other regulators. For lenders who have lived and worked through the last banking crisis, this is not new material. For bankers who have worked in this industry for shorter time periods, some of this material may be an education. During the conference call on December 3, 2009, Darrin Benhart, Director of Commercial Credit at the Office of the Controller of the Currency, stated, “I want to emphasize that there's no change to the definition or the process for analyzing credit in determining the classification.” The transcript for the call can be found at
http://www.fdic.gov/news/news/financial/2009/fil09068.html.

What the guidance does do is clarify the aspects of a loan credit that an examiner evaluates while reading the loan during an onsite examination. The guidance also discusses in detail the benefits of restructuring a note using an A and B note structure. In reality, many of a bank’s borrowers want to remain in good standing with their bank, especially if they have long-term established relationships with their community bankers. By restructuring a loan into two notes, the bank has the ability to structure the A note according to their institution’s board approved lending policy and eventually return this note to accrual status without an adverse classification. This scenario benefits everyone. The B note is typically charged off but the bank has the opportunity to recover if the situation presents itself.

By following this methodology, a bank will take a loss, but the loss will not be as severe. In my opinion this is not the regulators' way of saying not to recognize the loss, but a better way to estimate the actual loss. If this can be accomplished while banks are starting to realize increased earnings, more banks can be saved and the customer/banker relationship can be maintained. More importantly, the property will not have to be foreclosed upon, thus avoiding additional legal expenses for the bank and stemming the flow of distressed real estate in the market.

It is in no one’s best interest to have as many failures as the last banking crisis. During that crisis, the Resolution Trust Corporation was created in 1989 to facilitate the sale and disposition of bad assets, mostly consisting of real estate and securities, from failed thrifts. The RTC dealt with 747 thrifts with assets totaling over $394 billion. The assets were sold for cents on the dollar to investors. If they could make good on the loans, they were rewarded handsomely. Former FDIC Chairman William Isaac estimated that some funds who were organized by Wall Street investment banks earned annual returns of 40-50% on their investments.

While the ultimate cost to the taxpayer was not quite as large as originally estimated, the loss in the banking industry was huge. Efforts to contain this crisis and return the banking system to health is well worth the effort.

In My Humble Opinion

Federal Reserve Chairman Ben Bernanke is being nominated for a second term by President Obama. The hearings were televised on CSPAN and are available on the Senate’s website. It was interesting to hear individual Senators’ opinions on the job performance of Chairman Bernanke. Some Senators praised him for his decisive and effective efforts to prevent the collapse of the global banking system last fall. Some Senators acknowledged these efforts but were critical of other decisions while Senator (R) Bunning from Kentucky blamed Chairman Bernanke for everything since the Civil War.

Chairman Bernanke will surely serve another term during a critical time in our nation’s history. There are several major propositions that Congress is considering.

• First - The possible consolidation of the federal financial regulators. This, in my opinion, would be the worst possible outcome. The federal thrift charter remains an important mechanism in this country to finance residential mortgages by an insured depository institution. Many consumers are wary of obtaining financing through mortgage brokers and they should be. Also, there is the possibility that the Federal Reserve should not have direct supervisory responsibility over member banks. In my opinion this would also not be a beneficial change to the regulatory structure. Federal Reserve examiners provide valuable insight and direct access to banking issues during their examination processes.

• Second - The possible oversight of the Federal Reserve’s monetary policy function. This is also an area that should not be tampered with. Monetary policy is a long-term objective and should be conducted by individuals independent of political functions. There is plenty of transparency of the Federal Reserve board who issue the minutes of their meetings and frequently testify before Congress during hearings. The most successful countries are ones that allow monetary policy to be independent of the legislative or executive branches of government. 

• Third –Addressing the “too big to fail” concept. Never in this country’s history has this concept been more evident than over the last two years and if Congress can accomplish only one objective it should be this one. The nation’s largest institutions took on tremendous risk by filling their balance sheets with subprime and high risk/high LTV loans and the taxpayers subsidized this risk. The subsidy allowed these institutions to write off these bad loans and now bounce back to profitability from income streams derived from their nontraditional banking activities. Chairman Bernanke is in favor of empowering the FDIC with the authority to “wind down” the resolution of failed large institutions. This is a suggestion Congress should act on because the FDIC clearly has the infrastructure and experience to assume this new and incredibly important responsibility.

The nation is recovering from a large financial disaster, although the recovery is a shaky one. Many Americans are out of work, the credit markets are still not lending to their full capacity, and delinquencies and defaults on commercial real estate loans are rising. Because of this, the FDIC continues to close failed institutions and incur losses to the deposit insurance fund. Hopefully, we as a nation, and bankers especially, have learned valuable lessons from this economic recession. Going forward, better risk management practices are in everyone’s best interest.

Let's Talk "Loan-to-Value"

Much is being written in the press about bank’s tightening up their lending standards and becoming more conservative lenders. Part of the more conservative approach is to reduce loan-to-value ratios.

Loan-to-value is defined in Part 365-Real Estate Lending Standards of the FDIC’s Rules and Regulations as “the percentage or ratio that is derived at the time of loan origination by dividing an extension of credit by the total value of the property(ies) securing or being improved by the extension of credit plus the amount of any readily marketable collateral and other acceptable collateral that secures the extension of credit. The total amount of all senior liens or interest in such property(ies)should be included in determining the loan-to-value ratio.”

The Real Estate Lending Standards regulation details supervisory loan-to-value limits for various types of property, such as the raw land limit of 65%. Clearly regulators have an interest in every institution’s limits for loan-to-value. However, due to the economic recession and the impact on the nation’s community banks in particular, lenders are sensing the need to tighten standards even further. Many publications contain articles that quote bankers who have revised their loan policies which previously allowed an 80% loan-to-value and now require a 75% loan-to-value. These articles also refer to this practice as needing “more skin in the game to play today” . Another way to phrase this is that investors must have more “hard equity” in the deal to entice the lender to take the risk.

These practices are commendable but can provide a false sense of security for bankers. In the examples noted above, the scenarios would require the investor to have 20-25% equity in the deal. However, the commercial real estate market has experienced declines of substantially more than these amounts as demonstrated by the chart below.

The Moody’s/REAL Commercial Property Price Indices (CPPI) measures the change in actual transaction prices for commercial real estate assets based on the repeat sales of the same assets at different times. As you can see, the index as of September 2009 is 109.61 and is in line with prices during 2002. This index is down 42% from prices seen during the height of the real estate boom during the second and third quarters of 2007. Loans that were originated during 2007 are going into default at record paces quickly followed by loans originated during 2005 and 2006.

Bankers are quick to defend their loans because they were originated with “conservative underwriting standards”. However, as demonstrated above, the equity in a loan can quickly evaporate and leave the bank with a Net Collateral Shortfall. Not a good place to be, especially when your regulator is scheduled for a visit.

Bankers with proactive risk management programs can use these industry tools to their advantage and stress test their loans to arrive at good estimations of values that are current and projected values under “stress scenarios”. This information should also be used when senior management and the board of directors make critical decisions for the loan policy, such as loan-to-value limits.

Crafting a CRE Stress Testing Policy: A Simple Outline

Historically, writing a policy for your bank can be as easy as downloading one from the internet or borrowing one from a trusted friend at a neighboring bank. After obtaining a policy in this manner, remember to modify the policy to fit the particulars of your bank. This is a very important step because regulators hate to read a board approved policy that names another bank and details the other bank’s specific information in the policy. Bankers can do this for just about every bank regulation and issue out there. However, stress testing is a fairly new concept and policies are not readily available. When a bank commits to stress testing, a formal policy is needed and will be expected by your regulators.

The following are some suggestions when crafting the policy for your bank:

I. Opening Statement – For stress testing to be a successful exercise in your bank, the Board of Directors and Senior Management must “buy in” to the concept and recognize the value that can be derived. An opening statement should express the level of commitment by this group and individuals. For example, “The Board of Directors at Anytown Bank and Trust are committed to operating the institution in a safe and conservative manner and as such has decided to employ stress testing techniques to the CRE portfolio (or total loan portfolio).

II. General Purpose Statement and Information - This statement or paragraph should clearly detail why the bank is undertaking this exercise and what the expected value will be. For example, “The Board and Senior Management recognize that undertaking risk is an embedded part of the banking process and that it is the bank’s duty to originate safe and sound loans within the market or assessment area. During uncertain or downturns in the economic cycle these assets can decrease in value, often without any fault or neglect on the part of our customer. Part of management’s responsibility is to effectively manage these risks and concentrations to protect the bank’s capital base and ensure the long-term viability of this institution. With the information derived from the stress testing exercises, we will be able to assess the adequacy of the capital base under various stress scenarios and develop contingency planning, should the need arise.”

III. Responsibility and Independency – The policy should designate two individuals, one with primary authority and another with secondary authority, who are responsible for this exercise. The primary individual should have officer level authority and responsibility within the institution and have access to loan files, records, and information needed to ensure the success of this exercise. It would also be best for this individual to not have a vested interest from a compensatory standpoint, i.e. commissions or bonuses based on originations, in the results of this exercise.

IV. Reporting and Frequency – How often and in what format will the results be conveyed to senior management and the board of directors? The bank should decide upon the proper format for the reporting. Should a summary document be prepared? How much information from the output of software or spreadsheets should go to the board?

V. Scope – The policy should require the report to clearly define the scope of the stress testing. For example, “The stress test encompasses all CRE loans as defined in the 2006 Interagency Guidance which includes construction, multifamily, and commercial real estate for investment purposes only. The pool of loans consists of 150 loans totaling $7,500,432. Please note that loans secured by farms, 1-4 family residential properties, and owner-occupied properties are not included”.

VI. Assumptions and Scenarios - Any assumptions made during this process should be detailed in the summary document. These assumptions can include management’s lending focus, underwriting standards, and growth/no growth objectives for these loan products. Bankers should then decide how many stress test scenarios are needed and name them accordingly. If the institution is small and low-risk, it is possible that only two scenarios would be needed. Some possibilities include mild, moderate, severe, and extreme. What components will these scenarios actually stress? The Federal Reserve has committed to maintaining low interest rates for the foreseeable future but it would be wise to stress customer’s debt payments to interest rate shocks to predict possible cash flow shortfalls when monetary policy changes course. Interest rates have declined in a steep and quick manner but they can also rise with a vengeance. It’s better to be prepared. Other components to stress include changes or declines in Net Operating Income as well as collateral value decreases.

VII. Thresholds and Limits - The stress test policy should detail threshold levels for Loan-to-Value as well as Debt Service Coverage. If the stress scenarios result in loans exceeding these thresholds, what is your course of action? Some recommendations include downgrading the internal loan grade, allocating more funds into the ALLL, and devising a possible workout plan. You can reference the newly issued Interagency Policy on Prudent CRE Loan Workouts (http://www.fdic.gov/news/news/financial/2009/fil09061.html) for guidance.

VIII. Capital Levels - The goal of the stress test is a forward-looking capital assessment of how much is needed today to maintain a “well capitalized” status if the economy were to mirror the stress scenarios. With that in mind the report should detail the effect on the bank’s capital ratios if management had to offset credit losses under the stress scenarios. There are really only two capital positions for a bank, “Well Capitalized” and “Not Well Capitalized.” Projecting that your bank’s capital position will still be in the former category under reasonable stress scenarios would be the ultimate objective of this exercise.

IX. Contingency Planning – If the stress test reveals lower capital levels than recommended, the policy should detail possible courses of action management can take to mitigate the risk and achieve the higher capital status. Can the institution be successful with a public stock offering? Will the directors increase their investment in the institution? Does the institution have a strong holding company that can provide additional support?

These are just some suggestions to create a detailed stress testing policy for your institution. After writing the document and making the final adjustments, don’t forget to present the document to your full board of directors for their approval and document the approval in the board minutes.

CRE Still Lagging in the Economic Recovery

There has been some good economic news lately. The Federal Reserve’s Beige Book reported that residential real estate and manufacturing showed signs of improvement. The residential real estate market has been picking up, especially in sales of low-to middle-priced houses, due to the first time homebuyer tax credit. This portion of the economic stimulus has been a key driver in turning around the freefall in housing prices. However, the future is uncertain in this market because the tax credit is due to expire next year.

The tax credit has not benefitted the sale of higher-priced homes which continue to be depressed due to the large numbers of short sales and foreclosures, which are reported to be in excess of 4.1 million.

Commercial real estate was the weakest sector in the report with conditions described as either “weak” or “deteriorating across all Districts”. The report went on to state that “an inability to obtain credit was often cited as a problem for businesses that wanted to purchase or build space.” At the national RMA Conference in Lake Buena Vista Florida on November 9, 2009, Lloyd Lynford, CEO and Co-Founder of Reis, Inc. stated that all four major property CRE sectors (office, retail, apartment, and industrial) are experiencing the “Trifecta of Weakness.” This refers to escalating vacancy rates, declining effective rents, and protracted negative absorption. Vacancy rates are higher for landlords who are not offering concessions. But this practice leads to a significant difference between the “asking rent” and the “effective rent” and results in lower rates for the entire submarket where the property is located.

Not good news for any banker with CRE loans on the books. Robust risk management, especially for commercial real estate loans and including stress testing, is the key.

“CONCENTRATIONS ARE BANK KILLERS”

At the national RMA conference in Lake Buena Vista, Florida, on November 10, 2009, FDIC Associate Director Steven D. Fritts said that “concentrations are bank killers.” He went on to say that many of the banks that have failed have higher CRE concentrations. Virginia M. Gibbs of the Federal Reserve advised banks that they should invest in MIS systems to improve their risk management. "Without this capability," she asked, “how can you stress test?”

Regulators told the audience that over 2,000 banks in the country still have CRE exposure in excess of the 100% and 300% thresholds outlined in the interagency CRE guidance from 2006. Although FDIC Chairman Sheila Bair’s “problem bank list” is not public information, an informed individual can identify these institutions using pertinent ratios that are publicly available from the FFIEC’s website, which contains quarterly Reports of Condition and Income. A significant majority of the institutions with high CRE exposure will be on that “problem bank” list.

Now, more than ever, it is essential that bank management take steps to monitor and manage asset concentrations. The peak of CRE property values was in mid 2007 and the decline has been steady and severe ever since. Many banks still have loans on the books originated during the value peak. If these loans are still classified as “pass credits,” you need to update the value for these properties.

Obtaining new appraisals are expensive and due to the lack of “arm's length” transactions in the marketplace, arriving at a market value is a difficult assignment for any appraiser. However, collateral value is an important element of stress testing. When conducting this exercise consider the date of collateral value when determining your stress factors. If a majority of your loans were originated during the value peak, assigning a 30% or even a 40% stress factor would only bring this value current. This scenario will not project the impact to your capital base should the recession be prolonged with continuing negative economic factors. If your institution needs some help with this exercise email me.

Policy Statement on Prudent Commercial Real Estate Loan Workouts

Read What Regulatory Agencies Are Telling Examiners to Look For When Examining Your CRE Loan Portfolio

To Sum It Up:
The FFIEC CRE Loan Workout Guidance is well-written in plain English that everyone can understand. I've summed up the first 13 pages in the key points below, and the last 20 pages give real life examples of just about every situation that arises in a CRE loan workout during an economic downturn.

Key Points:

1. ADVERSE CLASSIFICATION - Regulators are acknowledging the decline in CRE property values, which is measured to be 35-40% from their peak in 2007, and that this phenomenon is not the sole basis for an adverse classification in an examination. Regulating agencies assure financial institutions that their performing loans "will not be subject to adverse classification solely because the value of the underlying collateral declined."
   
   
2. CONCENTRATION RISK - Risk management elements that are essential to loan workout programs are listed in detail on page 2. Included in this list is “Adequacy of management information systems and internal controls to identify and track loan performance and risk, including concentration risk.” This element should be no surprise to anyone, but take note that regulators are making it clear to bankers that stringent segmentation, monitoring, and reporting of concentrations is expected in every institution. Concentrations carry inherent risk regardless of the underwriting standards applied during the origination phase of the loan.
   
   
3. FINANCIAL STATEMENTS - Regulators are expecting bankers to obtain and analyze borrowers' and guarantors' CURRENT financial information, as detailed on page 3. Without this documentation, a banker can expect some type of criticism, and possibly an adverse classification. Scenario 2 for an income producing office building, presented on page 15, reveals that the examiner listed the credit as "Special Mention" in the report of examination because the “failure to request current financial information...represents administrative deficiencies”.
   
   This practice is also in a banker’s best interest because it offers the opportunity to be aware of a borrower's declining financial position. At a recent Town Hall Meeting in Tampa, FL, a top regional representative from the Atlanta Federal Reserve stated that the issue that keeps him up at night is the second wave of defaults. The industry has already experienced the first wave of defaults on borrowers/guarantors who clearly wouldn’t support their project but now the individuals who have stepped up during this crisis maybe running out of money, and even with the best intentions to make good on their commitments, they won’t have the ability.
   
4. COLLATERAL VALUES – “Financial institutions should have policies and procedures that dictate when collateral valuations should be updated as part of its ongoing credit review, as market conditions change….” The guidance goes on to state that if weaknesses in this process, including the appraisal review process, are evident and haven’t been addressed that examiners may make adjustments to the collateral’s value to reflect current market conditions and events.
   
   Bankers should make every effort to have current valuations on CRE properties, even for loans that are performing as agreed. As part of the examination process regulators will also review an institution’s “pass credits”. If examiners see a pattern of old valuations a red flag may go up. Typically these loans are not written with very long terms and renewal will soon be approaching. Examples of assumptions used in the CRE valuation process are detailed on page 6 and include, current and projected vacancy rates; capitalization rates; and net operating incomes.
   
   A CRE stress testing model can apply calculations, including property value trends and current capitalization rates to the loan’s basic information, such as the balance and terms, and arrive at a “derived value” (see image below). From that point all loans will have a current valuation and can be stress tested using the assumptions detailed previously to project a possible collateral shortfall.

OTS Jumps on the Bandwagon: Even Thrifts Now Getting CRE Loan-Related C&Ds

In December 2006, federal banking regulators issued the “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” document more commonly referred to as the CRE Guidance. The FDIC, OCC, and Federal Reserve issued a joint release which referred to the supervisory criteria of:

1. Total reported loans for construction, land development, and other land representing 100 percent or more of the institution’s total capital; or
2. Total commercial real estate loans as defined in the guidance representing 300 percent or more of the institution’s total capital, when the balance has increased by 50 percent or more during the prior 36 months.

Since the guidance was issued, regulators have referred to these percentages as thresholds only for which an institution with a large amount of CRE can be readily identified. These figures can be derived quickly from the Quarterly Reports of Condition for which the federal banking agencies monitor closely. If an institution is adding substantial amounts to the call report lines the agency will conduct an offsite monitoring investigation which can of course be converted to an onsite visitation or examination.

The Office of Thrift Supervision (OTS) was not a part of the guidance referred to above. Instead they issued their own guidance on December 14, 2006, which was very similar. However the OTS decided not to include the 100/300% screens because “savings associations are uniquely subject to a 400 percent of capital statutory investment limit on nonresidential real estate lending."


At the time the agency appears not to have been concerned that thrifts would engage in high volumes or concentrations. This has obviously not been the case as thrifts have failed at alarming rates due to this issue and the agency has taken notice. In a cease and desist order dated October 19, 2009 with Liberty Savings Bank, FSB, the OTS included an Asset Quality Provision ordering the thrift not to originate or participate in any new loan or line of credit secured by commercial real estate loans until the CRE loans on the books are reduced, and maintained, at 300% of core capital plus the Allowance for Loan and Lease Losses.

The C&D provision also specifically includes both owner-occupied and non-owner-occupied permanent commercial property mortgage loans although owner occupied was specifically excluded from the joint agency guidance.

Don’t be surprised if regulators start to treat and enforce these percentages as more of a “limit” instead of a guideline. Also, remember that that the guidance also includes the requirement for institutions with high concentrations to perform portfolio-level stress tests. Far better to be proactive and perform this exercise before reading about it in a regulatory enforcement action with your bank’s name on the first page...