CapitalSouth C&D: FRB Gets Serious About CRE Concentrations

CapitalSouth Bank of Birmingham, Alabama just got a C&D from the FRB. At the top of the bank’s to do list:

Enhanced risk monitoring policies, procedures, and practices to identify, measure, monitor, and control risks arising from concentrations of credit by industries, types of loans, and geographic locations, consistent with Interagency Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, dated December 12, 2006 (SR 07-1)

CapitalSouth was well above the trigger ratios for CRE lending, especially heavy on the construction and land development concentration.

• Ratio of construction loans to risk-based capital: 269% (169% over trigger ratio)
• Ratio of total CRE loans to risk-based capital: 403% (103% over trigger ratio)

Numbers based on CapitalSouth’s Sept. 30, 2008 call report.

How To Calculate Your CRE Concentration Ratio

The regulatory guidance says banks are subject to extra regulatory scrutiny if they are above two key concentration ratios for commercial real estate:

• Ratio of construction loans to risk-based capital exceeding 100%
• Ratio of total CRE loans to risk-based capital exceeding 300%

Calculating these ratios is not difficult, but there are some caveats. First, you need to put together these three numbers:

• Construction Total
  This is the sum of Schedule RC-C Part I 1a from your call report. You need to include both line items.
• CRE Total
  This is the sum of Schedule RC-C Part 1 1a, 1d, and 1e2. Make sure not to include 1e1 (owner-occupied). While the footnote in the regulatory guidance explaining how to calculate these ratios says that you should include 1e1, the whole rest of the guidance is very clear that owner-occupied CRE loans need not be included when analyzing your CRE loan concentrations.
• Risk-based Capital
  You can find this in Schedule RC-R 21 (if you don’t know it already).

After you have these three numbers, the calculations are easy:

• Ratio of construction loans to risk-based capital: Construction Total / Risk-based Capital Total
• Ratio of total CRE loans to risk-based capital: CRE Total / Risk-based Capital Total

CRE Concentrations Affecting Who Gets Bailout Money

While the FDIC, FRB, OCC, and OTS promised that the 300% CRE to risk-based capital ratio would be used lightly and viewed according to risk, it appears that the Treasury has a different idea. Treasury Secretary Henry M. Paulson Jr. has been clear that the federal bailout money is for healthy financial institutions. The Treasury has not publicly said how they define “healthy,” but NY Times DealBook obtained a list of questions that regulators are using to assess worthiness. Near the top of that list:

Is the level of commercial real estate loans relative less than 300 percent of a bank’s regulatory capital?

How Big Is the “Environment” You Stress Test Against

A fascinating article in the NY Times explains just how interconnected financial markets can be. Partial defaults on some corporate bonds triggered a chain reaction that eventually affected a school district in Whitefish Bay, Wisconsin, the NYC transportation authority, a bank in Ireland, and its parent bank in Germany.
The school district stands to lose nearly all of a $200 million investment which they were promised would only lose value if “15 Enrons” happened at once (oops). Interest rates skyrocketed on seemingly unrelated NYC transportation bonds, leading to a $900 million shortfall (hello taxpayers…). Many of these losses ended up at the feet of an Irish bank and eventually to its parent bank in Germany who was the recipient of a multi-billion bailout from the German government.
The school district is looking at cutting art and drama classes to make up for the shortfall (purchases, jobs, etc.). Local trends are not going to predictable for a while. The “environment” you have to consider when developing stress testing scenarios is getting bigger.
How are you developing your stress testing scenarios? Leave a comment below or email me.

Guide to the Guidance: Concentrations in Commercial Real Estate Lending

This is the short-short version of Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, the December 2006 regulatory guidance put out by the FDIC, FRB, OCC, and OTS.
The good news is that the whole guidance is only 3 pages, so it won’t take you long to read the whole thing.  Keep reading below for the summary, or just go straight to the source here:

• Federal Register Notice (FDIC, FRB, and OCC) [PDF]
• Federal Register Notice (OTS) [PDF]

Basically, community banks have been increasing their concentrations in CRE lending over the past few years, but the sophistication of their risk management systems have not evolved in kind. This troubled the FDIC, FRB, OCC, and OTS enough that they put out special regulatory guidance in December 2006 titled Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices. The regulatory agencies mostly forgot about this in 2007, but certain events triggered increased scrutiny in the second half of 2008.
This applies to any bank regulated by the FDIC, FRB, OCC, or OTS making CRE loans, especially if you have a high concentration of CRE loans. You have a high concentration of CRE loans if either:

• Construction and land development loans exceed 100% of your risk-based capital
• -or-
• Total covered CRE loans exceed 300% of your risk-based capital

The guidance goes out of its way to make sure to explain that these numbers do not imply either a safe harbor for banks below these guidelines nor limits for banks above these guidelines. Evaluations of CRE concentrations are risk-based and different from bank to bank.
Covered loans include those primarily backed by income from CRE. This means that you don’t have to worry about most owner-occupied CRE loans or loans where the CRE is just bonus collateral. You do need to worry about these:

• 1 – 4 family residential and commercial land development and construction loans
• Multifamily real estate loans (50% or more secured by income or sale)
• Nonfarm nonresidential real estate loans (50% or more secured by income or sale)
• Unsecured loans to land developers

CRE concentration analysis deserves special attention. This means looking at how your CRE loans compare to your other loans and your capital as well as looking at concentrations within your CRE portfolio.

You need to identify segments within your CRE portfolio that have common risk characteristics. When putting together your concentration analysis, consider these guidelines:

• Be honest – don’t segment your portfolio with unsupportable logic to mask concentration risk
• High concentration does not equal high risk – high concentrations can be justified if the risk is low or is sufficiently mitigated
• Beware of correlation between related segments – if multiple segments are subject to the same external factors, rethink your segmentation
• Suggested concentrations – property type, location, underwriting standard, take-out commitments (for construction loans), liquidity

Managing your risk with regards to your CRE portfolio is key. Your regulator will expect you to show that your CRE portfolio is reasonable and supportable. The guidance stresses that your existing risk management system may not be good enough. The whole reason that this guidance came about was because concentrations in CRE lending have been increasing faster than the sophistication of risk management systems.
When evaluating your risk management system, consider these guidelines:

• Evaluate risk at the portfolio level – it’s not enough to know the risk of each loan individually
• Know your market – have updated, appropriate market analysis that proves you know your environment
• Stress test – evaluate the sensitivity of your portfolio and risky segments by stress testing environmental issues like PGI, vacancy, cap rates, and interest rates
• Review underwriting standards – make sure underwriting standards are reflective of your complete risk landscape
• Involve your board – the board bears the ultimate responsibility and should dictate strong strategy, policy, controls, and oversight
• Review technology – your management information systems should conform to your risk analysis, not the other way around; upgrade as necessary