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...

Survival of the Fittest: FDIC Comforts Consumers While Shooting Down Fledgling De Novo Banks

The FDIC’s closing of seven banks on Friday, October 23, 2009, has received widespread publicity. Chairman Sheila Bair recorded a three minute video which is posted on YouTube and the FDIC’s home page reassuring the public that their insured deposits have always been and will always be safe. These statements and the constant positive publicity are good news for consumers who get nervous when their bank is on the “Friday List”.
       
Many of these closings have been small, local, and relatively new institutions. Previous FDIC policy mandated that a newly chartered institution be considered a “de novo” for the initial three-years. During this phase the institution was subject to higher capital requirements and more frequent examinations. However, the FDIC has found that institutions are still at a higher risk of failure for the initial seven years of operation. In accordance with this finding, the FDIC on August 28, 2009 issued Financial Institution Letter (FIL) 50 formally extending the de novo period.

At a Regulator Town Hall Meeting in Tampa, Florida, on October 22, 2009, a senior regional FDIC executive reiterated this finding by remarking that the “four to seven year de novo period is the biggest risk to the deposit insurance fund”. Last Friday four of the seven institutions closed by the FDIC were still in the newly defined de novo phase.

The aforementioned FIL lists these common risk factors during the first seven years of operation:

• rapid growth 
• over-reliance on volatile funding, including brokered deposits 
• concentrations without compensatory management controls 
• significant deviations from approved business plans 
• noncompliance with conditions in the deposit insurance orders 
• weak risk management practices 
• unseasoned loan portfolios, which masked potential deterioration during an economic downturn 
• weak compliance management systems leading to significant consumer protection problems 
• involvement in certain third-party relationships with little or no oversight

While all elements are risky, concentrations of credit seem to be the most significant risk at this time due to the fundamental decline in commercial real estate. A good stress testing model can help management’s forecast and greatly assist in concentration management.

How to Break the Shackles of Toxic CRE Loan Assets: Workout Guidance Coming Soon

CRE loans continue to drain banks of the earnings they so desperately need to maintain an adequate capital base. Community banks in particular are faced with the toughest challenge because lending to small businesses are what they do best. “These loans comprised over 43 percent of community bank portfolios and the average ratio of CRE loans to total capital was above 280 percent” as stated by FDIC Chairman Sheila Bair before a Senate Subcommittee on October 14, 2009. The federal regulators are advocating very strongly that banks work themselves out of these troubled assets as quickly as possible. It’s in a bank’s best interest to rid themselves of these troubled assets and move towards investing in assets that will return the bank’s core earnings to a positive stance.

To aid in this process the federal banking regulators will soon issue CRE Loan Workout Guidance. This document is reportedly long, approximately 28 pages, but well written and containing specific examples to assist bankers in this process. When a loan goes bad and is eventually written off a bank’s books it will hopefully be a lesson learned. However, the loans that remain on the books will be thoroughly scrutinized during the examination process. A bank can get to better know their credits by employing dynamic stress testing exercises. This knowledge will serve to support your loan loss reserve allocations, your internal loan review risk ratings, and ultimately protect your capital base.

Unemployment Wreaking Havoc on Commercial Real Estate Values

The unemployment rate stands at a 26-year high nationally of 9.8 percent with an expected increase soon to over 10 percent. The rate also rose in 23 US states in September and hit record highs in Nevada (13.3%), Rhode Island (13%), and Florida (11%). The number of states with at least 10 percent unemployment held at 14 in September.

This is very bad news for bankers with concentrations of CRE on their books. Unemployment affects the demand for office space. This in turn impacts rental rates and vacancy rates. When this happens, landlords will do everything in their power to maintain tenants in their buildings, including offering a free month of occupancy, better parking arrangements, and the ability to move into space prior to the commencement of the lease. However, when the rental rates fall and vacancy increases, the value of the property also declines.

In addition, because of the added risk, investors also demand a higher rate of return. In a speech before the Subcommittee on Financial Institutions on October 14, 2009, FDIC Chairman Sheila Bair remarked “Amid weak fundamentals, investors have been re-evaluating their required rate of return on commercial properties, leading to a sharp rise in “cap rates” and lower market valuations for commercial properties”.

A good loan administration includes the ability to stress test loans to see what impact these economic figures have on your CRE loan portfolio. Does your institution have this ability? If not, email me.

Smooth Sailing for Larger Banks, Everyone Else Struggling to Stay Afloat

The Dow Jones Industrial Average rose above 10,000 last week and erased some of the previous damage. The rally was led by financial companies, the large ones. Bank of America, American Express, and JPMorgan Chase & Co more than doubled since the low in March. It appears as if the larger banks are making a faster recovery from this banking crisis even though both Bank of America and Citigroup have not repaid the $45 billion each accepted of taxpayer money unlike many of their peers. Larger institutions benefit tremendously from trading profits in their investment banks; on their retail side they are more concerned with the spending patterns, or lack of spending patterns, of the American consumer.

It’s the nation’s small and medium sized institutions that are struggling and continue to drain the FDIC insurance fund. These institutions are hardest hit by concentrations of commercial real estate loans on their books and the negative effects of the economic downturn. Banks are seeing commercial real estate loans that are well underwritten with conservative lending standards going bad because of declining fundamentals. The question now is how long will CRE continue to drain the financial resources of our community banks? About $870 billion, or roughly half of the industry’s $1.8 trillion resides on the balance sheets of these institutions.

Interestingly enough, a NY Times article last week mentioned that Foresight Analytics, a research firm in California, performed a stress test applying only the commercial real estate loss assumptions that federal regulators used earlier this year on the nation’s largest institutions. The testing revealed that as many as 581 small banks were at risk by 2011. The nation’s 19 largest institutions passed the test with no systemic risk to the institution and only 5 of the next 100 largest banks were at high risk.

Obviously, stress testing is here to stay. Is your bank performing this very useful exercise as part of robust, dynamic, and proactive credit administration procedures? If not, email me.

Risky Lending Concentrations Spell Trouble for Community Banks

Regional and community banks are continuing to get hammered by regulators who monitor the declining levels of bank capital closely. San Joaquin Bancorp is a one bank holding company located in Bakersfield, California with assets slightly exceeding $686 Million as of June 30, 2009. On September 22, 2009, the Federal Reserve issued a Prompt Corrective Action Directive ordering the company to augment the capital base to adequately capitalized levels by October 15, 2009. To comply the bank would have to raise at least $27 million or more.

The bank appears to be desperately trying to comply with the directive. Earlier this week the bank announced major restructuring changes in their senior management. Bruce Maclin, the founding chairman since 1980, announced his retirement along with several other key management moves such as establishing a new Corporate Governance and Nominating Committee as well as restructuring the board to add more qualified individuals. These moves are commendable, but are only effective if we can assume the bank will meet its upcoming deadline and remain an independent entity--which at this point seems unlikely.

San Joaquin Bank has invested heavily in the local real estate market. Over 86% of the loan portfolio are real estate loans. These concentrations are inherently dangerous even when they are originated with conservative underwriting standards. This risk coupled with the dreary economic figures for the State of California have spelled trouble for the bank. California’s median home prices are continuing to fall and unemployment in the state is 12.1%, which is worse than the national average of 9.8%. In addition, all of the bank’s branches are located in Kern County which has an unemployment rate of 14.3% as of August 2009.

Such a serious downturn in the local as well as the nationwide economy is difficult to predict. However, the use of a forecasting tool would have greatly helped this bank. Most bank figures, such as ORE and default rates, are lagging indicators. This doesn’t help a bank stay out of trouble. Stress testing new loans as well as periodic testing of the entire portfolio can help identify concentration segments that present more risk to the institution than management may have possibly realized. If these are forecasted, management will still have time to act accordingly and take mitigating steps.

Cheap Office Space = Good for Businesses, Bad for Banks

Although Federal Reserve Chairman Bernanke said on September 15 that the recession is “very likely over,” the economy, and more specifically, the banks will experience effects of this very damaging recession for the foreseeable future. Many of the press reports are negative, however, there are some opportunities for new start up businesses. New York real estate firm Reis says that office vacancy has hit a five year high of 16.5%.

This is good news for companies looking to rent space as higher vacancy rates drive down the street rents making it more affordable for a new or start up business to secure good prices per square foot.

On the downside, banks who are holding commercial real estate loans secured by office buildings will see the negative effects of this phenomena. Lower rents translate into lower net operating incomes which can translate into the inability of the borrower to service the debt. If the loan is near maturity, this will spell disaster as the value of the property will decline and banks won’t offer to refinance the credit unless additional hard equity is injected into the deal.

Hopefully banks will have anticipated this event by continuing to conduct due diligence during the loan term by acquiring updated financial statements and by stress testing their CRE portfolio. Stress testing could have forecasted such an event by calculating the DSCR and LTV by stressing on lower net operating incomes and other pertinent factors, such as the capitalization rate.