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.