Does Your Bank Have Some Atypical Residential Loans on the Books?

Many banks these days have residential loans on their books that are not the typical mortgage to people living in their houses hoping to someday pay down their debt and live mortgage free. Unfortunately, with the residential slow down came the realization that many houses that were built under an acquisition, development and construction loan were not going to sell. The choices are either to let these houses sit vacant, which brings a whole host of troubles, or rent them with the hopes of offsetting some, if not all, of the debt service. Consequently these loans have inherent risk which is substantially higher but are still reported in the Call Report in the residential section (Schedule RC-C Line 1c).

 To address the supervisory concern, the OCC released a new bulletin (OCC 2012-27) on September 17, 2012, and the subject is Investor-Owned One-to Four-Family Residential Properties (IORR). The bulletin was published essentially to make bankers aware that these loans should not be treated internally as the typical residential loan. Banks should have credit risk management policies and processes specifically tailored to and suitable for these heightened risks which include: loan underwriting standards; loan identification and portfolio monitoring expectations; allowance for loan and lease losses methodologies; and internal risk assessment and rating systems. Highlights of each category are listed below.

Loan Underwriting Standards

• An appropriate amortization period that considers both the property’s useful life and the predictability of future value should be established which in this case ranges from 15 – 30 years;
•  Additional controls should be considered and they include loan covenants to require periodic financial analysis and both a willing and financially capable guarantor; 
• Appropriate owner equity, acceptable appraisal and valuation trends, insurance requirements, and ongoing collateral monitoring; and 
• Comprehensive global cash flow analysis if the borrowers has financed multiple IORR properties. 

 Loan Identification and Portfolio Monitoring Expectations 

• Make every effort possible to identify IORR properties and once this is accomplished, segregate this group from other residential loans to facilitate better risk management practices. 

Allowance For Loan and Lease Losses Considerations

• Until the bank’s systems are capable of identifying and segmenting this group, the un-quantified risk should be considered when making qualitative adjustments to the ALLL analysis. 

Internal Risk Assessment and Rating Systems

• Applying a rating system similar to that used for CRE lending is generally appropriate; and 
•  The Uniform Retail Credit Classification and Account Management Policy (Retail Policy Statement) does not specifically mention IORR loans, leading bankers to apply the classification time frames and the 180-day delinquency charge-off requirement to these loans. This is no longer acceptable. Banks should classify loans and recognize losses sooner if warranted by the situation. For further guidance and CRE risk management expectations and classifications refer to the interagency “Policy Statement on Prudent Commercial Real Estate Loan Workouts.” 

Regulatory Reporting, HOLA, and Risk-Based Capital Treatment

• Continue reporting IORR loans in the one-to four-family lines in the Call Report and they will continue to qualify as residential real property loans under HOLA. If certain regulatory requirements are met IORR loans will qualify for the 50-percent risk-based capital category. 

From this bulletin one can quickly surmise that investor owned residential properties have moved up a notch in bank analysis. These loans can no longer go unnoticed in the general pool of residential mortgage loans. They must now be grouped or segmented separately in all credit related policies and procedures including: the loan policy, underwriting standards, risk ratings, loan loss reserve analysis, and accounting treatment.

Let’s not forget that this grouping must be addressed in the bank’s board approved concentration policy, portfolio level collateral value monitoring, and stress testing. I am very fortunate to be working with bankers who are very proactive in their thinking and risk management. Many of our customers are already performing these steps and with great success.

Here are some quick steps illustrated with screenshots of the steps you can take to be compliant with the newly released bulletin:

1) Below is a simplified example of identifying and segregating the IORR loans from the pool of residential mortgages. As you can see there is a fairly small pool of residential mortgage loans in total, however, the IORR loans have been segregated and although there are only three in number the dollar value is more substantial.

2) Fortunately the underlying collateral of these loans is residential housing and there are several sources of third party property value indices that can be applied to estimate the individual and the portfolio’s current collateral value.

The screenshot below illustrates the adjustment to a residential house valued at $1,350,000 as of December 19, 2007, and the adjustment downward to $1,109,100 which is an estimate of the current collateral value using the Case-Shiller Index for Chicago Illinois.

 The screenshot below illustrates the impact to a residential house valued at $1,185,000 on March 6, 2008 using the FHFA property value trend for the Austin, Texas area. 

Both of the property value indices above are very useful but have some subtle differences. Once you decide which trend is more appropriate for your bank and portfolio you can see how quick and easy it is to estimate the current collateral value of your portfolio. Armed with this knowledge you should be able to identify loans that are underwater from a collateral perspective and perform some enhanced due diligence, which includes obtaining and reviewing updated financial statements and collateral inspection. You can also perform a portfolio level stress test with current values to determine the impact of further declines on collateral values as well as increasing interest rates to determine the debt service capacity on loans that are variable-rate and loans that will mature in the near term. Don’t forget that these loans should be evaluated and risk rated individually, similar to your CRE loans.

Don’t be surprised if a Call Report enhancement comes soon that adds an additional line to the 1-4 family residential properties section in Schedule RC-C for IORR. With that information regulators will be better equipped to monitor the higher risk in the residential portfolio during their offsite analysis.

Also, with the correlation of IORR loans to the CRE Guidance it’s very possible that these portfolios will be included in the 100/300% CRE thresholds levels if new revised guidance is ever issued.