Stress Is Good

Reading Between the Lines of FDIC Vice Chairman Gruenberg’s Speech

noreply@blogger.com (Michelle Lucci) — Tue, 02 Mar 2010 21:58:00 +0000

On February 26, 2010 Vice Chairman Gruenberg spoke before the The Committee on Financial Services and Committee On Small Business. His speech discusses key up-to-date industry statistical information and also addresses the complaints by bankers and industry groups regarding recommendations made, or supposedly made, by field examiners during onsite examinations. I’d like to quote the Vice Chairman’s speech and then follow with my commentary:

“Nationally, prices for CRE properties as measured by the Moody's/REAL Commercial Property Price Index are more than 40 percent below their October 2007 peak. As of fourth quarter 2009, quarterly rent growth has been negative across all major CRE property types nationally for at least the past year. Asking rents for all major CRE property types nationally were lower on a year-over-year basis.”

The Moody’s index is the standard of measurement in the CRE industry and is readily quoted by leading industry experts as well as the top regulators in the country yet many bankers believe that this statistic does not pertain to their market. While there may be some truth in that your local market may not have declined by 40 percent there is still very notable decline in values no matter where you in the country you are located.

If you believe your market has not suffered the same downturn you have some work to do. Obviously your examiners are very aware of this statistic so the burden of proof is on the banker to prove otherwise. Do some research before your next examination. Look for appraisals of the same property in your CRE portfolio from the peak of the market, third quarter of 2007, and a recent appraisal that you have reviewed and found to be in compliance that documents a smaller decline. Make sure the property is located within your lending area and try to do this for each property type in your loan portfolio. Supplement this information with documentation from local print or online publications that supports your hypothesis. It is best to be prepared.

“The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters continues to be in CRE lending.”

Expect your CRE loan portfolio to be the focus of your regulatory examinations for the next two years especially in community banks. Lenders should thoroughly work on their credits and have readily available and updated information such as: borrowers and guarantor financials including tax returns with all schedules; rent rolls; lease terms; and perfected collateral liens.

“As of December 31, 2009, CRE loans totaled almost $1.8 trillion, or 24.9 percent of total loans and leases. In terms of concentrations of credit, CRE at FDIC-insured institutions represented 133 percent of total risk-based capital, lower than the 151 percent seen one year earlier, but still significantly higher than levels at the beginning of the decade.”

CRE loan concentrations are still very prevalent especially in the nations’ community banks. Be sure that your bank has a comprehensive and board approved concentrations policy that sets standards and limits of the total portfolio as well as various segments as percentages of total risk based capital. Banks should have various methods of detecting concentrations and appropriate reporting mechanisms to the board. Also, the policy should have step-by-step methods of reducing concentrations that exceed limits that are deemed to represent an undue risk to the institution.

“Net charge-offs on loans backed by nonfarm, nonresidential properties have been just $11.3 billion over the past eight quarters. Over this period, however, the noncurrent loan ratio in this category has nearly quadrupled to 3.82 percent, and we believe it will rise further. It is likely that increased vacancy rates and lower rental income will translate into more borrowers unable to cover their debt service. The ultimate scale of losses in the CRE loan portfolio will very much depend on the pace of recovery in the U.S. economy and financial markets during the next few years…. Against a backdrop of 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.”

This is the perfect reason why every institution should be stress testing their CRE portfolio. This exercise will help a banker measure the effect of various economic, structural, and financial variables that are embedded in the value of CRE assets. Does your institution have the ability to quickly calculate what the effect of these variables is on the Net Operating Income and Collateral Value of the property? For example, the image below demonstrates that assuming no other deterioration a 2 percent rise in the cap rate reduces the collateral value by almost 24 percent. This is a very significant decline and can render the credit out of your institutions and regulatory loan-to-value ranges. Armed with this knowledge early bankers can work with borrowers and devise strategies to strengthen the loan and possibly avoid classification and a write down.

The CRE Concentration Ratios, once again

noreply@blogger.com (Michelle Lucci) — Fri, 26 Feb 2010 18:43:00 +0000

Bankers are continually reminded of the risks of having asset concentrations on their books especially ones that are highly affected by an economic downturn. This week year end statistics were published about the dismal performance of CRE loans on the books of the national’s financial institutions. Many articles were published in print and online that calculated the CRE ratios of various institutions and the authors were very creative in doing so. Therefore, I’d like to revisit the calculation of the two ratios according to the Interagency Guidance published in the 2006 guidance.

1) Total reported loans for construction, land development, and other land represent 100% or more of the institution’s total capital; or
2) Total commercial real estate loans as defined in the Guidance represent 300% or more of the institution’s total capital and the outstanding balance of the CRE loan portfolio increased 50% or more during the prior 36 months.

In the footnotes the Guidance states that construction, land development, and other land loans is reported in Schedule RC-C 1a which means that it includes (1) 1-4 family residential construction loans and (2) other construction loans, all land development, and other land loans.

The footnotes also define total capital as the Total Risk-Based Capital reported on Schedule RC-R Line 21. This is the denominator of the ratio and it’s very important that Total Risk Based Capital be used instead of Tier 1 Capital because the former includes the institution’s Allowance for Loan and Lease Losses. For further proof of the use of Total Risk Based Capital one can refer to public cease and desist orders issued by the FDIC. An order dated January 5, 2010, contained a provision to “Reduce Concentrations of Credit” and requires the bank to establish a plan that contains “appropriate commercial real estate lending risk limits and monitor concentrations of risk in relation to Total Risk-Based Capital.”

Total commercial real estate loans are defined in the footnotes to the Guidance as items 1a, 1d, 1e, and Memorandum Item #3. If you look closely at this schedule, item 1e Nonfarm Nonresidential properties breaks out owner-occupied. I can understand there being some question as to whether or not both items are included. However, if you page forward in the guidance under the Scope the Agencies clarified that the focus is on those CRE loans where the cash flow from the real estate collateral is the primary source of repayment rather than on loans to a borrower where real estate is a secondary source of repayment.

Clearly the owner-occupied amounts included in item 1e1 are not part of this ratio which makes perfect sense. When appraisers value these properties the sales comparison approach is the most appropriate valuation method with the income approach used as a back up or secondary method. Appraisers also typically don’t use the borrower’s income as a contribution to the property’s income stream.
Owner-occupied properties are recognized as having less risk and the year-end performance ratios for commercial banks evidence this assumption. The noncurrent loan rate for Nonfarm Nonresidential properties for owner-occupied is 3.25% versus 4.35% for purely investment properties. Net charge-off rates are 0.89% for owner-occupied and 1.56% for investment properties.

Something to consider though is that both of these ratios have steadily climbed since 2007. When performing portfolio stress testing which is required by the 2006 Guidance it would be your best interest to include both categories. If your institution has the technical ability you can segregate these portfolios and apply separate stress factors using a less harsh stress scenario for owner-occupied CRE loans.

An industry in distress, but with signs of life

noreply@blogger.com (Michelle Lucci) — Thu, 25 Feb 2010 15:00:00 +0000

Data for FDIC insured institutions as of year –end 2009 was released this week. As expected, the numbers evidence that our nation’s banking system is in distress with high levels of noncurrent loans dragging down bank earnings. The noncurrent rate for all loans reached 5.53% for commercial banks as of year- end 2009 and is displayed in the graph. For real estate loans this rate was 200 bp higher.

A ratio often used in conjunction with loan delinquencies is the coverage ratio which is simply the loan loss reserve as a percentage of noncurrent loans. As the graph demonstrates the two performance indicators have had an inverse relationship for the past two years which is not good news. The coverage ratio stood at a very healthy 95.73% as of the first quarter 2008 but has declined dramatically to 59.20% as of the most recent quarter end. This means that a bank’s capital accounts are at risk because the loan loss reserve cannot absorb losses that are unrealized and inherent in the portfolio.

Loan charge-offs have also risen dramatically during 2009. The annualized overall rate of charge-offs was 3.02% as of year-end. The overall rate doesn’t seem that high but embedded in that statistic are very problematic sectors such as construction and development loans whose charge-off rate was 7.77%. To put this in proper perspective, one looks to the previous banking crisis when the rate at its highest was 3.97% for the fourth quarter of 1992.

While charge-offs are painful and is categorized as a negative factor what this also means is that institutions are working diligently to recognize and take losses and move on. This figure will most likely continue to rise as the past dues mentioned above eventually default and have to be written off resulting in several more quarters of write downs until we have an industry recovery. Banking lags the general economy and failures will continue to be high during 2010.

What Can We Learn From Material Loss Reviews?

noreply@blogger.com (Michelle Lucci) — Thu, 18 Feb 2010 23:04:00 +0000

There are many lessons to be learned from these documents. But what are they?

Material Loss Reviews are written by the Office of the Inspector General (OIG). The reports are essentially a “lookback” or an autopsy of what went wrong , terribly wrong, to cause the failure of an insured depository institution and the resulting significant loss to the deposit insurance fund. The investigation and public report is required by Section 38(k) of the Federal Deposit Insurance Act and you can find them on the OIG’s website (http://www.fdicig.gov/MLR.shtml) within six months after the material loss becomes apparent.

As you can imagine the website now has many of these documents. Four reports were dated February 12, 2010, and were posted today but the one I want to highlight is dated January 22, 2010, and discusses the failure of Millennium State Bank of Texas (MSB).

MSB was insured by the FDIC on August 20, 2003 and closed by the Texas Department of Banking on July 2, 2009. The institution’s life span was less than six years. In a Financial Institution Letter last August 2009 (FIL-50-2009) (http://www.fdic.gov/news/news/financial/2009/fil09050.html ) the FDIC stated that recent experience has demonstrated that newly insured depository institutions represent a higher risk to the insurance fund and expanded the “denovo” period from three years to 7 years. During this timeframe the institutions will see a lot more of their regulators and be subject to enhanced supervisory procedures. I’m sure this FIL was not one of the more popular ones issued by the agency but the failure of MSB is a clear reason why the change was necessary.

MSB’s failure was an interesting one from the perspective of the institution’s business plan. The institution’s primary lending strategy was originating commercial real estate loans that were guaranteed by the Small Business Administration (SBA) or where the SBA subordinated its interest in the real estate collateral. At face value this strategy seems to be both lucrative and safe. Not so. The institution sold off the guaranteed portions of the SBA loans and the gain was their primary earnings stream and they did a lot of this. As you can see from the table below actual asset growth far exceeded the projections in their denovo business plan approved by the regulators. Rapid asset growth is a huge red flag.

Another aspect of the denovo’s business plan is that if properly executed, and it was, the resulting effect would be huge concentration of commercial real estate loans on the books. The following table illustrates how high MSB’s concentrations were in comparison to their peer groups:

Concentrations have inherent risk and must have heightened risk management practices to be successful long term. This was obviously not the case with MSB. The bank sustained $923,000 in loan charge offs during the first three years of operations. MSB’s loan portfolio was heavily concentrated in the following industries which were noted in their August 2007 Report of Examination as a percentage of Tier 1 Capital:

Hotels – 182 percent;
Convenience Stores – 169 percent; and
Car Washes – 102 percent.

The Interagency guidelines issued December 12, 2006 titled, Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, discuss how rising CRE concentrations could expose institutions to unanticipated earnings and capital volatility in the event of adverse changes in the general CRE market. The CRE market hit the height of its value during the third quarter of 2007 and since that time the market has displayed significant declines. The hotel sector of MSB’s portfolio comprised over 45 percent of the institution’s classified assets.

MSB is a classic case of a newly chartered institution that exercised some very poor business choices including: emphasis on quick gains and fast growth; originating loans to individuals with limited experiences; failure to diversify the loan portfolio; failure to put in place robust and effective risk management strategies; and failure to monitor the collateral and cash flow position in a declining economy.

One of the risk management techniques management could have employed was a CRE stress testing system. Utilizing a comprehensive tool to estimate how the portfolio would have reacted to the declining economy would have helped management steer the institution away from the riskier segments and provide better for future losses. The following chart displays how a sample portfolio would perform under current conditions as well as a mild and severe stress test scenario. As you can see the sample institution’s multi-family loan portfolio would have reacted very negatively under a declining economy and brought significant losses to the institution.

“Cap” Rates Are On the Rise

noreply@blogger.com (Michelle Lucci) — Fri, 12 Feb 2010 18:58:00 +0000

Bankers and investors are watching cap rates rise right now which is no real surprise. But where does the cap rate or the Ro actually come from? In the Direct Capitalization process there are four methods of Overall Rate Derivation (Ro) but in today’s market there seems to be issues with them all. Let’s take a look -

1) Market Extraction - this method requires the appraiser to confirm recent sales of similar properties and extract the cap rate. This is probably the most common method and in good times can be a fairly easy way to derive a cap rate. However, there are so few sales in the current market that this method has become difficult.

2) Survey Method – there are sources available both publicly and by paid subscription which will give you average cap rates in the nation by property type. The issues with these surveys are that the rates are not always applicable to community banks operating in a concentrated market. Also, there is a significant lag to the gathering, averaging, and publication of these rates. As you can see there are some differences in the rates but in this market these are as accurate as any of the other methods. The following are some examples:

Some other surveys are RERC.com, Caprate.com, and CBRE.com.

3) Band of Investment – this method simply quantifies the rate of return needed to attract capital to the project. The following example results in a 9% calculated overall rate:
Mortgage 75% X 8% First Year Mortgage Constant = 6%
Equity 25% X 12% Cash on Cash Return =3%

This method is commonly used by appraisers but the viability is questionable because of the credit crunch and the lack of transactions and mortgages currently being originated. Another thing to keep in mind is that the estimated cap rate can be skewed significantly based on the amortization period.

4) Debt Service Coverage Method – a simple method and a favorite among bankers. The rate is derived by multiplying the debt coverage by the bank’s required loan-to-value by the mortgage constant. For example,

8.55% = 1.20 X 75% X 0.95
Ro DCR LTV Mortgage Constant

A glaring omission of this method is the lack of return to the equity or the investor in this calculation. In this case the investor is counting on a big return upon sale of the property and is probably an event that is not too common these days.

A combination of these methods can give you an accurate rate. But what does it mean? The rate is the required rate of return for investors and is comprised of a multitude of factors including: the safe rate (what is the rate of return on money markets and cd’s); liquidity premium (can’t get out of real estate too easily); the cost of management (it takes time, effort, and expertise to manage these properties) ; and inflation.

The rise in rates right now means that values are falling and that net operating incomes are not keeping up with the pace. For investors, it’s a good time to buy but for bankers it’s a very difficult time to manage a portfolio. Does your institution have the management information system capability to quickly and easily measure the effect on values that rises in cap rates have on your portfolio?

The All Important Concentrations Policy

noreply@blogger.com (Michelle Lucci) — Fri, 15 Jan 2010 20:04:00 +0000

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?

noreply@blogger.com (Michelle Lucci) — Tue, 05 Jan 2010 23:05:00 +0000

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!

noreply@blogger.com (Michelle Lucci) — Thu, 17 Dec 2009 19:37:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Thu, 10 Dec 2009 22:19:00 +0000

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"

noreply@blogger.com (Michelle Lucci) — Mon, 23 Nov 2009 20:07:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Wed, 18 Nov 2009 21:47:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Mon, 16 Nov 2009 20:42:00 +0000

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”

noreply@blogger.com (Michelle Lucci) — Fri, 13 Nov 2009 16:40:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Wed, 04 Nov 2009 22:37:00 +0000

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:

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."
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.
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.

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

noreply@blogger.com (Michelle Lucci) — Fri, 30 Oct 2009 18:01:00 +0000

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:

Total reported loans for construction, land development, and other land representing 100 percent or more of the institution’s total capital; or

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

noreply@blogger.com (Michelle Lucci) — Tue, 27 Oct 2009 00:55:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Fri, 23 Oct 2009 21:05:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Wed, 21 Oct 2009 19:17:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Mon, 19 Oct 2009 19:22:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Thu, 08 Oct 2009 20:08:00 +0000

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

noreply@blogger.com (Michelle Lucci) — Thu, 08 Oct 2009 18:34:00 +0000

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.

CapitalSouth C&D: FRB Gets Serious About CRE Concentrations

josh.andrews@bankerstoolbox.com (Josh Andrews) — Fri, 07 Nov 2008 22:55:00 +0000

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

josh.andrews@bankerstoolbox.com (Josh Andrews) — Fri, 07 Nov 2008 17:12:00 +0000

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

josh.andrews@bankerstoolbox.com (Josh Andrews) — Mon, 03 Nov 2008 03:24:00 +0000

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

josh.andrews@bankerstoolbox.com (Josh Andrews) — Mon, 03 Nov 2008 02:48:00 +0000

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.