Stress Is Good

A Look at "An Analysis of the Impact of the Commercial Real Estate Concentration Guidance"

noreply@blogger.com (Michelle Lucci) — Tue, 21 May 2013 18:28:00 +0000

In April, a paper titled “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance” was issued. Written by Keith Friend and Harry Glenos, both with the OCC and Joseph B. Nichols of the Federal Reserve Board, the paper contains six parts that discuss the changes in CRE concentrations over time, their impact on bank failures and Bank’s Market Capital Ratio, and the Impact of the 2006 Interagency CRE Guidance and Market Conditions on CRE loan growth. The paper is chockfull of details, statistics, charts, and graphs and should be a must read if your bank engages in CRE lending. I’d like to point out some of the comments that I found particularly interesting:

In 2006, 31% of all commercial banks exceeded at least one of the concentration levels specified in the supervisory criteria. These institutions held $378 Billlion in outstanding CRE loans which was almost 40% of all outstanding CRE loans industry wide. Banks that exceeded both supervisory criteria failed at a rate of 23%. Banks for which neither of the criteria was exceeded failed at a rate of only 0.5%.
Banks that exceeded the Construction criteria failed at a rate of 13% and those that exceeded the Construction criteria alone accounted for an estimated 80% of the losses to the FDIC fund from 2007 to 2011. Of the “survivors” approximately 60% were in poor condition and received a CAMELS rating of 3, 4, or 5.
Banks with total CRE growth greater than 50% (ignoring the other components) failed at a rate of 9.9%.
Bank holding companies whose Construction concentrations were below 100% experienced a capital decline that was 3.6 percentage points less than those whose concentration exceeded 100%.
Since then there has been significant reductions in the number of banks close to or above one of the thresholds. By the fourth quarter of 2011, the supervisory criteria applied to only 11% of institutions which held $298 Billion, or 34% of all outstanding CRE loans.
The average construction concentration ratio fell from 77% in 2008 to 38% in 2011 primarily due to shrinking portfolios. The total CRE ratio declined from 177% to 141% over the same time period not nearly as dramatic of a decline as the construction ratio.
A “non-trivial number of banks exceeding the supervisory criteria in 2007 continued to increase their CRE concentrations though 2011”. The authors believe that there is a core group of banks that specialize in or are particularly dependent upon CRE lending.

The paper reiterates the spirit of the 2006 Guidance which was not to place “hard caps” of 100/300% onto banks, although during the comment period of this Guidance many institutions were afraid that would be the case. History has proven that regulators did not have that intention. The Guidance was meant to identify institutions that should have enhanced credit risk management practices, including stress testing, in place.

The paper does validate regulator’s concern for the buildup of CRE risk exposures on bank’s books over the previous two decades because “the recession also revealed that, while good risk-management practices and above-average capital are essential to mitigate risks associated with high CRE concentrations, they may not be sufficient to prevent bank failure.”

To download the full paper visit the OCC website.

Fil-12-2013 Electronic Data Fields

noreply@blogger.com (Michelle Lucci) — Wed, 15 May 2013 19:54:00 +0000

The Interagency Loan Data Request, or ILDR, has been around for quite a while now. In 2002, the State supervisors and the federal bank agencies implemented this voluntary process of providing loan information in an electronic format before an examination. Institutions simply upload the file to their regulators' secure site.

Every core system produces this file and I think for the most part institutions have been providing the data; however, there really has been no audit of the quality of the data at least until now.

It seems that the FDIC is going to be making better use of the data in the future. Although the agency is not changing the format or layout of the file, the agency is increasing the number of required fields from 5 to 30 for examinations starting on September 30, 2013.

A review of the new Required Fields reveals them to be Borrower Location information, Lending Officer, Original Amount and Date, Maturity Date, Interest Rate, Note Risk Rating, FFIEC code, and several fields related to past due and TDR status.

For more information visist the FDIC website.

Community Bank CRE Stress Testing: A Regulatory Review

noreply@blogger.com (Michelle Lucci) — Thu, 07 Mar 2013 18:53:00 +0000

On Wednesday, April 3 at 2:00 pm EST, I will be joined by my colleague Traci Moening and Grant Wilson, Director of Commercial Credit Risk at the Office of the Comptroller of the Currency for a timely discussion on CRE Stress Testing during the latest ABA Telephone Briefing. Read the telephone briefing description below:

During the recent financial crisis credit losses in CRE loans contributed to the failure of many community banks. Stress testing of loan portfolios has emerged as a best practice to help bank management better manage credit concentrations. The results of a stress test can predict what can happen to an institution’s capital base and earnings stream, allowing the bank to prepare its response should the test scenarios actually transpire.

In this live telephone briefing our panel of experts will discuss regulatory requirements, how to properly conduct a forward-looking and flexible stress test on your CRE portfolio, and what to do with the results.

Topics Include:
• Regulatory guidance history
• OCC’s latest guidance review
• What is Stress Testing?
• Stress Testing best practices
            o Sample portfolio
            o Data Calculations
            o Identifying High Risk Segments
            o Stress Factors
• Interpreting the results
• Presenting to senior management and board members
• Sharing the results with your regulator

The price is $225 (ABA/Service Members) or $355 (Non-members) Per Site.

For more details on the Telephone Briefing, visit the ABA website. Click here to register.

OCC Banks Get Their Marching Orders

noreply@blogger.com (Michelle Lucci) — Thu, 06 Dec 2012 15:47:00 +0000

On Monday the OCC held a nationwide telephone conference call to discuss the new Community Bank Stress Testing Guidance issued on October 18, 2012. Comptroller Tom Curry began the call with a brief introduction and commentary advocating the use of stress testing. He stated that the agency is taking a hard look at lessons learned from this banking crisis and that the evidence is clear that excessive CRE concentrations, most notably in the construction sector led to higher failure rates of community banks. Mr. Curry said that the purpose and value of the “what if” analysis is to assist management, the board of directors, and the regulators to assess the risk to the institution over time. Stress testing is a helpful exercise that can quantify how the risk is changing in an institution so that appropriate action can be taken. Mr. Curry told the group that the teleconference was scheduled because bankers mentioned that there has been a general lack of clarity on this topic.

There were four presenters from the agency who spoke during the teleconference which began with a top level review of the Stress Testing Guidance highlighting the benefits of testing, what to do with the results, and a simple stress test framework. This framework is presented in the Guidance as a top-level excel spreadsheet approach to analyzing the bank’s ratios after a Two Year Stress Period Loss Rate has been applied. The loss rate is applied to loan balances with the sum added to the provision expense after which an estimate of additional provision is applied to maintain an adequate ALLL. The spreadsheet estimates an income tax benefit and results in revised net income (loss) which is used to recalculate the Tier 1 Leverage Ratio. This method is a very simplistic approach and the presenters mentioned several times that this should be viewed as a starting point.

What Bankers Can Expect
The teleconference then moved into a discussion on what bankers can expect from examiners. The OCC conducted a nationwide conference call with their field staff one week ago to discuss examination procedures with regards to the Guidance. The presenters stated that examiners will begin initial discussions with bankers that will focus on the actions management has taken in response. The agency’s objective is to encourage and work with bank management to develop and implement an appropriate risk management program that includes periodic stress testing. The presenters stated that there are no plans for horizontal targeted examinations focused solely on stress testing in community banks. I’m sure there was a collective “whew” from the bankers on the call although they didn’t say that there wouldn’t be such plans in the future.

How Bankers Can Take Action
The OCC’s new tool for bankers was briefly discussed. It was reiterated repeatedly that the tool is just one method that bankers can use but if they already had something better in place to continue on. The examiner version of the tool was also discussed. This version contains proprietary vendor supplied information and will not be available to bankers although the assumptions used in the tool can be discussed. Presenters stated that when an institution has an established stress testing program that examiners will evaluate the results and then decide then if they should also use their stress testing tool. Examples were given when this would be appropriate such as: an independent check on management’s stress testing results, when the institution does not have an adequate stress testing process, during risk management discussions to provide better context by using real bank data, or when the institution’s strategic plan provides for aggressive growth in CRE lending.

Questions From the Audience
As expected there were quite a few questions from bankers with most of them coming from Florida and Georgia, the states hardest hit by the banking crisis and that still have quite a few banks operating under enforcement actions. The questions were very good ones and where I think the audience learned the most. Here is a summary of the questions and answers by topic:

Types of loans – The Guidance applies to all types of loans, not just CRE. Community banks tend to specialize in CRE so the discussion tends to center around that type; however, institutions are to look at all loans and pay attention to any concentrations on the bank’s books.

Loss rates – The OCC has available on the BankNet website a document that details two year loss rate ranges for loans by call report category that can be used for the stress testing exercise. The rates were derived from three stressful time periods for banks in the 75th to 95th percentile. Bankers questioned whether or not they can use the bank’s own loss rates if they were lower than the ranges provided in the OCC document and the general answer was that it may be appropriate.

ALLL Methodology – The results of this exercise do not tie back to the loan loss reserve methodology but are more useful in capital planning exercises.

1-4 Family Residential Mortgage Lending – The presenters referenced recent Guidance on Investor Owned Residential Real Estate Loans, and reiterated the requirements that these loans tend to behave differently than a typical owner occupied residential loan and that they need to be segmented with higher risk management practices applied.

A banker questioned at what CRE threshold level a bank should have to start performing stress testing. The answer was an emphatic “every bank should be stress testing!”

The summary comments were that bankers should talk to their board of directors and examiners about this process. Stress testing is an evolutionary process and that there will be flexibility in the short term but banks should get started.

First Look: OCC’s Community Bank Stress Testing Guidance

noreply@blogger.com (Michelle Lucci) — Tue, 13 Nov 2012 20:04:00 +0000

Recently the Comptroller's Office issued OCC 2012-33, "Community Bank Stress Testing: Supervisory Guidance," and it's been a long time coming!

For some time many community bankers did not understand what they were expected to do--if anything--in regard to stress testing. Now the mystery is solved--at least from the Comptroller's perspective.

Read the full article on the ABA Banking Journal website.

Book Review: Bair during the crisis

noreply@blogger.com (Michelle Lucci) — Mon, 22 Oct 2012 17:31:00 +0000

"They understood that I was doing my job--protecting the FDIC and the millions of depositors we insured. But Geithner just couldn't see things from my point of view. He never could."

"They" in this comment refers to Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke in an explosive comment found on page two of Sheila Bair's Bull By The Horns. Geithner, of course, is Timothy Geithner, the present Treasury Secretary, and then head of the New York Federal Reserve Bank.

This remark refers specifically to one meeting held on Monday, Oct. 12, 2008, but the sentiment permeates the entire book--indeed, the entire tenure of Ms. Bair's career as FDIC Chairman. She and Geithner rarely agreed, it would seem.

Her obvious despondency at the time of that comment was for me, a former FDIC field examiner, particularly disturbing to read. I suppose it's in my professional DNA. On day one of my employment at FDIC in the New York Regional Office, our class was taught that our primary job function was to "protect the Deposit Insurance Fund." Every FDIC employee takes that as their mission.

The meeting, of course, was a historic gathering, portrayed in other publications and even a movie, called by Mr. Paulson when the heads of the largest financial institutions were summoned to Treasury headquarters and told that their banks would have to accept billions in government capital investments. There was $25 billion for Citigroup, Wells Fargo, and JPMorgan Chase; $15 billion for Bank of America; $10 billion for Merrill Lynch, Goldman Sachs, and Morgan Stanley; $3 billion for Bank of New York, and $2 billion for State Street.

Read the full book review on ABA Banking Journal website.

Barney Frank’s Staff Analysis of “Too Big to Fail”

noreply@blogger.com (Michelle Lucci) — Thu, 18 Oct 2012 15:30:00 +0000

During this presidential campaign there have been unfortunate and misinformed comments about The Wall Street Reform and Consumer Protection Act, otherwise known as Dodd-Frank. In response, Congressman Frank released an analysis of the provisions in the law that address “too big to fail” in a clear, concise, and well written report by the minority staff of the House Financial Services Committee.

The actual Dodd-Frank bill is thousands of pages and even a person trained to read banking legislation and regulations, like myself, can find it very challenging. However, anyone can read and understand the report issued by Mr. Frank’s office and in fact everyone should so that they will be informed individuals who are capable of recognizing the rhetoric that is pitched, especially during a presidential campaign, for what it really is.

Here is a summary of the report as well as a link to the actual report.

The Financial Crisis

The height of the financial crisis was in 2008 when the Bush administration was forced to choose between propping up large failing institutions, at taxpayer risk and expense, or permitting them to go through the bankruptcy process. They chose to do both. The New York Fed supported and facilitated the acquisition of Bear Sterns and then let Lehman Brothers fail. The Lehman failure resulted in wide disruption of the financial markets and as a result AIG was then also bailed out.

At the urgent request of the Bush administration, Congress created the Troubled Asset Relief Program (TARP) to support a number of banks during the crisis and requested the FDIC create a loan guarantee program for banks to support their continue funding (Temporary Loan Guarantee Program or TLGP). These two provisions were for solvency support and liquidity support and Congressman Frank’s report states that they “….blurred the line….and perpetuated the belief that some financial firms were ‘too big to fail”.

Wall Street Reform Addresses the Too Big to Fail Problem at its Roots

The Act protects the financial system without protecting any one individual firm using two basic means by:

1) Providing a set of tools to ensure that large, complex firms and the financial system are more stable and transparent, and that regulators can supervise the systems and its constituent parts more effectively.

This is accomplished by automatically placing large bank holding companies with assets of $50 billion or more under enhanced prudential supervision by the Federal Reserve, and empowers the newly created Financial Stability Oversight Council (FSOC) to designate non-bank financial companies for supervision.

The enhanced supervision includes heightened capital, liquidity, and risk-management requirements, resolution plans, also known as “living wills” which detail how a company can be resolved in an orderly fashion, and rigorous stress tests.

The FSOC monitors the system for risks and can respond to identified threats by placing nonbank financial firms under Fed supervision and can provide for stricter regulation of systemically destabilizing activities and practices when they occur. The report states the very important and obvious conclusion that “had it been in place before 2008, could have allowed regulators to prevent poor mortgage underwriting practices and the shedding of all associated risk through securitization”.

The report rejects the claims that have been made that the Act caused the largest financial firms to get larger and points out that some firms got larger because they acquired other large firms that were on the brink of failure. These acquisitions were done at the urging and with the cooperation of Bush administration officials.

2) Ensuring that a failing firm can fail with minimal risks to the system and without any cost to the taxpayer.

The Act recognizes that bankruptcy will remain the failure mechanism for the vast majority of non-bank financial firms and bank holding companies. To address the rare situation when the operations of such a company are too complex or important to go through this process, the Act provides for a new Orderly Liquidation Authority as an alternative path to failure.

To use the Authority the Fed, the appropriate federal agency for the largest subsidiary of the failing firm, and the Treasury Secretary, in consultation with the President, must decide that the company is failing and that this would cause serious adverse effects in the system in which case the FDIC would be appointed the receiver. The FDIC would have many of the same powers it has had for many years when it liquidates failed banks and be required to liquidate the firm within five years. In the course of doing so, the FDIC would be required to fire culpable management and directors, and to ensure that shareholders and unsecured creditors bear losses consistent with their first and second loss positions.

During the process the FDIC will likely need access to temporary funding. The Treasury is authorized to lend to the FDIC but not until the FDIC presents an acceptable plan detailing how they will use the money. The loan is limited by a legal maximum but preempted by the debt ceiling because these transactions are considered public debt transactions. Therefore, there is no way that the Orderly Liquidation Authority could be used to lend money or save a failing firm.

There is also no risk that taxpayers will bear this cost for three reasons:

The FDIC and the United States are the first creditors in line for repayment from the proceeds of the sale of the firm’s assets.
If the proceeds of the liquidation are insufficient, then the FDIC is required to claw back any payments it previously made to creditors beyond the liquidation value of their claims.
If those sources in combination were inadequate, then the FDIC would be mandated to impose risk-based assessments on financial firms with total assets of $50 billion or more to recover the remaining shortfall.

The Act ends the need for solvency support but recognizes that liquidity support may be justified to enable healthy financial firms to withstand periods of systemic stress. The Act amends section 13(3) of the Federal Reserve Act so that the Fed now may provide emergency liquidity only to solvent firms and only through facilities that have broad-based eligibility. The law also ensures that the FDIC can establish a loan guarantee program only for solvent banking entities which must pay a guarantee fee and are subject to backup assessments to ensure that the program pays for itself and there is no cost to taxpayers. The law also removes authority for the FDIC to provide open bank assistance to failing banks.

There is also some discussion on the Republican’s “modified bankruptcy” proposal that was rejected because it would have actually slowed the bankruptcy process down and potentially frozen the claims of many creditors which would have precipitated runs on the failing firm and exacerbate the damaging effects on the system.

The report concludes by stating that “the financial crisis of 2008 devastated our economy and resulted in massive losses of jobs and household wealth. It would have been irresponsible for Congress not to have addressed the root causes of the crisis and end the TBTF problem that was so central to it. As the foregoing analysis shows, the Wall Street Reform and Consumer Protection Act accomplishes both goals by combining tools to prevent financial firms from failing with tools that allow a financial company to fail without causing collateral damage to the system if a failure nonetheless occurs”.

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

noreply@blogger.com (Michelle Lucci) — Wed, 19 Sep 2012 23:12:00 +0000

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.

Not Stress Testing? Don't Worry, OCC Examiners Will Do It For You!

noreply@blogger.com (Michelle Lucci) — Thu, 19 Jul 2012 14:03:00 +0000

An article I wrote was recently featured as a guest blog on the ABA Banking Journal's UNconventional Wisdom blog on July 17, 2012. UNconventional Wisdom is a periodic guest blog where authors hold up the so-called conventional wisdom to a fresh perspective, or apply common principles in new ways.

Would You Bring a Knife to a Gun Fight?
Of course not. So why would you bring an inferior stress test--or no stress at all--to a bank examination? With the imminent release of a portfolio stress testing tool by the Comptroller's Office, your field examiners will be able to enter some information on some loans in your portolio and roll up the results to calculate the impact of the stress test on your institution's overall capital and earnings. Does this frighten you? It most definitely should.

Click here to read the full article.

Comptroller Still Worried about CRE

noreply@blogger.com (Michelle Lucci) — Wed, 13 Jun 2012 20:15:00 +0000

Comptroller Curry spoke about the OCC’s perspective on commercial credit risk issues before the CRE Finance Council today. He stated that there are few concerns more central to the safety and soundness of the overwhelming majority of the banks and thrifts that are supervised by the OCC than commercial credit risk –particularly commercial real estate credit.

National banks and federally chartered thrifts hold over $700 billion in total CRE loans, which amount to 14 percent of their aggregate loan portfolios. However, and as expected, CRE accounts for 37 percent of the total loan portfolios of institutions in the OCC’s Community Bank Supervision program. Mr. Curry stated that the OCC recognizes that “CRE is a bread-and-butter product for community banks and thrifts” and that a well-managed CRE portfolio is central to a community bank’s long-term health.

He noted that unfortunately in too many cases CRE concentrations have led to significant losses and failures of community banks. The vast majority of failures over the past three years involved CRE to some degree and in most cases the exposure was the primary reason for failure.

The primary culprit is construction and development loans. In March 2007, nearly 2,000 banks held C&D loans that exceeded their capital. By September 2011, 13 percent of them failed. If you analyze banks using the 100/300 percent threshold outlined in the 2006 Interagency CRE Guidance, 23 percent of banks that had concentrations in excess of those limits failed. For banks within those thresholds, the outcome was far more favorable and only about one-half of one percent failed.

I have heard those statistics previously but they are so significant that they warrant being repeated.

The Comptroller went on to discuss trends in the CRE market which indicate that:

Demand for multifamily housing is increasing, largely due to the decline in homeownership rates from the economic downturn, and supply is growing as well;
Demand for office buildings is growing steadily but at a moderate pace because of slow growth in employment; and
Demand for retail and warehouse space is improving slightly due to increased consumption but weakness in other sectors as well as technology advances that favor internet sales over retail sales is still disrupting some market segments.

Mr. Curry also discussed some fundamentals with regard to the CRE markets. Most notably, he stated that while vacancy rates have improved they are likely to remain elevated in many markets over the next couple of years. Rental rates and net operating income are well below peak levels. NOI is expected to continue to decline nationally for the next year or two for warehouse, office, and retail space largely due to leases renewing at lower prices per square foot.

The supervisor stated that there are still significant obstacles to overcome including the fact that up to half of all outstanding CRE loans will mature by 2014 and many of these loans are currently on an interest-only or minimal amortization required basis. Bankers will have to resolve repayment issues, such as declining net operating income and underwater mortgages, while dealing with difficult economic conditions.

On an optimistic note, Mr. Curry stated that eventually the environment will improve and that learning from the mistakes of the financial crisis is where the agency will be focus moving forward.

More specifically, he mentioned that the OCC’s new handbook on credit concentrations. The handbook focuses on concentration risk management and encourages banks to recognize correlations between loan pool concentrations and emphasizes that different pools of the same size may represent different levels of risk.

The agency is also closely focusing on the appraisal process. The expectation is that banks will obtain appraisals from competent and qualified professional appraisers who will provide unbiased market value conclusions and that a documented review process is in place.

The OCC has also directed banks with significant CRE concentrations to develop more rigorous scenario analysis, or stress testing, that considers the effect of multiple variables, including interest rate changes, vacancy rates, and capitalization rates.

If you have been reading this article carefully, the Comptroller clearly outlined the CRE fundamentals that should be the driving factors in your stress testing analysis (vacancy rates, rental rates, and ultimately the NOI). If your institution has been one of the institutions he mentioned that has rolled over CRE loans on a short-term basis and is now faced with looming maturities, your stress test analysis should also include increased interest rates (as the upcoming maturities may have carried below market rates) and payment terms (if the upcoming maturities were largely interest-only payments).

The full text of his speech can be found at: http://www.occ.gov/news-issuances/news-releases/2012/nr-occ-2012-89.html

Large Bank Guidance

noreply@blogger.com (Michelle Lucci) — Wed, 23 May 2012 21:13:00 +0000

For a PowerPoint presentation that summarizes the guidance, click here.

Last week, the FDIC, Federal Reserve, and OCC issued the final guidance on Stress Testing for Banking Organizations Over $10 Billion in Assets, which will go into effect on July 23, 2012. This guidance does not implement the stress testing requirements imposed under Dodd-Frank, that are being implemented through separate notices of proposed rulemaking by the respective agencies. The guidance notes that the agencies believe that the principles contained in this document will be useful when conducting the stress tests required by the Act.

Issued concurrently were bulletins by the agencies clarifying that compliance with the guidance is not required by community banks. As soon as I read these bulletins, I realized that many bankers probably read only the first paragraph of this document and misinterpreted the message to be that stress testing is not required or recommended for any institution under the $10 billion threshold. That is not the case. Let me repeat, that is not the case.

The last paragraph of this document, as well as page four of the large bank stress testing guidance, reiterate that the previously issued supervisory guidance, including commercial real estate (CRE) concentrations, liquidity risk, and interest-rate risk management, remains in force as it should be.

The 2006 Interagency CRE guidance requires portfolio level stress testing for banks that exceed 100% and 300% of CRE assets to total risk-based capital. This guidance has been in place for quite a while now but, unfortunately, has not been successfully implemented by the regulators for various reasons according to the General Account Office's report issued on May 2011. In December 2011, the OCC's Concentrations of Credit Handbook was updated. It directs examiners to include a page in each Report of Examination that lists concentrations that pose a challenge and the risk management process in place to mitigate the potential negative impact on the institution. So beware. There is ample existing regulatory guidance that examiners can cite to enforce stress testing practices are in place at community banks.

I expect to see more enforcement of this guidance as banks emerge from the crisis. Once bankers move troubled assets off their books and have less conversations about ORE, nonaccruals, and TDR's during regulatory examinations, then examiners can focus on bank's efforts to proactively manage concentration risk.

With that said, even though I primarily work with community banks, I took the time to thoroughly read and absorb the large bank stress testing guidance. I strongly recommend that every banker working in lending, operations, and senior management of a financial institution do the same. The guidance is very well written and in a general format so that every bank, regardless of their size, can benefit from the information contained in the principles, approaches, and applications.

The guidance states: "All banking organizations should have the capacity to understand fully understand their risks and potential impact of stressful events and circumstances on their financial condition. The 2007-2009 financial crisis further underscored the need for banking organizations to incorporate stress testing into their risk management, as banking organizations unprepared for stressful events and circumstances can suffer acute threats to their financial condition and viability."

Regulators have highlighted the use of stress testing as a means to better understand the range of potential risk exposures. The guidance states that the stress testing framework should supplement other quantitative risk management practices, such as those that rely primarily on statistical estimates of risk or loss based on historical data, as well as qualitative practices. In this manner, stress testing can assist in revealing unidentified or under-assessed risk concentrations and interrelationships and their potential impact on the banking organizations during times of stress."

The guidance outlined five key stress testing principles:

The framework should include activities and exercises that are tailored to and sufficiently capture the organization's material exposures, activities and risks.
An effective stress testing framework employs multiple conceptually sound stress testing activities and approaches
An effective stress testing framework is forward-looking and flexible
Stress test results should be clear, actionable, well supported, and inform decision-making.
Strong governance and effective internal controls help ensure that the framework contains core elements, from clearly defined stress testing objectives to recommended ones.

The guidance states that a banking organization should employ several approaches and applications. Here are the two that are most appropriate for community bank:

Scenario Analysis: a technique where you apply a historical or hypothetical scenario to assess the impact of various events and circumstances, including the most extreme situations. Examples include sever recession, failure of a major counterparty, loss of major clients, localized economic downturn, or a sudden change in interest rates brought about by unfavorable inflation developments.

Scenario analysis can obviously be a very involved exercise because a recession or local economic downturn (such as the closing of a plant that is a major base of employment for a small town) will have an enormous impact on the bank's entire operation. However, for a community bank that typically specializes in CRE lending, the scenario can involve stress testing for accelerated loss default estimates or, in the case of rising interest rates, the CRE portfolio can be stress tested to determine if borrowers cash flow will be enough to absorb the higher debt payment once interest rates rise. A banker should be able to isolate the CRE loans that have a variable-rate feature as well as those loans that will mature in the short term to analyze the payment shock and recalculate the DSCR.

Sensitivity Analysis: refers to assessment of risk when certain variables, parameters, and inputs are "stressed" or "shocked." Unlike scenario analysis, this is performed without an explicit underlying reason or narrative in order to explore what occurs under a range of inputs and at extreme or highly adverse levels. The guidance state: "It can help to assess a combined impact on several variables, parameters, factors, or drivers. For example, an organization could better understand the impact on its credit losses from a combined increase in default rates and a decrease in collateral values....An organization can also explore the impact of highly adverse capitalization rates, declines in net operating income, and reductions in collateral when evaluating risk from CRE exposure."

This is clearly the most valuable type of stress testing for a community bank with CRE exposures. Imagine how important this information would have been if credit and risk officers were able to assess the impact of the bank's loan loss reserve and capital base when the recession first hit and collateral values declined so dramatically while default rates increased sharply.

The guidance also discusses stress testing for capital and liquidity and the governance and control expectations for an institution's stress testing framework. In conclusion, the guidance states, "Stress testing may be particularly valuable during benign periods when other measures may not indicate emerging risks."

Operational Risk a Top Concern for the Nation's Comptroller

noreply@blogger.com (Michelle Lucci) — Wed, 16 May 2012 22:27:00 +0000

Newly confirmed Comptroller of the Currency, Thomas Curry, spoke today before the Exchequer Club. He gave the audience quite a bit of good news declaring balance sheets stronger, earnings improving, and problem institutions and institution failures declining. Specifically, charge-off rates have fallen with reductions of 50% or more from 2009 levels in credit cards, C&I lending, and commercial real estate. Improved asset quality has enabled institutions to enhance earnings by trimming loan loss provisions. He stated that some asset concentrations remain embedded in portfolios, particularly in residential real estate, but they are mitigating these risks. The most welcome news is that capital levels are at their decade high resulting in low dividend payouts, new issues, increased earnings, and reductions in risk-weighted assets.

Mr. Curry reminded the group that institutions are "not out of the woods" despite the uptick in positive news. He mentioned loan demand remains sluggish as the economy continues to under-perform, and non-interest income is down along with an unfavorable yield curve.

Additionally, Mr. Curry cautioned the group that another type of risk, namely operational risk, is increasingly at the top of the list during safety and soundness examinations for OCC institutions. He mentioned that some of the field examiners, some with 30 or more years on the job, tell him this is the first time they have seen operational risk eclipse credit risk as a safety and soundness challenge.

Operational risk is defined as the risk of loss due to failures of people, processes, systems, and external events. Obviously in a financial institution these risk are everywhere from processing, accounting, information systems, to credit risk management procedures. If a community bank with credit concentrations relies on a flawed assessment of risk, it can lead to inadequate controls and an insufficient risk management system. He reminded the audience that, together with the Federal Reserve, new guidance was issued on model risk management about a year ago. If your institution is supervised by one of these two agencies, I highly suggest you read and become thoroughly familiar with this document.

Perhaps the most notable quote of this speech for me was:
"All institutions, regardless of size, must resist the temptation to under-invest in the systems and controls they need to prevent great risk and larger losses in the future."

The full test of this speech can be found here.

Federal Reserve's Policy on OREO Rentals

noreply@blogger.com (Michelle Lucci) — Fri, 11 May 2012 20:29:00 +0000

On April 5, 2012, the Federal Reserve issued a policy statement on renting residential real estate, specifically one-to-four family properties, that have been acquired through the foreclosure process and are now in banks’ book as Other Real Estate Owned.

The Federal Reserve acknowledges that the country is burdened by large volumes of distressed residential properties, and that in some markets there is high demand for rental housing. In light of these unusual market conditions, some banking organizations may choose to rent residential OREO properties, permitted by the Fed as part of an orderly disposition strategy.

The Fed reiterates their general policy of disposing of OREO by stating that the new policy statement only supplements other guidance. For example, 12 CFR 225.140 states that the Fed believes holding any asset acquired in foreclosure for an extended period of time is a nonbank activity and can result in an unsafe or unsound banking practice. Banks are therefore limited to a maximum holding period of five years from the date of acquisition.

The new policy statement is surely welcome news to Fed-supervised institutions because it gives banks some relief from a regulatory classification perspective. Generally, OREO is classified as Substandard during the examination process, which can result in high classification ratios when problem loans are also included. The higher ratio often will result in an unsatisfactory Asset Quality rating of 3 or worse – a major determinant of the bank’s overall composite rating under the Uniform Financial Institutions Rating System (UFIRS). However, the Fed’s new policy states that “residential properties with leases in place and demonstrated cash flow from rental operations sufficient to generate a reasonable rate of return should generally not be classified”.

Be warned, however, there are some hoops to jump through to gain this relief. If your bank can benefit from this new statement, take some time to read the new guidance. The Federal Reserve still expects institutions to evaluate the overall costs, benefits, and risks of renting, which depend significantly on the condition of individual properties, local market conditions for rental and owner-occupied housing, and capacity to engage in this activity in a safe and sound manner, consistent with applicable laws and regulations. In other words, it is not sufficient to invoke the new policy without thorough research and, most importantly, documentation to substantiate your bank’s claims.

Although this guidance can help an institution, this activity should still be viewed as short-term in nature. The holding period for bank holding companies and national bank associations is still five years. Institutions that are chartered by state authorities, such as state member banks, must also be aware of their prevailing regulation, which may or may not be consistent with the Fed. Refer to the state statutes where your bank is domiciled. These regulations can usually be found online. In Florida, Chapter 658.67.9.c states “unless an extension of time is approved in writing by the office, real estate shall be sold or charged off within five years of the date of acquisition….”

One other item also worthy of mentioning is that this new policy statement is only applicable for institutions supervised by the Federal Reserve. Banking regulators do make an earnest effort to issue guidance on a joint basis but that does not happen in this particular case. Therefore, the OCC and the FDIC are still of the opinion that OREO should be adversely classified. If your institution is supervised by either of those two agencies, getting OREO off the books as soon as possible should be your goal.

Changed Regulators? Here's How to Handle Residential RE Concentrations Now

noreply@blogger.com (Michelle Lucci) — Mon, 09 Apr 2012 14:48:00 +0000

An article I wrote was featured as a guest blog post on the ABA Banking Journal's UNconventional Wisdom blog on April 5, 2012. UNconventional Wisdom is a periodic guest blog where authors hold up the so-called conventional wisdom to a fresh perspective, or apply common principles in new ways.

Introduction:
In recent conference appearances I’ve been presenting the elements of commercial real estate concentration analysis and stress testing. However, it turns out some bankers have questions and concerns about the treatment of concentrations of residential real estate loans during their regulatory examinations. To read the full article, click here.

Are Lower CRE Concentration Ratio “Thresholds” On the Horizon?

noreply@blogger.com (Michelle Lucci) — Fri, 06 Apr 2012 14:49:00 +0000

The 2006 Interagency CRE Guidance outlines “threshold” ratios of 100% of total capital for construction and development loans and 300% for total CRE. During the comment period the industry spoke out vehemently against this guidance but one of the lessons learned from this banking crisis is that concentrations can be bank killers and there is mounting evidence that banks that exceeded these ratios failed at very high rates.

So are lower ratios on the horizon? Possibly… but even if they are not part of regulatory guidance bankers might want to lower the ratios in board approved concentration policies anyway and stick to them. Many times actual practices deviate from bank policies and business plans and the responses are to have the board grant an exception and revise the guiding document. In this case doing so will not protect the bank from the danger that concentrations present.

Consider these statistics...

Construction Loans as a % of Capital

Total CRE as a % of Capital

Of the 7,379 bank charters-

1,909 banks, or 26%, had more than 100% of their capital base invested in construction and development loans. Of these banks 13% failed comprising 80% of the FDIC’s losses. A high percentage of the “survivors” are CAMELS 3,4, or 5;

1,310banks, or 18%, had over 300% of their capital base invested in CRE loans. The failure rate in this category was 16%; and

2,819 banks, or 38%, with CRE loan growth over 50% in three years had a failure rate of 9.9%.

Banks that were over the regulatory guidance on all three criteria failed at a rate of 23%.

The charts and data came from the recent ABA Real Estate Lending conference where Darrin Benhart, the OCC’s Deputy Comptroller for Credit and Market Risk, spoke about Portfolio Stress Testing Options. The ratio values were a snapshot at March 31, 2007 and are based on national bank data. CRE values excluded owner occupied nonfarm nonresidential real estate.

Crest Gives First Federal Savings Bank of Twin Falls a Proactive Approach to CRE Loan Portfolio Management

noreply@blogger.com (Michelle Lucci) — Wed, 14 Mar 2012 14:45:00 +0000

Banker's Toolbox just released their latest case study discussing the impact property value trends in Crest made on the First Federal Savings Bank of Twin Falls. Read the success story to hear Elaine Bowman, Assistant to the Loan Administrator, discuss why she chose Crest and what it has done for her financial institution.

"The ability to watch, from one quarter to the next, how loans are developing, and to be able to step in before any real damage occurs and take proactive action is invaluable in my mind."

- Elaine Bowman, Assistant to the Loan Administrator, First Federal Savings Bank of Twin Falls

To read the entire case study: click here

ABA Conference for Community Bankers - Next Week!

noreply@blogger.com (Michelle Lucci) — Tue, 14 Feb 2012 22:03:00 +0000

I am very excited to head to Palm Desert, CA next to speak at the ABA Conference for Community Bankers. Hopefully I will have the opportunity to meet many of you and answer any questions you might have. Below is a summary of what I will be discussing in my session. I hope to see you there!

CRE Loan Stress Testing for the Community Banker
Hazardous lending concentrations and the lack of robust risk management practices have led to increasing failures among community banks, which has in turn renewed federal regulators' commitment to focusing on the issue of better CRE concentration analysis and stress testing capabilities. After this session, you will be better prepared to comply with regulatory expectations because we will cover how to identify and monitor risky segments and concentrations in your own commercial real estate loan portfolio. This session will also teach you how to properly perform and interpret the results of portfolio level CRE stress testing in a community bank, and you will be given a clear understanding of what to do with those results once you have them

Learning Objectives:

Identify and monitor CRE concentrations
Perform portfolio level CRE stress testing
Interpret the results and assess the impact of the institution's capital, asset quality, and earnings

OCC Issues New Guidance on Credit Concentrations and Stress Testing

noreply@blogger.com (Michelle Lucci) — Wed, 14 Dec 2011 23:06:00 +0000

Yesterday the OCC issued a new version of their “Concentrations of Credit” booklet. The booklet directs examiners to include a page in each Report of Examination that lists concentrations posing a challenge to management or presenting unusual or significant risk to banks, collectively. Following are some highlights from the sections of the booklet along with my commentary but I encourage institutions supervised by the OCC to read the entire booklet (which for regulatory material is fairly short at 29 pages!).

From the Introduction:

“Credit risk management does not conclude with the supervision of individual transactions. It also encompasses the management of concentrations, or pools of exposures, whose collective performance has the potential to affect a bank negatively even if each individual transaction within a pool is soundly underwritten. When exposures in a pool are sensitive to the same economic, financial, or business development, that sensitivity, if triggered, may cause the sum of the transactions to perform as if it were a single, large exposure.”

I think this is a key opening statement. As an examiner and even now in my present role as a consultant I have always heard statements from bankers such as “we know our credits,” “we underwrite conservatively,” and “we know our market,” among others. This opening statement makes it clear that concentration management of pools is always necessary because there are risks that can affect a bank’s viability even when individual credits are structured and underwritten in a prudent manner.

From the Definition:

“Other credit concentrations, such as loans secured by first liens on residential real estate, have historically posed few problems. However, during the recession of 2007-2009, the banking industry experienced significant losses in these exposures when the national housing market suffered broad declines in home values. This experience indicates that although a concentration has not proven problematic in the past does not mean that it is precluded from becoming a problem in the future."

Hopefully we have all learned this lesson from this banking crisis. Historically home mortgages had excellent repayment histories. A review of the FDIC’s Quarterly Banking Profile reveals that the Net Charge-Off rate for closed end 1-4 family residential mortgages was as low as 0.04% during the first quarter of 2005 and was at similar levels from 2002 through the first half of 2007. This rate rose to as high as 1.81% as of the fourth quarter of 2009 and is currently at 0.97%. But there are still elevated levels of loan amounts in the 30-89 past due category indicating that there may be more to come. The lesson is here is that when analyzing the bank’s loan loss reserve analysis and a particular loan category does not have any historical loan loss don’t be fooled into believing that future experience will mirror the past.

From Pools of Transactions With Similar Characteristics:

The booklet lists the historical pools of transactions that may perform similarly but also goes on to state that industry practitioners and supervisors have further refined the original framework to include other sources of concentrations which augments and focuses the framework based on the results of stress testing. This can be very revealing of otherwise unidentified concentrations. The booklet lists several but I’d like to discuss commercial real estate which includes construction and development:

“CRE merits explicit mention because of its historical volatility and its role in a disproportionate number of bank failures. Banks may view CRE as a product, which would include all transactions secured by CRE. Alternatively, banks may also take an “industry” view, which would include only those transactions where the primary source of repayment is sale or refinancing of CRE or collection of lease/rental payments. A CRE pool may be further segmented by:
     * property type;
     * geography;
     * tenant concentrations (listed by name of tenant or by industry);
     * risk rating;
     * credit structure (e.g. fixed versus variable interest rate);
     *and debt service coverage."

As a consultant, the above list is a starting point for my analysis with clients. We also go on to include LTV, the Business Type of the borrower, relationship(s) as well as others. Also the list above is considered to be high level segments that can be refined into much greater detail. For example, property type historically has been limited to groups such as Retail, Office, and Industrial but the analysis doesn’t have to stop there. With the proper MIS or analysis tool, the property type of Retail can be broken down into more granular segments, such as Gas Station – individually owned and operated, Gas Station – individual owner of several stations, Hotel – Long Term/Extended Stay, Hotel – Motel, Hotel – Resort, Hotel – Unbranded, and so on. Risk factors for the higher level groups vary widely and grouping them together does not always provide the level of detail that institutions can benefit from.

From Identifying Concentrations:

“For very broadly defined pools such as CRE, the concentration limits would necessarily be higher than for more narrowly defined sub-segments such as acquisition, development, and construction loans. When banks set higher concentration limits for broadly defined pools-especially where those limits are more than 100 percent of capital-the OCC expects appropriate sub-limits for material groups of segmented exposures."

As we know many community banks especially are heavily concentrated in the broader category of CRE. However, the commentary above requires this group to be broken down into more refined segments, such as:

*Lots – held for long term speculation and lots for immediate development by type, residential or commercial, and then also by geographic area. If necessary the groups can also be further segmented by developer. A community bank shouldn’t want to hold a significant amount of investment in this category for the individual/company, same purpose, and in the same area.

From Stress Testing:

“Stress testing is an effective tool for identifying correlated pools of loans. Stress testing can be used to quantify the potential impact from different scenarios on those pools of credits…It is critical to ask the ‘what if’ questions and incorporate the answers into the risk management process. Stress tests can reveal the kinds of events that might present problems…As the bank’s knowledge of stress testing grows, it should strive to make the analysis more robust by simultaneously stressing a number of related variables. Banks of all sizes will benefit by supplementing stress testing of significant individual loans with portfolio and firm-wide stress testing. The overall goal is to quantify loss potential and the impact on earnings and capital adequacy."

The footnote to this section states: Bank management may want to consider modeling software as it becomes more refined and readily available.

The 2006 Interagency CRE Guidance has been public information for quite some time now. The Stress Testing section in the new booklet not only reaffirms the recommendation for bankers to perform this exercise at regular intervals on a portfolio level basis using multiple variables simultaneously but makes it a requirement because examiners are instructed to “obtain and review the bank’s capital planning and stress testing policies, procedures, and results” when assessing the adequacy of a bank’s credit concentration management (Refer to Examination Procedures page 19).

Although this exercise can sound like a difficult task as a novice, it really is not. I think the availability of tools in this industry has progressed to a point that it is fair for regulators to expect this analysis even from the smallest community bank. Bankers no longer have to rely on the simple excel spreadsheet, which works for a single variable stress test on an individual loan, but falls short when trying to stress test multiple variables on a portfolio-wide basis.

From working with our customers continuously I have found that examiners are very pleased with the results when the banker can demonstrate that:

this analysis can be performed at least quarterly because what value does this really have if the process takes six months to do and the report is using balances that are already stale-dated;
the results are being quantified as to the impact on the institution’s capital and earnings under at least two stress scenarios;
the credits displaying risk (or failing the stress test) are isolated with immediate action being taken by management to shore up the credit as best as possible; such as ordering a new appraisal; requesting updated financial statements; and performing a site analysis;
groups of credits displaying the most risk are being evaluated in terms of:

the overall concentration levels as permitted by bank policy with the goal of reassessing whether or not this risk is acceptable to the institution or if the level should be reduced with action plans to be taken to diversify; and
assessing whether or not the loan loss reserve is adequately funding this group. Many times, especially in a young institution, the group of loans that display the most risk as determined by the stress testing results is a group that has not even exhibited any loss history to date. In this case is a qualitative factor adjustment being provided in the ALLL?

From the Conclusion:

“The size of a concentration, however, does not necessarily determine the risk. Different pools of the same size may represent very different levels of risk. Although 25 percent of capital remains the threshold for capturing concentrations for regulatory purposes, the OCC expects that institutions will build their concentration management process based on the risk that a pool of loans represents.”

There are also examination procedures contained in this document that should be reviewed. For the full text click here.

ABA Conference for Community Bankers

noreply@blogger.com (Michelle Lucci) — Wed, 30 Nov 2011 17:10:00 +0000

I am very honored to have been asked to speak at the ABA Conference for Community Bankers coming up in February 2012 in Palm Desert, CA. Overall, I believe this conference will be very beneficial and informative to those in the community banking industry. Hopefully it will also be an opportunity to meet many of you and answer any questions you might have. Below is a summary of what I will be discussing in my session. I hope to see you there!

CRE Loan Stress Testing for the Community Banker
Hazardous lending concentrations and the lack of robust risk management practices have led to increasing failures among community banks, which has in turn renewed federal regulators' commitment to focusing on the issue of better CRE concentration analysis and stress testing capabilities. After this session, you will be better prepared to comply with regulatory expectations because we will cover how to identify and monitor risky segments and concentrations in your own commercial real estate loan portfolio. This session will also teach you how to properly perform and interpret the results of portfolio level CRE stress testing in a community bank, and you will be given a clear understanding of what to do with those results once you have them

Learning Objectives:

Identify and monitor CRE concentrations
Perform portfolio level CRE stress testing
Interpret the results and assess the impact of the institution's capital, asset quality, and earnings

Thoughts from the RMA Annual Conference

noreply@blogger.com (Michelle Lucci) — Mon, 31 Oct 2011 20:22:00 +0000

My coworkers and I recently returned from the RMA’s Annual Conference held at the Marriott Wardman in Washington DC. This conference is always a good one and this year was no exception. The general sessions included a presentation by Mark Zandi, Moody’s Analytics Chief Economist; and the Keynote Speaker was David Gregory, the Moderator from NBC News’ Meet the Press. There was also a regulator panel that included representatives from the Federal Reserve, OCC, & FDIC.

I have had the pleasure of hearing Mr. Zandi speak many times. He is an incredibly brilliant man for whom I have tremendous respect. In my opinion, his sense of humor is one of his best personality traits. Being able to make an audience laugh while delivering news that the economy has a 40% chance of sliding back into another recession takes real skill!

The regulator panel was represented by Jack P. Jennings, II from the Federal Reserve, Darrin Benhart from the OCC, and Chris Spoth from the FDIC. The panel answered numerous questions that were previously submitted by attendees as well as some impromptu questions by the audience.

Below, I’ve paraphrased their remarks on key topics.

Forward Looking Risk Management

What Benhart (OCC) said on this topic…
Lagging indicators, such as nonaccrual, past due, and criticized/classified loan levels, did not serve us well during this banking crisis. In the future, there should be more emphasis on capital planning and every institution should have a realistic grasp of its vulnerabilities. Institutions should define and monitor pertinent “Early Warning Indicators,” such as cap rate spreads, average leverage on large deals, results of stress testing, etc.

Jennings (Federal Reserve) added…
When it comes to forward looking risk management, expectations are different for smaller institutions. The regulators are currently working on new guidance for stress testing in community banks.

Spoth (FDIC) pointed out…
Acting FDIC Chairman Martin Gruenberg is currently focused on the approximately 7,000 institutions that have total assets less than $1Billion.

For information on the FDIC’s initiative you can read Mr. Gruenberg’s speech to the American Banker on September 19, 2011. http://www.fdic.gov/news/news/speeches/chairman/spsep1911.html

Frequent Issues/Challenges

Spoth (FDIC) mentioned these frequent issues…
Credit risk and the overhang in real estate exposure. Appraisals are not always necessary for workout situations unless there is new money granted to the borrower. Cash flow is the major consideration. TDR’s by definition have a credit weakness. It is always classified as Substandard? One way to answer this question is to ask yourself, “Is there risk to the bank’s capital account?”

Benhart (OCC) brought up…
There are lots of complaints right now. A major challenge is trends in underwriting due to low loan demand and the competition for loans.

Emerging Risks

Jennings (Federal Reserve) said…
There is legitimate concern over CRE concentrations. Another concern is whether institutions are performing risk assessments for new products. Agricultural lending also has some very legitimate price concerns currently.

Spoth (FDIC) said…
Institutions should determine if/how the agricultural market affects them; nonbank investments may potentially be driving up land prices. Interest Rate Risk is a concern and there is new guidance. New products and third party vendors can also present new risks, and institutions should be concerned with what those risks could be.

Community Banks Feel Overly Criticized

Spoth (FDIC) pointed out…
The market is extremely tough for community banks right now and we have tremendous empathy. There are over 800 banks on the problem bank list but most won’t fail. The earnings cycle is very tough. The FDIC is the predominant regulator for community banks and Acting Chairman Gruenberg has a year long focus to answer the questions:

What are the models that work?
What are the challenges?
What are the solutions?

Benhart (OCC) added…
The OCC has an increasing emphasis on community banks due to their thrift responsibilities.

Jennings (Federal Reserve) explained…
Federal Reserve Governors Duke and Raskin have their roots in community banks. Governor Raskin has formed a subcommittee of the Board which is very active. They meet every two weeks and sometimes more frequently. Each Federal Reserve District has also established a Community Depository Institution Advisory Council (CDIAC) pursuant to the Dodd-Frank Act. These committees will have input on the economy, lending conditions, and other community bank issues.

For more information on these committees you can refer to the website for each Federal Reserve Bank such as: http://www.frbatlanta.org/news/pressreleases/staffdirectors/110318.cfm

Where Should Efforts Be Focused Now?

Spoth’s (FDIC) advice to insitutions…
Efforts should focus on loan workouts, securing more capital now, the overhang in residential credits, and holding properties.

Jennings (Federal Reserve) said…
Real estate issues and commercial real estate. There are also concerns on the residential side due to the long slog in the housing market with servicer issues. The agency supports looking for revenue growth.

Benhart (OCC) agreed…
Bankers are facing a lot of issues right now. He recommended focusing on the core business processes that usually center on lending, underwriting, and risk tolerance. Institutions should be asking themselves, “Where are we comfortable with setting risk limits? What are the take-aways from stress testing?”

How to Stregthen Your CRE Loan Portfolio Using Stress Testing

noreply@blogger.com (Michelle Lucci) — Thu, 22 Sep 2011 15:17:00 +0000

CAB and Banker's Toolbox are presenting a FREE stress testing webinar!
CAB, the Corporation for American Banking, is a subsidiary of the American Banking Association.

Date & Time:
Thursday, September 29
2:00 - 3:00 p.m. ET

Register Here

Being proactive in managing loan risk has never been more important. A forward-looking approach that can help you steer the course of your institution in every economic scenario is key. Crest from Banker's Toolbox, ABA's recently endorsed CRE loan stress testing solution, will enable you to recognize the strengths and weaknesses that are currently going undetected in your portfolio.

Webinar Take-Aways:
Attending this webinar will help set you on a path toward establishing a strong CRE loan portfolio risk management program that includes:

CRE Concentration Analysis
Portfolio-Wide and Loan-Level Stress Testing
What to Do with the Results of Your Stress Test

I will be one of the presenters, along with my colleague, Doug Keipper, National Risk Manager, Commercial Real Estate. I hope to see you there!

Crest takes First National Bank of Wyoming to the Next Level

noreply@blogger.com (Michelle Lucci) — Tue, 13 Sep 2011 19:23:00 +0000

Banker's Toolbox just released their latest case study discussing the impact CRE stress testing with Crest has made on the First National Bank of Wyoming. Read the success story to hear Rick Melone, SVP and Chief Credit Officer, discuss why he chose Crest and what it has done for his financial institution.

"l love the ease, I love the content, and I love the information it produced. It made it very easy without having to put in a lot of work."

- Rick Melone, SVP & CCO, First National Bank of Wyoming

To read the entire case study: click here

To Stip or Not to Stip?

noreply@blogger.com (Michelle Lucci) — Thu, 08 Sep 2011 20:41:00 +0000

Your bank is being asked by the regulators to stipulate to a formal enforcement action. Should you sign the consent order or refuse?

There have been upwards of a thousand enforcement actions issued during this banking crisis but a trend has emerged more recently. The FDIC Press Releases have contained the names of community banks that refuse to sign the order, prompting the agency to issue a Notice of Charges.

What is a Notice of Charges? Section 8(b)(1) of the Federal Deposit Insurance Act states:

“The notice shall contain a statement of the facts constituting the alleged violation or violations or the unsafe or unsound practice or practices, and shall fix a time and place at which a hearing will be held to determine whether an order to cease and desist there from should be issued against the depository institution or the institution-affiliated party.”

While the description contained in the Act doesn’t sound quite so alarming, in reality these public documents are very specific in nature and detail the exact circumstances that were discovered during the bank’s most recent examination which prompted this action.

The opening and first paragraphs will state that the FDIC is of the opinion that “named bank” has engaged in unsafe or unsound banking practices and violation of laws or regulations and the pertinent statutory references. The second paragraph will detail the examination and financial information dates as well as the bank’s levels of capital, deposits, assets, ALL, etc. The remaining paragraphs will begin with the FDIC general statement on which area of the bank is being criticized, such as: the bank engaged in lax loan administration and underwriting or the bank operated with an excessive level of classified assets. Following the general statement, the Notice of Charges will list details of the examination findings in order of importance.

What's Included in a Typical Notice of Charges:

the types and totals of loan concentrations and their respective percentages of capital;
information related to loans to insiders and their interests, including Regulation O violations, and large borrowing relationships along with the loan(s) total, percentages of capital, and their classifications (i.e. Substandard, Doubtful, Loss);
the total of adversely classified assets listed individually along with the percentages of capital; For example:

Substandard $10,500,000
Doubtful $620,000
Loss $4,300,000
TOTAL $15,420,000

the total of assets listed for Special Mention; and
general comments such as, the Bank failed to monitor the development activity of acquisition, development, and construction loans; the Bank extended loans to borrowers without properly evaluating their global cash flow and ability to repay; the Bank extended loans without the proper staff and experience to service these loans; and the Bank’s ALLL was inappropriate because the internal loan grading system was not accurate.

In contrast, a typical Consent Order will simply state that:

“Within 10 days from the effective date of the ORDER, the Bank shall eliminate from its banks, by charge-off or collection, all assets or portions of assets classified ‘Loss’ and 50 percent of those assets or portions of assets classified ‘Doubtful’ in the Report."

As you can see…the Order itself only refers to the classified assets but does not list the exact totals of each category unlike the Notice.

Other sections of the Notice will have comments related to the other CAMELS components and detail why there are unsafe and unsound banking practices, such as:

The Bank has operated with inadequate earnings to fund its operations and augment capital. For the year ended 2010, the Bank reported a net loss of $9,000,000 which represents a return on average assets of negative 3.9 percent. The Bank’s net interest margin was adversely affected by the volume of nonperforming assets and declining loan and investment yields. The Bank’s poor earnings are expected to continue due to losses caused by deteriorating asset quality.
The Bank’s Board of Directors failed to provide adequate supervision over and direction to management of the Bank; and
The Bank is operating with inadequate liquidity and funds management as evidenced by reliance on volatile funding sources to fund growth. As of December 31, 2010, the Bank $25,000,000 in Federal Home Loan Bank borrowings and $15,000,000 in brokered certificates of deposit.

As you can see, a Notice of Charges has an excruciating amount of detail about the bank and far more than what is actually contained within a typical Consent Order. Why would any bank want this information published?

In conclusion…
The point I’m making is if your bank is faced with this situation it would be well worth your time to read any Notices of Charges that have already been published. The commentary can be very damaging especially if the Administrative Law Judge (ALJ) recommends the bank be subject to the order requiring the bank to then go look for sources of equity capital. It would also be beneficial to read some orders that include the Decision (ALJ) and Order to Cease and Desist. These documents will detail the entire process from the examination through the Notice and finally the findings of the ALJ which lead into the Order to Cease and Desist. After reviewing some of these documents it becomes clear that it will be very difficult for a bank to prevail during this process.

Although the FDI Act does not specify what constitutes an unsafe and unsound practice, these documents state that courts often cite with approval the 9th Circuit’s definition of

“one which is contrary to generally accepted standards of prudent operation, the possible consequences of which, if continued, would be abnormal risk or loss or damage to an institution, its shareholders, or the agencies administering the insurance funds and that it is a practice which has a reasonably direct effect on an association’s financial soundness.”
-Simpson v. Office of Thrift Supervision, 29 F.3d 1418, 1425 (9th Cir. 1994).

Remember that the threshold for imposing a cease and desist order may be based on finding just a single instance of unsafe or unsound conduct. For regulators to find that an Order is necessary in a problem bank there are usually multiple instances of these practices.

In addition, the examiners’ opinions matter! There are several court cases that have recognized that bank examiners’ unique experience leads to the conclusion that their determinations are entitled to great deference and cannot be overturned unless shown to be arbitrary and capricious or outside a “zone of reasonableness.”

Hopefully your bank can make an informed decision if this situation arises. Senior management and the board of directors should have all the pertinent facts and discuss among themselves the best course of action for the bank. Be careful of persuasive arguments from external individuals who encourage you to fight while they are charging the bank by the hour. Their interests and the bank’s best interest may not be the same!

Achieving Maximum Long-Run Growth

noreply@blogger.com (Michelle Lucci) — Mon, 29 Aug 2011 15:12:00 +0000

The Federal Reserve’s 2011 Economic Policy Symposium was held last week in Jackson Hole Wyoming. The theme for the conference was Achieving Maximum Long-Run Growth and the conference featured speakers from Harvard, MIT, the University of Chicago and many more.

While there, Kansas City Federal Reserve President Thomas Hoenig gave an interview with Michael McKee from Bloomberg against the beautiful backdrop of the Wyoming landscape. He speaks frankly when discussing many topics including the evolution of the Wyoming conference from an agricultural focus into a full economic symposium; the Fed’s language on low interest rates from the last meeting; the limit on how much the central bank can do to help the economy and the focus on fiscal policy; and the outlook for monetary policy.

Please take a few minutes to watch the video and learn from an incredibly brilliant and experienced leader.

OCC Raises the Bar for Community Bank Stress Testing

noreply@blogger.com (Michelle Lucci) — Fri, 19 Aug 2011 21:57:00 +0000

Gil Barker, the Deputy Comptroller for the OCC’s Southern district, testified for the Subcommittee on Financial Institutions and Consumer Credit on Tuesday. Mr. Barker oversees the supervision of more than 550 national community bank and 109 federal savings associations.

Mr. Barker opened his testimony by emphasizing the crucial role that community banks play in providing consumers and small businesses across the nation with essential financial services and credit that are critical to economic growth and job creation. To be able to perform these important functions, he said that a key element of the OCC is to assist bankers with recognizing and addressing problems in the earliest possible stage when remedial action will be most effective, before a bank become ineffective.

A hot topic in the industry lately has been if regulators should practice “forbearance” with community banks and allow troubled institutions to ignore credit problems in hopes that they will improve in the future. Mr. Barker states that “this is not permissible under generally accepted accounting principles. Nor would it be advisable. As the savings and loan crisis of the 1980s demonstrated, regulatory forbearance, by delaying the recognition of problems, can ultimately make those problems and their cost of resolution far worse.” He cites the Congressional Budget Office staff memorandum from 1991, “The Cost of Forbearance During the Thrift Crisis”, which estimated that regulatory forbearance increased the cost of resolving the thrift crisis by $66 Billion.

When conducting a routine examination of an institution, OCC field staff review a bank’s loan portfolio. The primary objectives of this review according to Mr. Barker are threefold:

First, examiners assess whether the bank has adequate systems to identify, measure, monitor, and control the amount of credit risk in its loan portfolio. A key component is the system the bank has in place to monitor and rate the relative risk of loans
Second, examiners assess whether the bank’s financial statements accurately reflect the condition of its loan portfolios and adhere to standard accounting principles with regard to loan loss reserves, the accrual of interest income, and the reporting of troubled debt restructurings
Third, examiners assess whether the bank has adequate capital cushions to support its lending activities and credit risk exposure.

Mr. Barker emphasized that the accuracy of a bank’s regulatory reports are extremely important. He referenced Section 121 of FDICIA, passed in 1991, which requires that the accounting principles used for regulatory reporting should be no less stringent than GAAP. The accounting concepts that bankers and examiners must consider are:

The concept of interest income accrual - Call Report instructions require a loan to be placed on nonaccrual when a principal/interest payment in full is not expected or principal/interest has been in default for a period of 90 days or more, unless the asset is both well secured and in the process of collection.
Deciding if a modified loan should be reported as a “troubled debt restructuring” (TDR) - A TDR requires that the bank, for economic or legal reasons related to the borrower’s financial difficulties, grant a concession to the borrower that would not have otherwise be considered.
The proper assessment of loan loss reserves for an impairment - The bank is expected to maintain an appropriate ALLL. This should cover estimated credit losses on individually evaluated loans that have been qualified as impaired. It should also include estimated credit losses inherent in the remainder of the loan and lease portfolio.

The most interesting part of the testimony is when Mr. Barker acknowledges that proper classification, accrual, and TDR treatment are fact specific. He then gives his response to a series of banker concerns. I’ll highlight two that I think are notable and include my comments, but I encourage everyone to read through them all.

Concern: Examiners are barring loans to certain borrowers or industries that are experiencing difficulties. Examiners are also criticizing loans simply for being located in a state with a high mortgage foreclosure rate.

Mr. Barker: The OCC expects banks to have robust credit underwriting and risk management processes which monitor and control overall exposure to a particular borrower and industry segment. We also expect bankers to assess how borrowers, and their industries, may perform in stressed economic environments to ensure they will continue to have the capacity to perform under the terms of their loan obligations.

My Comment: Mr. Barker is letting it be clearly known that stress testing is expected of all banks, including community bank, that engage in CRE lending, regardless of the threshold levels presented in the 2006 Guidance. His comments seem to indicate that portfolio level stress testing is a requirement, because that is the only way to assess whole segments within a portfolio. An individual loan level spreadsheet analysis will not accomplish this task.

Concern: Examiners are penalizing loan modifications by aggressively placing loans on nonaccrual status following a modification, even though the borrower has demonstrated a pattern of making contractual principal and interest payments under the loan’s modified terms.

Mr. Barker: Determinations about a loan’s accrual status are based on interest income recognition criteria in GAAP. For a loan that has been modified, if the borrower has demonstrated performance under the previous terms and shows the capacity to continue to perform under the restructured terms, the loan will likely remain on accrual. If the borrower was materially delinquent on payments prior to the restructure, but shows potential capacity to meet the restructured terms, the loan would likely remain on nonaccrual until the borrower has demonstrated a reasonable period of performance.

My Comment: This particular response from Mr. Barker is the one that I found to be particularly interesting. As noted above, there are two provisions to consider when determining accrual status: payment history and full payment of principal and interest. It is very possible in this scenario that there is more to the story than meets the eye. The banker’s comment focused solely on the repayment history of the loan. However, although the loan was current, it is possible that the examiner’s assessment found that the loan was not restructured with prudent and reasonable repayment terms that would ensure full repayment of both principal and interest. This assessment would have to be supported by a current, well-documented credit assessment of the borrower’s financial condition and prospects for repayment under the revised terms.

From my personal experience working with bankers and regulators, I know that CRE loans, especially ones that have been modified, can be very complicated. It seems that the accrual issue is the most confusing and the most hotly debated issue right now between bankers, auditors, and examiners. Once a loan is placed on nonaccrual and is reported on the Call Report, external ratings agencies pick up this information and it becomes widely publicized, which is a serious concern for the bank.

Mr. Barker summed up his testimony by stating that credit plays a vital role in restoring economic growth and jobs to our communities and that bank’s should not be unduly constrained. However, the industry must learn from past mistakes and avoid forbearance strategies that defer recognition of loss.

To read the full text click on http://www.occ.gov/news-issuances/news-releases/2011/nr-occ-2011-108.html