By Lyn Farrell
Banking industry regulators, along with elected officials and just about everyone else, have been preoccupied of late with the subprime crisis, and with good reason. But this is by no means the only pressing regulatory concern. Long before subprime and “meltdown” began to appear regularly in the same sentences, federal bank regulators were targeting the increasing risks in commercial real estate (CRE) loan portfolios.
Those concerns, which took formal shape in interagency guidance published in December, 2006, have intensified as the economy generally, and real estate markets in particular, have begun to weaken. Recent economic turbulence aside, the statistical basis for this increased regulatory attention is not hard to understand. The amount of commercial real estate loans outstanding has skyrocketed in the last 15 years. The concentration of these loans in bank portfolios nearly doubled during that period, growing from 156 percent to 314 percent as a percentage of tier one capital. With the current round of examinations, bankers are getting their first glimpse of how the regulators are implementing the CRE guidance and how they expect financial institutions to respond.
The guidance establishes the criteria regulators will use to determine when concentration levels require additional measures. These criteria are:
Total construction, land development, or other land loans representing 100 percent or more of the institution’s capital; or
Total CRE loans representing 300 percent or more of the institution’s total capital, and an increase of 50 percent or more in CRE loans outstanding over the preceding 36 months.
Lending volume that falls outside those boundaries won’t trigger adverse regulatory action, but it will prompt attention from examiners, requiring lenders to demonstrate that they understand the CRE risks they have incurred and have in place the policies, procedures, and systems required to measure, monitor, and manage those exposures.
In the joint policy statement that accompanied the guidance and in public comments since, regulators have emphasized that the goal is not to restrict commercial lending or to set arbitrary concentration limits. “The bottom line purpose of the guidance is simply to remind bankers that their risk management practices need to keep pace with increasing exposures to commercial real estate and construction activity,” Sheila Bair, chairman of the Federal Deposit Insurance Corporation, said in a speech to bank executives last year. The challenge for banks is to demonstrate that they understand their risks and are managing them appropriately.
A comprehensive risk management plan should include the following components:
Identifying the risks
Identifying mitigating factors that offset or reduce the risks
Stress testing to assess how the CRE portfolio will respond to changes in critical variables
Reporting procedures to communicate test results and information gleaned from ongoing monitoring of the portfolio
Examiners will begin their assessment of your institution’s CRE risks by looking at your analysis of those exposures. Your assessment should be as detailed and as specific as necessary to characterize your portfolio, with loans broken down by categories and sub-categories of different property types. For example, within a major category, such as retail properties, you might classify specific properties as convenience stores, supermarkets, regional shopping malls, urban strip malls, and the like. Be careful with this reporting process, however. The classification by sub-category simply describes different retail exposures; it doesn’t reduce the overall concentration of retail loans or the overall CRE concentrations limits in your portfolio.
Reporting and Monitoring
Many institutions have effectively reported CRE concentrations for years in board reports. As with actually measuring risks, the systems for reporting risks can vary. One area of reporting that is specifically addressed in the guidance is migration analysis. Banks with significant CRE concentrations will have to report, in graphic or narrative form, changes over time in their concentration levels. Problems within the CRE portfolio (past due and problem loan levels) should also be tracked and reported. As systems for stress testing CRE portfolios are developed, the loans that exhibit a higher level of risk after the shocks are imposed should also be tracked over time.
The guidance identifies a number of specific mitigating factors, many of which match, or should match, the approaches banks use in establishing their lending policies, defining risk tolerances, and underwriting and approving CRE loans. The most important of these mitigants include:
Market research. This is the essential information about demand, vacancy/occupancy rates, leasing/rental rates, business conditions, competition, and economic trends on which lending decisions should be based. Some community banks operating in relatively small markets obtain ground level information from personal contacts with local builders, developers, and other business executives in their community, and by tracking the volume of public filings; larger banks may rely on sophisticated analysis of local, regional, and national markets and property types available from many research firms. The source of the information doesn’t matter, as long as it is credible and reliable; the key is, you must be able to demonstrate that your loan decisions and your assessment of your CRE portfolio risks are based on an analysis of market conditions and an understanding of the properties and property types you are financing.
Underwriting standards. Some banks do such a good job of assessing collateral value, they think they can emphasize other important factors less. That is making deals, not making loans — a dangerous game that can prove costly. All components of the loan analysis – collateral value, cash flow, credit, and capacity — are important. You shouldn’t rely solely on any single component over the others, and you ignore any of them at your peril.
Take capacity, for example. It is important to consider the borrower’s ability to withstand financial or economic reversals going into a loan, because it can become essential if the deal unravels later on. Simply obtaining a guarantee often isn’t enough. Absent other incentives that will encourage the borrower to hang on, a guarantee becomes a flimsy branch in a financial storm, The best protection for the bank, and a valuable risk mitigation strategy, is to insist on a hefty up-front cash investment from CRE borrowers.
Some banks accomplish this by using a loan-to-cost rather than a loan-to-value ratio in their CRE underwriting. That was the case with one of our bank clients, who had financed a number of raw land and development loans for several developers. When the bottom fell out of the local market, these borrowers had several million dollars of their own funds invested in the deals, making walking away from the loans a less than appealing option. Instead, the borrowers agreed to invest more cash as a condition of restructuring the loans after the development projects were discontinued, leaving the bank’s position secure and the risk associated with these loans well within manageable levels.
Owner occupancy. Owner-occupied commercial buildings, like owner-occupied homes, are viewed as inherently less risky than investor-owned properties, and for the same reason – owners are less likely to walk away from a property in which they maintain a business. Reflecting that assumption, the CRE guidance does not count owner-occupied commercial buildings toward the 300 percent concentration trigger, provided that the owner uses at least 50 percent of the space.
Diversification (by property type and location). Because all property types and all markets are unlikely to experience the same problems at the same intensity at the same time, a portfolio that includes office, retail, and multi-family properties will be viewed as less risky than a portfolio that consists only of office buildings or undeveloped land.
Portfolio liquidity. The key question here is how readily the bank could convert its loans, or the collateral securing them, to cash. There are a number of ways to demonstrate liquidity. A portfolio of seasoned, well-performing loans would be more liquid than a portfolio filled with newly-originated loans. Properties with low loan-to-value ratios would also rate favorably on the liquidity scale for similar reasons – the bank could divest those assets readily and emerge whole, or close to whole, from the transactions.
Exit strategies. Although somewhat different, this category is closely related to portfolio liquidity. Regulators want to know that your institution could alter its exposures if conditions require an adjustment. They want to see that you have a divestiture plan in place, even if you don’t expect to use it. Although the guidance doesn’t set specific concentration limits, we have seen regulators require banks to develop strategies for reducing their exposure in situations where the banks had amassed large concentrations of commercial real estate loans without adopting adequate risk mitigation measures.
Regulators have made it clear that they expect banks to stress test their CRE portfolios. The goal is to produce a global view of how “shocks” or dramatic changes in key variables (interest rates, collateral value and income) will affect the performance of the portfolio, and the resulting impact on the bank’s income and capital position. Banks will find the application of this technique to their CRE portfolios to be challenging.
Changes in interest rates are reasonably straightforward; you can measure the impact of rate shocks across any portfolio, no matter how varied its loans. Collateral value shocks are a little more difficult, but not impossible to measure on a global basis in a CRE portfolio, using existing analytical tools.
It is the income shock that will be the most difficult to perform. Cash flow problems are a leading indicator of credit impairment so you want to spot them early, but which income variable should you shock? Total sales would be the best measure for some properties, but net profit, vacancy rates, or rents will be more appropriate for others. This gets even more complicated when you consider that some borrowers submit quarterly financial statements, while others submit statements monthly or annually. Which statements should you shock – the most recent for each, which would mean 10-month-old information for some?
Some models will sort all of this out for you, but those models must be fed; you have to crack the files within the portfolio, do a hands-on, variable-by- variable analysis of each loan, then combine those results to produce the global stress analysis that examiners want and that you need.
Some companies are working to produce a software package that will provide this analysis, and there will be tremendous demand for it if they succeed. But in the meantime, banks will have to do this difficult, labor-intensive work themselves or hire someone to do it for them. It isn’t clear that the regulators themselves know what this test should look like, so it is difficult to predict what they will accept. In the near term, probably any reasonable and well-documented stress testing efforts should pass muster.
Whatever the regulators expect, this is not an area banks want to short-change. Of all the risk mitigation strategies available, stress testing is probably the most important. Especially in a down or declining market, this is where the risk management rubber will meet the road.
Kathlyn L. Farrell, J.D., CRCM, CAMS, AMLP, is the Managing Director of Risk Management Services for Sheshunoff Consulting + Technology, an Austin-based bank consulting company. She is a licensed attorney with 30 years experience in banking. She can be reached at firstname.lastname@example.org or 800-477-1772.