CRE CONCENTRATIONS: Challenges, Regulatory Requirements and Recommendations

Roots of the CRE Crisis

The need for liquidity tempted banks to become conduits for subprime and other non-traditional home loans that Wall Street pooled and packaged as mortgage-backed securities. The rise in residential foreclosures, precipitous drop in real estate values and subsequent stock market losses made investors and consumers afraid to spend. That caused businesses to falter; many closed or downsized. Unemployment accelerated and vacancies in commercial and industrial buildings grew. Landlords began to struggle to make loan payments, and CRE defaults increased.

As late as the summer of 2008, CRE was considered a safe haven for lenders. Optimism faded quickly thereafter, but small and mid-sized U.S. banks had already developed credit concentrations secured by grossly overvalued commercial real estate accepted as collateral during the growing real estate “bubble.” The sizeable risk this represented in terms of LTV ratios was compounded by the fact that underwriters (often too young to have experienced the last real estate cycle) failed to consider the potential dangers such cycles represent.

Big Changes

Risk factors that were largely invisible during economic good times have loomed large during the current severe recession. An interagency Final Guidance on Concentrations in Commercial Real Estate Lending was published in late 2006, but some regulators did not seem to have totally grasped the enormity of the risk until the plummeting value of CRE collateral and proportionate rise in LTVs became the primary stressors of bank balance sheets. The FDIC published Managing Commercial Real Estate Concentrations in a Challenging Environment (FIL-22-2008) in March 2008. And by March 2009, the WSJ reported that “commercial real estate loans are going sour at an accelerating pace, threatening to cause tens of billions of dollars in losses to banks.”

There has been an abrupt (if necessary) change in the examiners’ approach. Examiners have ratcheted up criticisms to levels not previously seen (and not necessarily related to economic reality or the usual measures of credit quality). Profitable banks accustomed to positive regulatory reviews and CAMEL ratings of 1 or 2 have suddenly become subject to harsh criticism, leaving management in perplexed confusion. However, it is clear that they expect you to immediately apply extraordinary internal risk management efforts (monitoring systems, internal loan reviews, etc.) to loans secured by commercial real estate. Stress testing individual loans (for primary default triggers) is a recommended risk management tool. In addition, the regulators expect your internal risk assessments to be viewed in the context of changing local, regional, and national economic factors, as well as industry trends.

Exams are Significantly Tougher

We generally take a more conservative view of the loans we review than the examiners in their reviews of the same loans and portfolios. But starting in 2009, we found instances where loans have been criticized to a point beyond reason or justification. We are hardly alone in this observation. Testifying before the FCIC (1) on behalf of the Independent Community Bankers Association (“ICBA”), “Rusty” Cloutier, President and CEO, Midsouth Bank, N.A., Lafayette, LA, said on 1/13/2010: “Even though community banks did not cause the economic crisis, we have been affected by it through a shrinking asset base … and a suffocating examination environment. …We are hearing from community bankers… that the way they have conducted business in the past is no longer acceptable. In a recent (if unscientific) survey conducted by ICBA, 61 percent of respondents said that their most recent safety and soundness exam was “significantly tougher” than their last exam.”

Uncharted Waters

Let’s consider the regulators’ perspective: The head of the FDIC, Sheila Bair, said in a speech on January 20, 2010 (2) : “…while CRE price declines began well after the fall in home values, they have actually been larger on average ... with CRE price indices down by over 40 percent from their Fall 2007 peak…. FDIC-insured banks and thrifts still hold the largest share of commercial mortgage debt. Their dollar exposure to CRE loans stands at an historic high….”

“The annualized net charge-off rate of 6 percent on C&D loans in the third quarter significantly exceeds the highest rate seen in the last crisis, which was about 4 percent. ….Noncurrent CRE loans on income producing properties have risen by 250 percent over the past year to $44.8 billion.”

The regulators have been severely criticized by Congress and the press for failing to do their jobs properly. And the scope of the financial crisis is so huge and the extraordinary measures required to address it so unprecedented, that the regulatory community seems uncertain about how to proceed. Fed Vice Chairman Donald L. Kohn’s address in Atlanta on January 3, 2010, was telling in this respect “…it is well to remember that we are still in uncharted waters. We do not have any recent experience with financial disruptions of [this] breadth, persistence, and consequences…. And we have no experience with most of the sorts of actions the Federal Reserve has taken to counter the shock.” (3)

Shocking Statistics

The Congressional Oversight Panel’s (COP) report of February 10, 2010 points out that average CRE values have fallen more than 40% since January 2007. Vacancy rates for multifamily housing stand at 8%. Vacancies have increased to 18% for office buildings. Rents have declined 40% for office space and 33% for retail space. The report cites loans “…made carelessly” and borrowers’ inability to refinance maturing loans as the likely culprits for CRE defaults. Almost 3,000 banks have CRE concentrations of 40% or more. About $1.4 trillion in CRE loans will mature between 2010 and 2014 and nearly half of these are “underwater – that is, the borrower owes more than the underlying property is currently worth,” making these loans almost impossible to refinance and making foreclosures inevitable. The largest CRE losses, as high as $200-$300 billion, are projected for 2011 and beyond. The COP summarizes the consequences of these compelling problems as follows: “Commercial real estate loan failures…could jeopardize the stability of…the nation’s mid-size and smaller banks, and…contribute to prolonged weakness throughout the economy.”

Unprecedented Challenges with No Easy Solutions

There is no doubt that banks will face unprecedented challenges: increasing write-downs, charge-offs, and loan loss provisions – and for state-chartered branches, additional capital requirements. CRE lending tops the regulators’ watch list and the regulators will want documentary evidence that your staff is well trained and that your commercial portfolio is being monitored by a disciplined internal risk management system. The regulators have identified nearly one-in-eleven financial institutions as troubled in some fashion. Closures in 2010 could almost double the 140 institutions that failed last year. Thus, we don’t think that the new regulatory toughness will be a passing phenomenon; to the contrary, we believe that the new approach will become more stringent.

It won’t be easy. It may not always be possible, for example, to lessen risk by requiring additional collateral because added pressure could now push a previously credit-worthy customer into a death spiral, creating a lose-lose situation. Knowing this, the regulators assured those banks with meaningful risk avoidance programs that they will not be subject to adverse classifications “...solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.”

The fact that the latest interagency issuance deals with Prudent Commercial Real Estate Loan Workouts is sobering. New CRE policies and procedures for underwriters and loan administration staff need to be taught and implemented. Risk management systems and workout programs designed to minimize losses have to be developed.

Effective Risk Management

Maximizing Loan Review Results. Without the requisite background, a loan reviewer may fail to identify control weaknesses and other important problems in a timely manner. Competent loan reviewers help to anticipate and ameliorate risk arising from both internal and external changes. For example, when the regulators published their guidance on CRE concentrations in 2006, we recognized the emerging CRE risk and immediately started to assess the “risk sensitivity” of real property collateral to troubled real estate sectors. Independent loan reviewers (internal or external) working as a team with management, can prevent problems from escalating.

Risk Prevention at Origination. The analyst’s responsibilities go beyond confirming the financial strength of the borrowers and guarantors. The analyst must determine whether the projections and/or goals for which the loan proceeds will be used are realistic. This may require an analysis of trends in the borrower’s industry and its growth and/or seasonal patterns, of demand for the borrower’s product or service, and of competition within the borrower’s market, etc.

Updating the Value of CRE Assets.  Property valuations are critical to credit decisions in terms of risk, pricing, etc. Appraisers must be independent, qualified, and should have the specialized knowledge and experience required to evaluate the type of real estate securing the loan. Loan policy should require new appraisals based on loan/borrower status, type of real estate and locale, current trends, and the amount of time since the last appraisal.

The Benefits of Stress Testing. Stress testing can reliably predict the viability of an individual loan, or of a loan portfolio. It becomes a powerful tool when a bank faces unpredictable turns of internal or external events – whether it is a borrower’s inability to comply with loan covenants or a significant shift in the economy. Stress testing also can predict how changes in specific economic/market factors can impact a bank’s commercial loan portfolio, and can provide direction with respect to strategic planning and risk management. The sophistication of the process depends on the size, complexity and risk characteristics of the portfolio.

The Regulators’ CRE Recommendations

The interagency Policy Statement of March 2008 reinforced the recommended risk management practices detailed in the interagency Guidance on CRE lending published December 2006. The ALLL Policy Statement issued in 2006, detailed board/management responsibilities, reviewed considerations for estimating the ALLL and the elements of effective loan review and sound credit grading systems. In both documents, the emphasis was (and it continues to be) on the maintenance of strong capital and loan loss allowance levels, together with robust credit risk-management practices.(4)

The 2006 CRE Guidance defines CRE concentrations as loans for land, construction, and land development representing 100% or more of Total Capital, or total CRE loans representing 300% or more of Total Capital where the outstanding balance of CRE has increased by 50% or more during the prior 36 months. Recommendations for navigating significant CRE concentrations in a deteriorating market conditions include:

1. Increasing capital and/or maintaining an already strong capital position to protect against unexpected losses in stressed markets.

2. Analyze the ALLL on a quarterly basis to ensure proper coverage of estimated credit losses on individually evaluated loans and in the remainder of the portfolio.

3. Enhancing risk management of construction and development and CRE loans by implementing prudent new lending policies, providing MIS reports sufficient to support informed credit decisions, and strengthening loan review and risk rating systems.

4. Maintaining updated financial information on borrowers/guarantors and relevant appraisals on real estate collateral.

5. Bolstering Special Assets with sufficient, appropriately-skilled staff.

Loan Workouts- Forbearance v. Hard Ball

Banks both large and small must convince the regulators of their capacity to reduce concentrations and/or quickly move troubled credits. Regulatory forbearance will allow community banks to give their solid borrowers more time to cure defaults if the bank has demonstrated an earnest effort to clean up its commercial portfolio. However, the current environment should inspire quick action on troubled credits, either “workout” or “work with.” (5)

Policy Decisions. Fair lending regulations require that they be uniformly applied. The established Fair lending policy criteria should cover: (6)

• Characteristics of financially-distressed borrowers based, for example, on changes in financial condition, increases in LTV ratios, reduction in DSCR, decreases in NOI, etc.

• Reasons for undertaking to negotiate a loan modification or refinance, i.e. the circumstances under which a distressed borrower will be considered creditworthy.

• Whether to proactively reach out to borrowers in trouble, or consider their plight only when they ask (which may have a higher risk of disparate impact).

• Circumstances deemed appropriate for providing benefits that would make a loan more affordable or cure a default.

• Changes in the borrower’s condition that would make restructuring a credit viable, as opposed to foreclosure, repossession, etc.

Designing a Workout Process. The bank’s workout process should identify the deficiencies which the bank must address, determine whether they can be fixed, and how the fix is to be implemented. Staff involved in this specialized process must have a solid understanding of how their jobs fit into the big picture. They must keep in mind that the ultimate goal is to limit the bank’s losses and, at the same time and whenever possible, help creditworthy borrowers survive a business environment that has created financial difficulties beyond their control. The workout procedures must establish a new set of underwriting protocols which include an immediate and thorough review of the borrower/guarantor’s current financial condition. Additional security may be required, including personal assets, e.g. of a sole proprietor or guarantor.

The regulators’ 2009 CRE Workout Guidance on prudent CRE workouts provides examples of analytical review processes designed to ensure that arrangements comply with all regulatory requirements, including reporting and accounting requirements.(7)  Regulated institutions are assured that performing loans, including loans that are renewed or restructured on reasonable modified terms, will not be subject to adverse classification “...solely because the value of the underlying collateral has declined to an amount that is less than the loan balance.”

Review of “Work With” and “Workout” Decisions. Management decisions on troubled loans, whether related to work-with or workout situations, must be reviewed and approved by a senior staff individual before the decision is finalized. Similarly, the board or its loan committee should be able to assume that the borrower is eligible under bank policy when a refinanced or modified loan is submitted for approval. “Work-with” and “workout” agreements must be in writing. Loan files must reflect, document and justify approval of all exceptions to bank policies and procedures, whether part of the formal agreement or otherwise.

Amassing OREO in a Down Market. Borrowers and lenders seem to have been playing a consensual game of “extend and pretend.” In order to avoid accumulating distressed OREO, lenders have not foreclosed on financially stressed CRE owners who are defaulting on loan agreements. Instead, many of these loans have been renewed or extended, which is akin to “kicking the can down the street for awhile.” It passes the time but it does nothing to solve the problem.

Preparing for a Commercial Loan Exam

The regulators expect banks to have implemented comprehensive CRE risk management programs. The examiners expect that certain standard steps are being taken to ameliorate the enormous risk that large CRE concentrations represent. They are checking to see if banks are:

• Adhering to underwriting policy standards appropriate to current conditions in the financial sector.

• Segmenting the CRE portfolio into meaningful categories (e.g. geographies, industries, property types, etc.), and setting maximum threshold levels by dollar amount and percentage of Tier 1 capital.

• Minimizing (and tracking) exceptions to policy.

• Establishing the “credit-ability” (i.e. repayment capacity) of the borrower and guarantor(s) by performing ongoing cash flow analyses, verifying subordinated debt/contingent liabilities, requiring current financials, tax returns, etc. (and analyzing all such documents).

• Monitoring the depth and effectiveness of the bank’s cash flow analysis function.

• Insuring that file documentation is sufficient and current.

• Drafting loan agreements requiring the borrower to provide the data needed to determine whether contractual LTV and DSCR ratios are being met.

• Stress testing CRE loans/portfolios as appropriate to identify the key factors most likely to trigger defaults.

• Independently scrutinizing and tracking the status of CRE collateral by examining updated rent rolls, average daily rates, etc., and periodically comparing findings.

• Examining leases for expiration dates, rights upon default, etc., and checking lease provisions for options that could impact cash flow, such as the right of smaller businesses to terminate or reduce rent if a major tenant vacates.

• Maintaining updated appraisals that specify absorption rates and use a realistic capitalization rate together with a review/analysis of the appraisal.

• Implementing a centralized appraisal review process and assigning responsibility to one officer.

• Periodically reviewing appraisals on major credits (as such credits are defined in the policy) to ensure that there are no material changes in market conditions that would require a new appraisal for an existing loan.

• If risk exposure is high and deemed advisable by management, suspending internal valuations and using outside appraisers - even for loans under $250,000.

• Complying with the 2006 Interagency ALLL Policy Statement as reflected in related FAQs, which update the ALLL Policy Statements of July 2001 and March 2004.

• Amending loan policies to reflect the interagency guidance of October 2009 on CRE Workouts.

• Incorporating findings from stress test results in the loan loss reserve methodology, as well as capital and budget planning.

• Tracking total loan classifications to total capital (CRE in excess of 3xCapital).

• Tracking owner-occupied loans (despite the exclusion in the 2006 CRE exam guidance) because of recent slowing in the retail business sector.

All of the recommended steps that ensure a good loan examination should be applied equally to the bank’s efforts to minimize loan losses. In addition, it is prudent during the current unpredictable economy to require as a condition of, and prior to, approval of refinancing or extending an existing CRE loan:

• That the borrower provide additional collateral to offset an increase in the LTV ratio;

• That a new appraisal be performed;

• That the borrower agree to provide, as often as the Branch requests, additional cash flow and/or NOI documentation, including but not limited to rent rolls, ADR data, tax returns, financial statements etc.;

• That the banks compare new tax returns, financial statements, etc. to previous submissions, and perform an analysis which is documented in the file. The objective is to resolve all questions and concerns that are noted.

• That specific loans be stress-tested in a manner which isolates the factors most likely to trigger a default in order to sharpen the focus of oversight by the loan department.

Regulatory Concerns about Safety and Soundness

A majority of enforcement actions are currently focused on safety and soundness issues. Enforcement actions most frequently cite a need for increased capital (77 percent) and address asset quality (83 percent). Provisions aimed at asset quality have included directives to reduce problem assets and to improve lending policies/procedures, and/or compliance with related laws and regulations. Reference is often made to appraisal requirements and OREO accounting. More than three-quarters of enforcement actions cite factors related to management, such as mandates to improve board oversight of risk management, and specific requirements pertaining to the knowledge and experience of the individuals serving on the board or as part of the management team.

Other significant issues that are currently being addressed in enforcement actions are: required policy revisions (87 percent); correction of examination findings (75 percent); and development of additional controls (72 percent). Enforcement actions also point to deficiencies in training (45 percent), the need for additional MIS reporting (50 percent) and/or enhancement of the internal audit function (44 percent)


Footnotes
(1) The Financial Crisis Inquiry Commission was created by Section 5 of the Fraud and Recovery Act of 2009
(2) See http://www.fcic.gov/hearings/pdfs/2010-0113-Cloutier.pdf
(3) See https://www.federalreserve.gov/newsevents/speech/kohn20100103a.htm
(4) The SEC took action against SunTrust Bank in 1999, alleging that it was manipulating earnings by setting aside excessive loan loss reserves, an action which undoubtedly had a negative effect on bank reserves through the early 2000s. Lower reserves resulted in increased earnings, and increased earnings allowed banks to pay out more capital and expand their balance sheets.
(5) Steve Cocheo (Executive Director), “Digging in for a Long Stretch of Workouts,” ABA Banking Journal October 2009.
(6) Carl G. Pry, CRCM, “To Modify or Not,” ABA Bank Compliance November/December 2009
(7) FIL-61-2009 published October 30, 2009, replaces the Interagency Policy Statement on the Review and Classification of CRE Loans (November 1991)