Tread carefully back to CRE lending

Surveys recently released by the regulators reveal that banks are once again throwing their hats into the CRE arena. This trend should drive some hard thinking about how to approach this potentially lucrative, but historically risky, credit area.

What’s going on out there

The OCC’s 2013 Survey of Credit Underwriting Practices is based on input by 86 banks and savings institutions with total assets of $3 billion or more and FDIC’s Credit and Consumer Products and Services Survey draws its conclusions from more than 3,700 surveys completed by examiners based on risk management examination findings.

OCC’s survey reported that, overall, most underwriting standards have not changed but where there was a shift it was towards looser standards. “Examiners cite the competition in the real estate market, product performance, risk appetite, change in market strategy, and increased liquidity as the main reasons for bank’s net easing of standards,” the report stated.

The survey also noted that 35% of examiners surveyed believe that non-construction CRE lending risk will rise this year.

The FDIC survey notes that 76% of respondents indicated no material change in loan underwriting practices since the last examination. However, when a change was noted, the trend was towards tightening, rather than loosening. Higher-risk lending practices continue to exist most frequently in ADC (acquisition, development, and construction) lending, although the frequency of these practices continues to decline.

ADC loan balances have risen slightly but there was an even more dramatic increase in unfunded commitments, especially for commercial real estate projects. Approximately 300 institutions with ADC and other CRE concentrations are increasing these portfolios. The number rises to almost 500 when owner-occupied properties are included. The survey notes that “growth in concentrated portfolios has been an important risk factor in banking crises.”

All these statistics and verbiage really are good news. It means that banks are returning to the activities for which they went into business. It’s good news for the economy and especially small businesses as banks are the preferred provider of CRE credit. Community banks in particular are the lending choice of the nation’s small businesses.

If you are the bank in this position you are surely looking forward to some earnings growth. But CRE growth should serve as a type of “Check Engine” warning.

This is the time to ensure that the bank’s policies, practices, and procedures are in place to ensure that CRE growth will be conducted not only profitably but safely.   

Look to the basics

For help in this area there are two primary pieces of regulatory guidance to which one can refer: the 2006 Interagency Guidance on Concentrations in Commercial Real Estate Lending and the OCC’s Concentrations of Credit Handbook, which was updated in December 2011. There is additional information in the OCC’s Community Bank Stress Testing Guidance from October 2012 as well as FDIC’s Supervisory Insights publication from Summer 2012.

Regardless of your bank’s charter it is well worth your time to review all these publications.

The following provides a brief summary of key provisions:

1. Revisit, revise, and possibly even create certain corporate governance documents, including:

Business Plan. Every good business plan includes some essential components. When your institution is exhibiting CRE growth, review each of these components to ensure this area is properly addressed. Your bank’s plan may not follow the exact provisions as titled and listed below but in general they will include an:

• Overview of the business: When describing the institution and its products and services include the availability of CRE financing and the types offered. It may also be appropriate to include the geographic area of this availability. This will help demonstrate to regulators that the bank will not strive to originate new out-of-area CRE loans, which were very troublesome during the recent financial crisis.

• Marketing plan: How is CRE loan growth coming to the bank?  Is there a channel not previously mentioned in the plan that is producing the new growth?  If so, add this information and include whether or not it is expected to continue. If currently not included, add a provision requiring the bank to monitor current and projected market conditions in these areas.

• Financial management plan: This section should already be robust but be sure that CRE growth is clearly addressed in all areas, including:

a. Assumptions: Does the bank assume the growth to continue on the current pace, escalate even further, or decline?  If growth continues to be forecasted, are there limits established at which time the bank will apply the brakes?

b. Key financial indicators: Describe in detail how the CRE growth impacts important ratios for assets, capital, income, and expenses. If continued growth is expected (as noted in the assumptions area) how will the ratios be impacted going forward? Funding should also be discussed in detail, with the goal to assure the regulators that funding will be derived from stable or core sources and not from brokered deposits or unstable sources.

c. Management team: The bank’s plan should highlight the experience of the management team in originating quality credits. The plan should also provide for sufficient internal staff to administer and effectively monitor the entire portfolio.

d. Budget: Although CRE growth will usually result in higher earnings, especially in the short term, these loans may and probably should result in higher expenses for the administration and monitoring of the portfolio. Are these expenses built into the projections? Additionally, the bank’s ALLL methodology may include a qualitative factor for concentration growth which would result in higher provision expenses. Does the budget account for this factor?

Capital Plan and Budget: Institutions with credit concentrations are expected to hold substantially higher levels of capital to mitigate losses. Do board members clearly support this requirement? Does the bank’s capital plan make this provision, especially in the long term?

Concentration risk assessment and policy: The bank should perform a risk assessment on the impact that these credit concentrations can have on the institution. The objective of this exercise is to identify pools where the individual or collective performance might reasonably exceed internal established limits. Such limits include their rising to a certain percentage of earnings; reduction of the allowance for loan and lease losses by a certain percentage; reaching a certain percentage of capital; lowering the bank’s prompt correction action classification; forcing the bank to cut or suspend its dividend; or causing a credit rating downgrade.

While this may sound easy enough, in practice there are challenges to this exercise, especially if the bank does not have any of its own actual loss history obtained during a financial crisis for reference. Of course there are industry statistics, however, this requirement is meant to be bank specific.

In order to create a risk assessment, management might consider working in reverse by first performing a portfolio-wide stress test and then deciding upon its threshold limits, which will then be supported by the test’s results.

If a properly performed portfolio-level stress test has been conducted, the results should render this information in bulk. This is not a simple sensitivity analysis performed during the origination process. Instead, it is a robust test performed on all loans by applying  multiple variables (i.e. interest rate increases, income and collateral value reductions) and calculating the effects on each loan, segment, and the bank’s key financial ratios.

With the results of the test bankers should be able to identify individual credits and pools that will no longer cash flow and are collateral deficient when variables are altered. Some pools that are at risk should already be known to bank management. However, be open to the possible identification of other pools that also display higher than normal amounts of risk.

Concentration thresholds for regulatory purposes remain at 25% of capital. But this does not preclude smaller pools from being labeled a risky concentration. With this information risk limits and tolerances that will allow loan growth and profitability but still protect the institution can be set.

Once well-defined threshold limits are obtained they should be incorporated into the Concentration Policy documenting that they are reasonable and detail the way they are measured. Perhaps even more important are periodic monitoring requirements of these limits and specific steps for the firm to follow if the limits are surpassed, by either or both, static ratios or the results of periodic stress testing.

Risk mitigation strategies should include options that will have both an immediate impact as well as a long-term impact such as increasing capital; selling loan participations; purchasing credit derivative protection; obtaining insurance or guarantees; and modifying underwriting standards to ensure origination of higher-quality credits.

The regulators do not want to see institutions exceeding these limits and then responding by adjusting the limits to meet the growth already realized. Remember that these risk mitigation strategies are of primary importance and will be a significant factor when examiners assign the bank’s rating.

Concentration Procedures: This document should be more detailed and include the following, at a minimum:

• Established processes to continually monitor known concentrations.

• Methods to uncover new concentrations.

• Thorough and portfolio-wide stress testing capabilities, including reporting to senior management and the board of directors.

• Identified roles and responsibilities, which detail the ability to cross business lines resulting in a firm-wide structure.

One of the key themes in this narrative is to make sure all the Corporate Governance documents complement each other. To do this you may need to take a step back and conceptually think about the bank’s direction. If CRE growth is mentioned in the Business Plan do the effects carry through to the capital plan, budget, and concentrations policy? 

2. Honestly assess the bank’s MIS capabilities.

The key word in this sentence is “honestly.”

On the loan side of the bank, MIS capabilities have historically been bare bones. But on a positive note, these have started to improve.

A bank’s loan systems should capture not only the minimum information needed to properly satisfy regulatory reporting responsibilities but also capture individual credit statistics. These measurement include loan debt service coverageratio and loan-to-value ratio; collateral value and date of original and updated evaluations; property type; guarantor information; collateral location; and additional collateral amounts and as-of dates.

Also helpful is Borrower Industry—Appendix A of the OCC handbook. This contains a list of 8 sectors, 25 groups, and 94 industries which you may find helpful.

This information should be readily available in a timely manner and continuously updated with accurate information. The system(s) should also be flexible enough to permit manipulation of the data and arrange elements in different ways because what may be a risk correlation in one loan type may not hold true for another. For instance, investor-owned CRE is typically segmented  into property type and geographic locations while CRE owner-occupied CRE typically begins with the Business Type (SIC, NAICs) and then can be further segmented by supply chains, etc.

All this information is critical to performing the portfolio-wide stress testing analysis on every loan in the bank’s portfolio. Without this capability an institution displaying CRE concentrations will not be in compliance with the 2006 Interagency Guidance.

MIS will also support the corporate governance documents. Systems should be able to produce timely and accurate ratios for all concentration segments; portfolio level ratios (as contained in the 2006 CRE Guidance 100%/300%); and other ratios detailed in the business plan and concentration policy.

3. Shore up the bank’s loan review, credit grading processes, and accounting procedures.

Remember that the review function should also test for MIS capabilities and clearly define any weaknesses present in their reports so that management can address the deficiency prior to a regulatory examination.

After the above steps have been taken, at a minimum, the bank should be able to proceed with caution.