Regulators Focus on Commercial Real Estate Portfolios: Are You Ready?

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1 Regulators Focus on Commercial Real Estate Portfolios: Are You Ready? The Unique Alternative to the Big Four

2 In today s highly volatile real estate market, banks need to understand and manage the risks associated with their commercial real estate portfolios. An integrated approach to CRE risk management can help banks accomplish these objectives and comply with regulatory scrutiny.

3 Crowe Credit Risk White Paper 2 Summary To better understand and manage their portfolios of commercial real estate (CRE) loans and comply with the latest regulatory requirements, banks are adopting an integrated approach to CRE risk management. Such an approach comprises four phases: data validation, concentration risk analysis, risk mitigation, and reporting. The result: more effective control over these critical assets. Trends CRE is an important part of many financial institutions loan portfolios. Depending on the markets they serve and the competition they face, financial institutions can develop CRE concentrations that prove risky during downturns in the U.S. economy. If regulators determine that financial institutions lack proper policies to manage their concentrations of risk or even have high-growth areas that have not yet crossed one of the CRE thresholds they might be forced to respond with severe penalties. In these cases, it s not uncommon for regulators to place a financial institution under a memorandum of understanding until concentrations have been addressed or even to issue cease-anddesist orders for certain types of lending. In December 2006, three federal regulatory agencies the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) issued guidance to help financial institutions avoid developing dangerous CRE concentrations. Titled Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, the guidance reflects the agencies concern for rising CRE concentration levels, especially among small and midsize financial institutions. 1 1 Federal Banking Agencies Issue Final Guidance on Concentrations in Commercial Real Estate Lending, joint press release of the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation, Dec. 6, 2006 ( bcreg/ a.htm). Copyright 2008 Crowe Chizek and Company LLC

4 3 Crowe Credit Risk White Paper Then, in March 2008, the FDIC issued a letter, Managing Commercial Real Estate Concentrations in a Challenging Environment, which complements and reinforces the principles articulated in According to FDIC chair Sheila C. Bair, It is a good time to re-emphasize the 2006 guidance because a number of banks have significant CRE concentrations, and the weakness in housing across the country may have an adverse effect on those institutions. 2 In a supplement to the final guidance, which went into effect on Dec. 12, 2006, the agencies noted that small to mid-size institutions have shown the most significant increase in CRE concentrations over the last decade. CRE concentration levels at commercial and savings banks with assets between $100 million and $1 billion have doubled from approximately 156 percent of total risk-based capital in 1993 to 318 percent in third quarter This same trend has been observed at commercial and savings banks with assets of $1 billion to $10 billion with concentration levels rising from approximately 127 percent in 1993 to approximately 300 percent in third quarter These CRE concentration levels involved three types of loans: those secured by real estate for construction, land development, and other land loans; multifamily residential properties; and nonfarm nonresidential properties. CRE as a Percentage of Total Risk-based Capital Source: Interagency guidance Guidance on on concentrations Concentrations in commercial in Commercial real Real estate Estate lending. Lending. 350% 318% 300% 300% 250% 200% 150% 156% 127% 100% 50% 0% 1993 Small Banks Midsize Banks Federal Deposit Insurance Corporation Stresses Importance of Managing Commercial Real Estate Concentrations, FDIC press release, March 17, 2008 ( 3 Federal Register, Vol. 71, No. 238, Dec. 12, 2006, p ( edocket.access.gpo.gov/2006/pdf/ pdf). Copyright 2008 Crowe Chizek and Company LLC

5 Crowe Credit Risk White Paper 4 Challenges The interagency guidance applies to national and state-chartered financial institutions. The Federal Reserve Board has said that it believes the guidance is broadly applicable to bank holding companies as well. Significantly, the guidance does not establish financial institution lending limits but instead suggests that financial institutions employ enhanced risk management techniques and capital levels as they approach either of two thresholds: Loans for construction, land development, and other land are 100 percent or more of total capital; or Loans for construction, land development, and other land and loans secured by multifamily and nonfarm nonresidential property (excluding loans secured by owner-occupied properties) are 300 percent or more of total capital. The regulators have said that if they see fast growth in either one of these areas but the levels are still under the threshold, they will likely conduct more in-depth analysis. Financial institutions should be prepared to explain to all stakeholders how they are managing that risk. Solutions For many financial institutions, understanding and managing CRE risk can be viewed as an integrated process comprising four principal steps: 1. Validate CRE data. Financial institutions must examine their loan portfolio databases and ensure that the information is classified correctly. In many cases, coding errors and other inaccuracies can present a distorted picture of CRE concentrations. 2. Analyze concentration risk. Once loan portfolio databases have been validated, financial institutions should conduct a risk analysis that looks at both portfolio and loan sensitivity. 3. Mitigate CRE risk. After analyzing CRE concentrations, the next step is to mitigate risk by establishing policies and processes to monitor CRE loan performance closely and, where appropriate, to change the mix of the portfolio. Report to senior management and the board. 4. The final step is to provide management and directors with periodic reports on CRE loan quality and trends. Copyright 2008 Crowe Chizek and Company LLC

6 5 Crowe Credit Risk White Paper Step 1: Validate CRE Data The quality of data in a management information system (MIS) is the foundation of all CRE concentration issues. Data entry is a classic source of problems when analyzing CRE quality. In many cases, financial institution employees don t have the time or the correct codes available when they enter the data, so they either leave fields blank or enter the numbers they think should apply. These employees may also lack specific knowledge of loans or collateral and unintentionally introduce other errors in the data. One simple way to help assure data integrity is to provide each employee with a specific reference list of key codes to use when booking loans. If they have to look up the codes in a manual, it is more likely that incorrect information will wind up in the MIS. It is also very important for financial institutions to have an accurate quality control process in place to verify that the correct codes are entered into the MIS. If the loan officers don t enter the codes themselves, someone who is familiar with the transactions should review the entries to ensure they make sense. Otherwise, when the regulators come in to conduct their reviews, it could appear that there are CRE concentrations when, in fact, there are none. To help mitigate problems, financial institutions should validate data by testing statistically reliable samples from their CRE records. As simple as this sounds, the step of validating CRE data is often overlooked. Step 2: Analyze Concentration Risk After validating CRE data, the next step is to analyze the loan portfolio for concentration risk. The assessment should identify concentrations by stratifying the CRE portfolio into segments that have common risk characteristics or are sensitive to similar factors. These can include: Loan types, such as residential development, industrial development, retail, residential rental, and nonowner-occupied manufacturing facilities; Similar repayment sources; Fixed rate or adjustable rate; Geographic markets; Common tenants; Risk rating; Loan purpose; Loan-to-value ratios; and Debt service coverage. Copyright 2008 Crowe Chizek and Company LLC

7 Crowe Credit Risk White Paper 6 Stratifying a loan portfolio by different criteria helps to identify diversification within categories of CRE loans. For example, before stratification, a financial institution might appear to have a large number of hospitality development loans for hotels and motels. But if stratification reveals that these loans are distributed among several developers in different counties or states, the concentration risk would be lower than if they all belong to one or two developers in the same county. Financial institutions should also stress-test their loan portfolios by looking at the effects of changes on earnings, capital, and criticized and classified levels of assets. Using historical loss given default rates, what would be the effect if the number of defaults increased incrementally? At what point, if any, does a financial institution become vulnerable due to a weak capital position? What happens if default rates remain flat but the losses per default increase? And if both default rates increase and losses per default increase, what would be the effect on capital and earnings? At what levels would the financial institution be vulnerable? There may be other factors to stress-test as well. For example, financial institutions that serve markets affected by hurricanes and wind damage need to ask what the effect is of decreased insurance coverage or significantly increased deductibles for property and casualty insurance. Identifying underlying broad risks in the portfolio is a key step to understanding how the portfolio may deteriorate. Financial institutions should consider integrating all of the data that they may have and using that data to more quickly identify changes in levels of risk. Integrating customer data, such as cash flow and debt service coverage by industry or some other meaningful segmentation, would provide an earlier warning to deterioration than using past dues or charge-off data, which usually lag behind events significantly. Financial institutions should also consider combining core system data with customerspecific data. For example, financial institutions might be able to analyze hospitality loans over $500,000 to borrowers in a certain geography by key attributes such as occupancy, average daily room rate, debt service coverage, and cash flow. This type of information would enable lenders to identify problems much earlier and react much more quickly. In addition, financial institutions should stress-test individual loans as part of the underwriting process by examining lease rates, vacancy rates, capitalization rates, insurance rates, and other key variables that affect borrowers ability to repay especially when economic conditions change. Copyright 2008 Crowe Chizek and Company LLC

8 7 Crowe Credit Risk White Paper Step 3: Mitigate CRE Risk Stratification helps financial institutions refine their thinking and gain a more detailed understanding of where their pockets of risk are. With that knowledge, financial institutions can then start to mitigate their risk by addressing the following points. Board and Management Oversight The board of directors and senior management are responsible for protecting the financial institution against the risks associated with concentrations in CRE lending. Financial institutions should have strategies in place to understand, monitor, and mitigate this risk including overall growth objectives; CRE as it relates to overall growth of the portfolio; financial targets; and a capital plan. Financial institutions written policies that establish limits and standards for CRE lending should: Address overall CRE lending strategies for the level and nature of the CRE exposures that financial institutions find acceptable; Ensure that management has in place procedures and controls that enable it to follow and monitor compliance with its lending policies and strategies; Review information that identifies and quantifies the nature and level of risk presented by CRE concentrations, including reports that describe changes in CRE market conditions; and Periodically review and approve CRE risk exposure limits to conform to changes in strategies and respond to fluctuations in market conditions. Recently, one bank in a volatile real estate market underwent a CRE regulatory examination. Although the market had experienced a shaky period characterized by numerous bankruptcies and foreclosures, this particular bank passed its examination with flying colors. The reason? It had appropriate policies and procedures in place that demonstrated to regulators that it was on top of the situation and took several bold steps to head off problems. To start, the bank s solid market intelligence had enabled management to anticipate the shakeout in real estate nearly a year in advance. As a result, management analyzed its loan portfolio, identified prospective CRE concentrations, and made appropriate adjustments. It secured new appraisals for certain properties, required borrowers to put up more equity, and even forced some liquidations. Copyright 2008 Crowe Chizek and Company LLC

9 Crowe Credit Risk White Paper 8 Portfolio Management Financial institutions often focus on underwriting individual loans but pay less attention to their portfolios as a whole. To reduce CRE risk, financial institutions should incorporate both the aforementioned stress-testing and portfolio management processes into their oversight processes. Financial institutions need to have policies they can adjust in response to changing market conditions. For example, it is important to establish limits for various types of real estate and types of lending in different markets. It is also important that the policy have measurable limits that can be applied and modified if the institution s risk tolerance changes. These strategies can include loans sales, securitizations, or participations as ways to reduce risk when market conditions become adverse. In addition, financial institutions should perform certain monitoring of the level of risk in this portfolio. Stress-testing the effects of increased default rates and decreases in real estate values should be incorporated in the overall understanding of the risk in the portfolio. Management Information Systems An effective MIS that can provide management with sufficient information to manage the credit risk in the CRE portfolio is essential to any financial institution. The system should be able to stratify the CRE portfolio in different ways in order to analyze risk. Market Analysis Market data should provide management with information to support decision making involving current and future CRE loans. One of the problems financial institutions can face during the analysis is finding market data to compare to their own internal loan data. It s one thing if a financial institution appears to have a concentration of hospitality loans; it s another if those are the only such loans in the county or if they are part of an emerging glut of hotels and motels. Understanding the market is a key part of understanding the risks involved in lending. In fact, one of the most challenging tasks is to understand the market and what effects market changes will have on the portfolio. Gathering external data can be especially difficult in small markets. Large markets often have a variety of sources available everything from local chambers of commerce to national firms that gather and sell information. In addition, the Federal Reserve publishes economic information for larger markets. Potentially useful sources for such data include local real estate sales organizations, building trade groups, appraisers, and business journals. Copyright 2008 Crowe Chizek and Company LLC

10 9 Crowe Credit Risk White Paper Credit Underwriting Standards Financial institutions need to have policies in place that clearly articulate the underwriting standards for CRE loans. These policies should represent their appetite for risk, be supported by loan monitoring processes that ensure these policies are followed, and make sure that exceptions are rare and made only under mitigating circumstances. Financial institutions should review their credit underwriting standards periodically and update them as necessary to help manage portfolio risk. Awareness of the policies by all individuals key to the underwriting process is important. According to the new CRE guidelines, credit underwriting standards should include: Maximum loan amount by loan type; Acceptable loan terms; Pricing structure; Collateral valuation; Loan-to-value limits by property type; Requirements of when feasibility or market studies are needed; Procedures for stress-testing loans; Requirements for capital and hard equity by borrower; and Minimum standards for borrowers, such as net worth, property cash flow, debt service coverage, vacancy rates, and lease-up time frame. Underwriting should also include an analysis of the project being financed as well as the strength of the borrower. Because many developers borrow from several institutions, an understanding of borrowers other projects is essential to understanding their strength. Adherence to prudent appraisal guidelines, regular inspections, tracking of sold-tounsold units, pre-leasing, tenant analysis, and proper draw procedures are just a few of the other items that are necessary to provide a strong CRE lending function. Step 4: Report to Senior Management and the Board The final step in the process of managing risk is providing senior management and the board of directors with periodic reports on CRE loan quality and mitigation efforts. In most financial institutions, weekly or biweekly reports to management and monthly reports to the board are sufficient. Financial institutions with higher levels of CRE loan activity, however, may want to invest in dashboard reporting systems that can provide management with current information in reports on demand. Copyright 2008 Crowe Chizek and Company LLC

11 Crowe Credit Risk White Paper 10 Conclusion Understanding and managing CRE risk does not have to be difficult. It requires having a foundation of accurate data, conducting a thorough analysis to identify possible concentrations, and mitigating potential risks through appropriate planning and oversight. Such an approach can prove to be very effective, even when local real estate markets are in turmoil. Contact Information Scott C. Miller is an executive specializing in credit risk consulting for financial institutions with Crowe Chizek and Company LLC. He can be reached at or scmiller@crowechizek.com. Copyright 2008 Crowe Chizek and Company LLC

12 Crowe Chizek and Company LLC is a member of Horwath International Association, a Swiss association (Horwath). Each member firm of Horwath is a separate and independent legal entity. Accountancy services in the state of California are rendered by Crowe Chizek and Company LLP, which is not a member of Horwath. This material is for informational purposes only and should not be construed as financial or legal advice. Please seek guidance specific to your organization from qualified advisers in your jurisdiction Crowe Chizek and Company LLC FI8701