Reading Between the Lines of FDIC Vice Chairman Gruenberg’s Speech

Reading Between the Lines of FDIC Vice Chairman Gruenberg’s Speech

Tuesday, March 2, 2010

On February 26, 2010 Vice Chairman Gruenberg spoke before the The Committee on Financial Services and Committee On Small Business. His speech discusses key up-to-date industry statistical information and also addresses the complaints by bankers and industry groups regarding recommendations made, or supposedly made, by field examiners during onsite examinations. I’d like to quote the Vice Chairman’s speech and then follow with my commentary:

“Nationally, prices for CRE properties as measured by the Moody's/REAL Commercial Property Price Index are more than 40 percent below their October 2007 peak. As of fourth quarter 2009, quarterly rent growth has been negative across all major CRE property types nationally for at least the past year. Asking rents for all major CRE property types nationally were lower on a year-over-year basis.”

The Moody’s index is the standard of measurement in the CRE industry and is readily quoted by leading industry experts as well as the top regulators in the country yet many bankers believe that this statistic does not pertain to their market. While there may be some truth in that your local market may not have declined by 40 percent there is still very notable decline in values no matter where you in the country you are located.

If you believe your market has not suffered the same downturn you have some work to do. Obviously your examiners are very aware of this statistic so the burden of proof is on the banker to prove otherwise. Do some research before your next examination. Look for appraisals of the same property in your CRE portfolio from the peak of the market, third quarter of 2007, and a recent appraisal that you have reviewed and found to be in compliance that documents a smaller decline. Make sure the property is located within your lending area and try to do this for each property type in your loan portfolio. Supplement this information with documentation from local print or online publications that supports your hypothesis. It is best to be prepared.

The most prominent area of risk for rising credit losses at FDIC-insured institutions during the next several quarters continues to be in CRE lending.”

Expect your CRE loan portfolio to be the focus of your regulatory examinations for the next two years especially in community banks. Lenders should thoroughly work on their credits and have readily available and updated information such as: borrowers and guarantor financials including tax returns with all schedules; rent rolls; lease terms; and perfected collateral liens.

“As of December 31, 2009, CRE loans totaled almost $1.8 trillion, or 24.9 percent of total loans and leases. In terms of concentrations of credit, CRE at FDIC-insured institutions represented 133 percent of total risk-based capital, lower than the 151 percent seen one year earlier, but still significantly higher than levels at the beginning of the decade.”

CRE loan concentrations are still very prevalent especially in the nations’ community banks. Be sure that your bank has a comprehensive and board approved concentrations policy that sets standards and limits of the total portfolio as well as various segments as percentages of total risk based capital. Banks should have various methods of detecting concentrations and appropriate reporting mechanisms to the board. Also, the policy should have step-by-step methods of reducing concentrations that exceed limits that are deemed to represent an undue risk to the institution.

“Net charge-offs on loans backed by nonfarm, nonresidential properties have been just $11.3 billion over the past eight quarters. Over this period, however, the noncurrent loan ratio in this category has nearly quadrupled to 3.82 percent, and we believe it will rise further. It is likely that increased vacancy rates and lower rental income will translate into more borrowers unable to cover their debt service. The ultimate scale of losses in the CRE loan portfolio will very much depend on the pace of recovery in the U.S. economy and financial markets during the next few years…. Against a backdrop of weak fundamentals, investors have been re-evaluating their required rate of return on commercial properties, leading to a sharp rise in "cap rates" and lower market valuations for commercial properties.”

This is the perfect reason why every institution should be stress testing their CRE portfolio. This exercise will help a banker measure the effect of various economic, structural, and financial variables that are embedded in the value of CRE assets. Does your institution have the ability to quickly calculate what the effect of these variables is on the Net Operating Income and Collateral Value of the property? For example, the image below demonstrates that assuming no other deterioration a 2 percent rise in the cap rate reduces the collateral value by almost 24 percent. This is a very significant decline and can render the credit out of your institutions and regulatory loan-to-value ranges. Armed with this knowledge early bankers can work with borrowers and devise strategies to strengthen the loan and possibly avoid classification and a write down.

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