Managing Commercial Real Estate Concentrations ommercial real estate (CRE) loans comprise a major portion of many Background Cbanks’ loan portfolios. Demand for According to History of the Eighties— CRE lending—a traditional core business Lessons for the Future, the high number for many community banks—has been of bank and savings institution failures very strong in recent years, and a growing during the 1980s and early 1990s can be number of banks have CRE concentra- attributed primarily to overinvestment in tions that are high by historical standards CRE loans.2 Weak underwriting stan- and rising. Growth in land acquisition, dards and portfolio management tech- development, and construction (ADC) niques during this time contributed to a lending has been especially pronounced. significant oversupply of CRE properties Many de novo banks in areas with signifi- that weakened the entire CRE market, cant job and population growth (predomi- leaving borrowers unable to repay their nately in East and West Coast states) loans and collateral that provided far less have used ADC loans as the primary asset support than originally thought. Other class to drive growth and meet pre- factors that contributed to the CRE opening projections. The rapid growth in losses included: CRE exposures in recent years presents additional challenges for bank manage- I Lack of market information ment as it monitors and controls risks it I Highly leveraged transactions may not have faced in the past. I Relatively low borrowing costs and the In response to rapid growth in CRE loan easy availability of credit concentrations and observed weaknesses in risk management practices at some I Government policy, including income institutions, the Federal Deposit Insur- tax benefits ance Corporation (FDIC), the Board of I Long gestation periods that allowed Governors of the Federal Reserve System supply-and-demand dynamics to (FRB), and the Office of the Comptroller change before a project’s completion of the Currency (OCC) (collectively, the federal banking agencies) published I Nonrecourse lending and legal struc- Joint Guidance on Concentrations in tures that shielded project sponsors Commercial Real Estate Lending, Sound from risk Risk Management Practices (CRE guid- I Out-of-area lending, including the 1 ance) in December 2006. This article purchase of loan participations from provides additional information and out-of-area lenders context to some of the topics discussed in the CRE guidance, drawn from the I An unregulated real estate appraisal authors’ firsthand observation of the risk industry that often used inflated management practices of both large and assumptions and relied on inexperi- small banks. It covers market monitoring enced appraisers and analysis, credit underwriting and Today, many lenders, directors, and administration, portfolio management, senior officers have not experienced a credit risk rating and review, and stress CRE downturn in their careers. They testing. may never have learned the lessons of

1 Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, Federal Register, Vol. 71, No. 238, December 12, 2006, pp. 74580–74588 (CRE Guidance). Also see FDIC FIL-104-2005 at www.fdic.gov/news/news/financial/2006/fil06104.html. 2 See FDIC’s History of the Eighties—Lessons for the Future, December 1997, at www.fdic.gov/bank/historical/ history/contents.html.

12 Supervisory Insights Winter 2007 the 1980s or may view them as distant CRE loans. The guidance “focuses on history that “can’t happen again.” Indus- those CRE loans for which the cash try and regulatory changes that arose flow from the real estate is the primary from the tumult of the 1980s remain source of repayment rather than loans to intact and are intended to prevent a re- a borrower for which real estate collateral occurrence of the ill-conceived practices is taken as a secondary source of repay- of the past. For example, the appraisal ment or through abundance of caution.”6 industry is now regulated, and appraisal The target of the guidance, then, gener- quality is far superior to what it was in ally would include development and the 1980s. Banks and thrifts must now construction loans for which repayment follow federal appraisal regulations, and is dependent upon the sale of the prop- regulators require banks to establish an erty as well as properties for which repay- effective real estate appraisal and evalua- ment is dependent upon rental income. tion program to ensure independence The CRE guidance also identifies insti- and improve quality.3 4 tutions that are potentially exposed to In addition to the changes regarding significant CRE concentration risk as appraisals, the federal banking agencies, those that have experienced rapid growth along with the Office of Thrift Supervi- in CRE lending, have notable exposures sion (OTS), have established underwrit- to a specific type of CRE, or are ing and risk management requirements.5 approaching or exceed the following A pillar of these requirements is loan-to- supervisory criteria: value (LTV) limits for different CRE prop- I Total loans reported on the Report erty types. Adhering to these regulatory of Condition for construction, land LTV limits should make institutions less development, and other land repre- vulnerable to downturns in CRE markets, sent 100 percent or more of the insti- as borrowers will have more tangible tution’s total capital; or equity in the collateral real estate to cushion against declining values. I Total CRE loans as defined in the Conversely, institutions that ignore these CRE guidance represent 300 percent LTV limits and have substantial volumes or more of the institution’s total capi- of high LTV loans are more susceptible tal, and the outstanding balance of to the adverse affects of CRE downturns. the institution’s CRE loan portfolio has increased by 50 percent or more CRE loan growth recently prompted during the prior 36 months. regulators to issue guidance to address concerns about CRE concentrations and These criteria are not limits and are to provide expectations for managing a viewed neither negatively nor as a safe concentrated portfolio. The CRE guid- haven. A bank can have significant ance recognizes that diversification can diversification within its CRE portfolio be achieved within CRE portfolios and or have a concentration within a specific differentiates risk in different types of CRE category. If a bank’s portfolio goes

3 The federal bank and thrift regulatory agencies have adopted substantially similar appraisal regulations. See 12 CFR 323 (FDIC); 12 CFR Part 34, subpart C (OCC); 12 CFR 208.18 and 12 CFR 225, subpart G (FRB); and, 12 CFR 564 (OTS). 4 FIL-74-94, Interagency Appraisal and Evaluation Guidelines, November 11, 1994, www.fdic.gov/news/news/ financial/2003/fil0384b.htm. 5 See Interagency Guidelines for Real Estate Lending Policies: 12 CFR 365 and appendix A (FDIC); 12 CFR 34, subpart D and appendix A (OCC); 12 CFR 208, subpart E and appendix C (FRB); and 12 CFR 545 and 563 (OTS). See also Interagency Guidelines Establishing Standards for Safety and Soundness: 12 CFR 364, appendix A (FDIC); 12 CFR 30, appendix A (OCC); 12 CFR 208, appendix D-1 (FRB); and 12 CFR 570, appendix A (OTS). 6 CRE Guidance, p. 74585.

13 Supervisory Insights Winter 2007 Commercial Real Estate continued from pg. 13 outside of these general guidelines, as obtain market data for CRE other than many do, the bank will not automatically single-family residential properties from be criticized, but heightened risk national providers such as Property & management practices may be needed. Portfolio Research, Real Estate Invest- Different CRE types may have different ment Services, and Torto-Wheaton risk characteristics. Risk management Research. Residential market information practices should be commensurate with is also available from a number of national the complexity of the bank and its port- and regional providers. Outside of large folio. The guidance states, “in evaluating MSAs, vendor data are often unavail- CRE concentrations, the Agencies will able. In these areas, in-house knowledge consider the institution’s own analysis of and communication with local builders, its CRE portfolio, including considera- developers, real estate agents, and civic tion of factors such as: leaders may be the primary tools for gathering information on market activity I Portfolio diversification across prop- and gauging market conditions. erty types. The level of CRE monitoring required I Geographic dispersion of CRE loans. can differ among institutions depending I Underwriting standards. on exposure level or perceived risk in a product type or geographic area. Institu- I Level of pre-sold units or other types tions involved in construction and devel- of take-out commitments on construc- opment lending have a greater need to tion loans. monitor CRE markets, as conditions can I Portfolio liquidity (ability to sell or change dramatically between the time an securitize exposures on the secondary institution makes a loan commitment and market).”7 the time a project is completed. Moni- toring speculative single-family housing These factors could mitigate the risk development can be especially challeng- posed by the concentration. Additionally, ing. Institutions must have a clear under- banks that have experienced recent, standing of the demand for housing significant growth in CRE lending will within geographic areas, submarkets, or receive closer regulatory review than specific projects, as well as price points those that have demonstrated a success- within markets or projects. Institutions ful track record of managing the risks should track available inventory and their of CRE concentrations. own levels of exposure at a level of granu- The remainder of this article provides larity sufficient to allow management to context and additional information for determine if the institution should curtail some of the topics addressed in the CRE lending for specific products or in loca- guidance. tions of concern, even if other products or locations continue to perform well. The granularity warranted may be product-by- Market Monitoring and product, location-by-location or some Analysis other degree (e.g., price point, specula- A bank’s ability to monitor develop- tive versus presold), depending upon the ments in its CRE market area is a critical institution’s markets and product types. element of successful CRE lending. Vari- Markets may be monitored by staff or ous tools may be available to monitor management, but ultimately both must CRE markets, depending on the size of understand what is being monitored and the market. In many larger metropolitan why. The monitoring function can be statistical areas (MSAs), institutions can organized in a variety of ways. For exam-

7 CRE Guidance, p. 74587.

14 Supervisory Insights Winter 2007 ple, the institution may create a CRE risk reference to identify whether the strategy management function that is responsible for a particular market or product type is for establishing CRE concentration risk to grow, maintain, or reduce exposure. In limits (approved by the institution’s markets where demand is very strong, board) and overseeing compliance with management may instruct lending staff those limits. To ensure that risk manage- to pursue additional opportunities and ment and lending are working in concert, adjust pricing and other terms to attract the two functions must communicate. The additional business. In areas where lending staff must pass along market infor- management deems risks to be higher, mation to the risk management function. lenders may be instructed to curtail or Once risk management has compiled the discontinue lending activities altogether. information, it must deliver its market No matter the form of the market analysis back to the lending staff. (See analysis, management must convey its Figure 1.) This mechanism ensures that strategy to lending staff in a timely both risk management and the lending manner and maintain sufficient over- staff are in agreement about the market- sight of lending activity to ensure that place conditions and the lending strategy. the loans being originated are consistent Risk management staff should provide with management’s strategy. Reporting its analysis of market data to senior systems should be sufficiently detailed management in a manner they can use to to identify situations where the strategy develop a comprehensive lending and risk is not being followed. mitigation strategy. A common delivery method is to provide lenders with a “heat map” that details management’s view of Credit Underwriting the demand for product types in each Standards and Administration geographic market and directs lenders’ A CRE concentration increases the degree of aggressiveness for those prod- importance of sound lending policies. ucts. A heat map can serve as a quick An institution’s lending policies should

Figure 1. Communication must occur between lending and risk management functions.

Credit Risk External External Market Management Market Information Group Information Evaluated Data Heat Map

Market Information

Market Information

Market Information

Lenders Lenders Lenders

Lenders Lenders Lenders

15 Supervisory Insights Winter 2007 Commercial Real Estate continued from pg. 15

communicate the level of risk acceptable An institution’s lending policies should to its board of directors. The policies permit only limited exceptions to under- should provide clear and measurable writing standards. When an institution underwriting standards that enable lend- permits an exception, it should docu- ing staff to evaluate all relevant credit ment how the transaction does not and market factors. The CRE guidance conform to the institution’s policy or provides several internal and external underwriting standards and why the factors that should be considered when exception is in the best interest of the establishing policies, such as market bank. The institution should also ensure position, historical experience, present that appropriate management approvals and prospective trade area, probable are obtained. Robust risk management future loan and funding trends, staff systems can also track the number of capabilities, and technology resources. exceptions by type and amount to help point out areas of policy that may need Institutions should also consider the permanent amendment or that need to following items with regard to managing be reinforced by the institution’s board construction loans: of directors. I Independent property inspections— There should be initial site visits and ongoing inspections during the Portfolio Management construction phase. The bank should have a management I Loan disbursement practices—They information system (MIS) that provides should be based on engineering or sufficient information to measure, moni- inspection reports, requirements for tor, and control CRE concentration risk. lien waivers from subcontractors, etc. This includes meaningful information on CRE portfolio characteristics relevant to I Sponsor/developer experience level— the institution’s lending strategy, under- Institutions should establish standards writing standards, and risk tolerances. to ensure that the sponsor/developer Many institutions will want to expand the as well as the underlying contractor level of information captured to specifi- has a proven track record and suffi- cally include underwriting characteris- cient experience in the market and in tics, such as LTVs, debt service coverage the property type being developed to levels, speculative versus presold units, complete the proposed project. etc., to allow for more enhanced report- I Loan agreements, collateral documen- ing and analysis. Information can be tation, and appraisal practices—Robust captured on mainframe systems or other loan agreements and collateral docu- systems—including the use of simple mentation are expected. Plans and spreadsheets—but should be retained in budgets are also needed to establish a form that can be readily accessed for disbursement/draw schedules. Loan analysis purposes. agreements should clearly communi- MIS reports may include: cate draw schedules, release provi- sions, and repayment requirements. I CRE loan segmentations (to deter- mine diversification within a portfolio) I Debt service coverage analysis—Debt service coverage thresholds as well as I Established concentration limits (for presold or preleased standards are CRE in aggregate as well as by useful tools to control the risks in a subcategory) CRE transaction. I Concentration reports by property I Sponsor or guarantor financial analy- type sis, if applicable.

16 Supervisory Insights Winter 2007 • Presold (considered lowest risk, but CRE markets are typically cyclical. purchaser deposit amounts should Strong markets promote additional build- be considered) ing, which can result in oversupply • Speculative (no sales contract or followed by weakened market fundamen- prelease agreement exists) tals. Consequently, the real benefit of • Portfolio or borrower aging (age of implementing systems to identify and CRE inventory by portfolio or control CRE concentrations lies in limit- borrower) ing the level of risk brought on by those concentrations when markets begin to • Aggregate by market (CRE inven- falter. While it may be easy to manage a tory broken down by market or concentration during the good times, submarket) managing one once market demand has • Aggregate by price range (CRE slowed is much more challenging. inventory broken down by price range) Good risk management starts with setting reasonable concentration limits I Borrower concentration reports, for different products and markets. including guidance line (informal, Adjusting those limits when market uncommitted) limits fundamentals change is also a prudent I Loan underwriting exception reports risk management tool. After all, how (CRE loans requiring loan policy beneficial can market monitoring and exception approvals) analysis be if concentration limits and • Number and volume of exceptions exposures are not adjusted when that by nature, justification, and trends market information indicates a change in market conditions? Listed below are • Performance of exception loans some examples of possible indicators compared with loans underwritten that particular markets are at or near a within guidelines peak. The specific numerical examples I Supervisory LTV exception reports8 are not intended to represent triggers we believe bankers should use, but merely to I Typical loan production and perfor- illustrate that management may wish to mance reports by type, region, officer, consider a number of concrete numeri- etc. cal indicators in forming a judgment Many banks fail to collect the data about the risks in a particular market: necessary to produce the reports listed I Loan pricing becomes too thin for the above. They may have separate legacy underlying risk (e.g., construction systems that do not aggregate data effi- loan pricing has fallen almost 150 ciently, if at all. In addition, many banks basis points in recent years owing to do not have the resources to search competition). hard copy files and backfill data into their systems. Management first needs I Underwriting weakens to unreason- to identify the drivers that will affect able levels or to levels banks previ- segmentation at origination and then ously would not have approved (e.g., capture those data fields on the system. deposits for qualifying presold These drivers could be LTV, rate type condominium units are reduced by (fixed versus floating), debt coverage half to entice enough preconstruc- ratios, or large tenants that could create tion buyers to demonstrate demand concentrations when aggregated. for a project).

8 Appendix A to 12 CFR 365—Interagency Guidelines for Real Estate Lending Policies—states that loans exceed- ing the supervisory LTV guidelines should be recorded in the institution’s records and reported to the board at least quarterly. See section titled “Loans in Excess of the Supervisory Loan-to-Value Limits.”

17 Supervisory Insights Winter 2007 Commercial Real Estate continued from pg. 17

I Inventory and planned production are and early 1990s, developers walked away excessive relative to market dynamics from partially finished properties, and (e.g., office space in the pipeline some lenders were forced to complete exceeds several years’ absorption rate projects to salvage their investment. In without any significant increase in many of these instances, costs escalated employment expectations; condo- dramatically as lenders were forced to minium units in the pipeline exceed restart projects and remediate shoddy the level of several prior years’ sales). workmanship, adopt engineering and architectural changes to make the proj- I Speculators drive prices to unwar- ect viable, pay off subcontractor liens, ranted levels (e.g., home prices and pursue zoning or other legal issues. increase by 30 percent year-over-year for an extended period, while inven- Another major expense often overlooked tory is expected to grow to unprece- is the opportunity cost of holding a large dented levels). volume of nonearning assets. Lenders often severely underestimate the length of I The regional or national economy time necessary for the sale of foreclosed shows signs of stress. assets in a distressed market. Additional If CRE lending is a substantial source costs accrue during the holding period, of revenue, the decision to reduce expo- including property taxes and the cost of sure levels will likely be met with signifi- sales, maintenance, and security. Many cant resistance from managers and loan lenders found during the CRE downturn officers concerned about short-term of the 1980s and early 1990s that the earnings performance. If CRE lending is “first loss is the best loss,” meaning that it the primary earnings driver, the institu- would have been cheaper in the long run tion should be prepared to diversify into to have disposed of distressed CRE assets other areas of lending or wait for CRE earlier rather than later. markets to return. The failure to control exposure levels when warning signs are evident can result in excessive loan Credit Risk Rating and Review losses. The level of losses will generally Risk rating systems can vary greatly depend on the quality of loan underwrit- between community and large banks. ing and the breadth and depth of the One solution does not and should not CRE market downturn. fit all banks—the risk rating and review Unfortunately, the importance of CRE process should be commensurate with portfolio management and appropriate the bank’s size and complexity. A small, concentration limits becomes most noncomplex bank may need only a one- apparent only when the bank’s market dimensional rating system with a small enters a downturn. As loan quality deteri- number of rating grades, while a large orates, banks must expend significant or complex organization may require resources, both human and monetary, a rating system with more grades to for collection and, in some cases, foreclo- measure risk levels adequately. Larger sure on the underlying collateral. While banks often use rating systems that the direct costs of these actions are assign separate ratings for default risk apparent, there are often other costs that and loss severity. This type of system bear mention. If market conditions dete- has the added benefit of delineating riorate severely, sponsors or developers credit risk, which should aid lenders may simply abandon a project, especially in mitigating those risks. if they have insufficient capital invested In addition to being used to determine and there is no recourse to the princi- capital levels, adequacy of the allowance pals. In many instances during the 1980s

18 Supervisory Insights Winter 2007 for loan and lease losses, and loan pric- eliminated if a CRE downturn appears ing strategy, risk ratings can be used as to be on the horizon. a parameter for setting concentration Independence in the validation process limits and sublimits. Risk ratings should is the third leg to any successful rating be accurate and uniformly applied system. Individuals outside the lending across product lines and geographic process should evaluate and validate the areas. Banks identified as having CRE entire process. Banks with limited staffing concentrations possess an additional resources can use external audit staff or level of risk and complexity that should consulting firms to conduct the validation. be considered when evaluating the risk As banks grow, this process is typically rating and review system. Risk rating brought in-house. The review and valida- and review processes should have the tion personnel will generally be the best following characteristics: resource for identifying problems in the I Transparency rating system. Credit review personnel should provide the board and senior I Granularity management with periodic feedback I Independence regarding the effectiveness of the rating system and any recommended changes for Transparency is critical for any risk improving transparency and granularity. rating system. Account officers, loan review personnel, and regulatory exami- nation staff should be able to review Portfolio Stress Testing and rating guidelines and reach the same Sensitivity Analysis conclusion on the rating grade assigned to individual credits. This becomes Most geographic locations in the United increasingly important as the bank grows States have not experienced serious and more people are involved in the risk declines in CRE markets for a number rating process. Specific, objective rating of years. Much has changed in CRE criteria rather than broad, subjective lending since the last downturn. Some criteria promote consistency in the analysts suggest that a major sea change rating process. Transparency is generally has occurred in the form of greater evaluated by reading the bank’s rating transparency and liquidity that acts as policy guidelines and conducting transac- a cushion against the deep losses of the tion testing. The key is to have someone 1980s and 1990s. Banks may tend to other than the original credit analyst believe that the losses during that time attempt to come to the same conclusion were much more severe than they would using the tools provided by policy. If ever again encounter. Yet, while the CRE agreement with a high percentage of credit market has been influenced by assigned credit ratings cannot be excess liquidity for a number of years, achieved, the rating guidelines may recent events in the credit markets for need further clarification. housing and leveraged finance demon- strate that liquidity can evaporate quickly Granularity is also necessary to if lenders’ and investors’ perceptions of provide an accurate assessment of port- the level of risk inherent in those loan folio risk. At a minimum, the risk rating products change. system should rank order risk in the portfolio and provide enough grades so In light of the possibility of significant that the vast majority of loans do not fall losses in CRE portfolios, banks with into just one grade. A granular rating concentrations in CRE can use stress system that effectively rank orders risk testing to assess the extent of their should aid management in identifying exposure to a downturn in CRE the exposures that should be reduced or markets. Stress testing can also inform

19 Supervisory Insights Winter 2007 Commercial Real Estate continued from pg. 19

management of the institution’s specific writing criteria and lending standards. vulnerabilities to CRE markets and indi- Along with project assumptions, loan- cate where actions should be taken to specific variables, such as interest rates mitigate those risks. and LTV ratios inferred from capitaliza- tion rates, are commonly analyzed. The CRE guidance includes a general expectation that an institution with CRE While loan-level sensitivity analysis is concentrations will conduct portfolio stress a valuable tool for all banks originating testing consistent with the size, complex- CRE loans, this type of analysis could ity, and risk characteristics of its CRE loan be performed on a portfolio-wide basis. portfolio. However, the guidance does not Such an analysis would measure the provide specific minimum expectations. depth and breadth of the portfolio’s Following are examples of the types of vulnerability to changes in real estate stress tests commonly used in banks. markets and interest rates. These analy- ses can be conducted on a scheduled Transactional Sensitivity Analysis basis or when market fundamentals dictate. Systematically aggregating the Most institutions that specialize in CRE results of individual transactional stress lending, and especially ADC lending, tests could involve: are accustomed to running analyses to determine loan and project exposure as I Determining market fundamentals for part of the underwriting process. Before each product type and geographic making a commitment for financing, market where the bank has funds an institution will analyze sponsor and committed. (For practical purposes, lender assumptions to determine the it may be necessary to establish a degree to which a project can withstand materiality threshold.) market fluctuations and still repay the I Developing sensitivity analysis fore- loan. Analysis covers testing the casts, such as increased vacancy rates common assumptions and combinations in the market by product type, slower of assumptions shown in Table 1. absorption rates, reduced sales prices, higher capitalization rates, or higher Table 1 interest rates. Assumptions to be tested for I Testing each credit in the portfolio, CRE lending considering the current status of each Properties Properties Loan project against the impact of the sensi- for Sale for Lease Variables tivity analysis forecasts. Absorption Absorption Interest rates rates rates I Aggregating the impact of each tested Sales prices Rent rates LTV ratios credit to determine the vulnerability Contingency Vacancy rates Amortization within the portfolio. reserves term For income-producing properties with Rollover risk long-term, fixed-rate loans and long-term Reserves for tenants, the analysis may reveal little or maintenance and no additional exposure unless capitaliza- improvements tion rates are expected to increase on the specific property type. However, the analysis of loans granted for speculative Given that some of the assumptions lot development projects with slower interact with other assumptions, a range absorption rates could reveal substantial of outcomes may be used to determine if additional exposure, suggesting that the the loan meets the institution’s under- bank should consider limiting its expo-

20 Supervisory Insights Winter 2007 sure in certain geographic markets or granularity. For example, the ADC product types. loss history on the reference port- folio is for a geographically diverse Stressed Loss Rates group of loans, but the current portfolio is largely concentrated Stressed loss rate testing entails deter- in one location. In this case, an mining loss rates at levels that could be upward adjustment in loss rates expected during CRE market downturns would seem necessary to address and forecasting the ultimate effect of the additional concentration risk. these losses on capital. The stressed loss rates would be developed through an I Calculate the losses that would be analysis akin to the following: expected in a market downturn by applying the adjusted historical loss I Obtain historical loss rates on CRE rates to the current portfolio. loans (the “reference portfolio”) at the most granular level available. If the bank has not previously experi- (Available data will often be fairly enced significant CRE downturns, using general in nature—losses on hotels, external data may be more appropriate retail buildings, office buildings, etc.— than using internal data. The FDIC has rather than for more specific product historical CRE data that could be used types—suburban hotels versus down- to construct loss rates, although the town hotels, multitenant office build- FDIC data lacks much granularity.9 ings versus owner-occupied office Like an aggregate transactional sensitiv- buildings, etc.) In banks with more ity analysis, stressed loss rate testing can limited CRE lending experience, the provide useful input to a bank’s capital, data may be at higher levels, such as earnings, and liquidity planning. While all types of ADC loans or even all not providing specific information for CRE loans. Generally, the longer a managing CRE concentrations, it should bank has been a CRE lender, the inform management of the possible level more granular the loss data. of the bank’s exposure if a CRE down- I Identify loss rates that occurred as a turn were to occur. The usefulness of this result of previous market downturns, type of test relies heavily on the reference generally the highest loss rates experi- portfolio selected to conduct the test. In enced in the reference portfolio. Loss institutions with limited or only recent rates may lag the downturn by a experience in CRE lending, the historical number of months or years. perspective required to conduct this sort of stress analysis would be based on I Identify the similarities or differences external data that may or may not be between the bank’s current portfolio applicable. In these institutions, the type and the historical reference portfolio, and level of adjustments to historical loan and adjust the loss rates appropriately. loss rates are critical elements to develop- • In general, the loss rates from the ing a useful outcome. reference portfolio will be a good starting point. The historical loss rates are applied at the same gran- Scenario Analysis ular level as the reference portfolio. Thus far, the examples cited have not • Adjustments to the historical loss necessarily been related to a particular, rates may be necessary to account perhaps local, event. For risk management for differences in the current port- purposes, a bank may develop stress folio. This is especially true if the scenarios customized to its circumstances data for the reference portfolio lack to make assumptions about how its CRE

9 See Statistics on Depository Institutions at www2.fdic.gov/sdi/index.asp.

21 Supervisory Insights Winter 2007 Commercial Real Estate continued from pg. 19

portfolio would react. For example, a cated internal data is to stress ratings community bank might assume layoffs at migrations. This process requires a a major employer and measure the antic- review of prior years’ migrations to deter- ipated results on new housing demand mine the typical migration experience. and other CRE property performance. Each year a percentage of credits (oblig- The trickle-down effect of the layoffs could ors in cases of banks with two-dimen- spread across CRE property types if local sional rating systems) improves, remains businesses’ revenues slowed and tenants the same, or declines. If sufficient data were unable to make their lease payments. exist to capture a CRE downturn, the bank could select the year with the high- The results of the scenario might affect est percentage of downgrades as the the bank’s other credit portfolios and stress year. Alternatively, the bank could lines of business, in addition to CRE develop a relationship between economic loans. Although most banks do not variables and ratings migrations. If these perform bankwide scenario stress test- data are not available, a bank might ing, the process of developing such choose to apply conservative estimates stress tests may be useful for planning of migrations to establish a stress year. purposes and to identify potential vulner- abilities. (See, for example, the discus- The bank would use the results of sion of planning for contingencies in the stress year migration to move the “Liquidity Analysis: Decades of Change” appropriate volume of exposures in in this issue of Supervisory Insights.) each current rating grade to the grades reflected in the stress year ratings matrix. Ratings Migration Analysis The new volumes in each grade would then be processed through the bank’s Another technique used by some banks allowance for loan and lease loss model with larger portfolios and more sophisti- to determine what provisions might be needed to value the CRE portfolio and the Table 2

Effects of a market downturn Total Total Borrowing Total Borrowing Average Annual Migration Rate 1 2 3 4 5 6 7 8 1 92.08 7.09 0.63 0.15 0.06 0.00 0.00 0.00 2 0.62 90.83 7.76 0.59 0.06 0.10 0.02 0.01 3 0.05 2.09 91.37 5.79 0.44 0.16 0.04 0.05 4 0.03 0.21 4.10 89.38 4.82 0.86 0.24 0.37 5 0.03 0.08 0.40 5.53 83.25 8.15 1.11 1.45 6 0.00 0.08 0.27 0.34 5.39 82.41 4.92 6.59 7 0.10 0.00 0.29 0.58 1.55 10.54 52.80 34.14

Stress Scenario—Annual Migration Rate is Double the Average Rate 1 2 3 4 5 6 7 8 1 84.14 14.18 1.26 0.30 0.12 0.00 0.00 0.00 2 0.31 82.61 15.52 1.18 0.12 0.20 0.04 0.02 3 0.03 1.05 85.97 11.58 0.88 0.32 0.08 0.10 4 0.02 0.11 2.05 85.25 9.64 1.72 0.48 0.74 5 0.02 0.04 0.20 2.77 75.76 16.30 2.22 2.90 6 0.00 0.04 0.14 0.17 2.70 73.94 9.84 13.18 7 0.05 0.00 0.15 0.29 0.78 5.27 25.19 68.2

22 Supervisory Insights Winter 2007 effect of these provisions on earnings and taken. The CRE guidance provides a capital. When compared to the current good framework to assist banks in ratings, the effect of a market downturn addressing the concentration risk and could be measured (see Table 2). also helps establish the federal banking agencies’ expectations during subse- quent risk management examinations. Conclusion Regulators and bank management must History has clearly demonstrated that not become complacent or static in their CRE can experience cyclical changes in approach to risk management; they must which supply and demand get out of continually evolve and change as the envi- balance, resulting in significant losses for ronment changes and new risks appear. financial institutions. To reduce potential With the risk management tools listed in losses in the future, banks must have the CRE guidance and further supported strong board and management oversight by other regulatory guidance, there is as well as robust risk management no reason CRE loans cannot continue processes for their CRE loan portfolios to be a favored asset class for banks. to recognize and control risk through all phases of the economic cycle. Bank Steven G. Johnson management should also be willing to Senior Examination Specialist forego potential CRE income when the Atlanta, GA risk exceeds the reward. A well-diversified bank is, in general, Mark D. Sheely better insulated against market down- Examination Specialist turns. However, investing in assets that Columbia, MO management does not understand can also carry significant risks. When Tracy E. Fitzgerald prudent diversification across a variety Examination Specialist of asset classes is difficult to achieve, Tulsa, OK it becomes even more important for management to deploy tools and imple- Charles M. Foster ment strategies similar to those outlined Supervisory Examiner here to recognize and control the risk Tulsa, OK

CRE Regulations and Guidance Applicable to FDIC-Supervised Institutions

To assist and encourage banks to recognize and control CRE lending risks, bank regulators have developed a significant body of regula- tory guidance for CRE transactions. Much of this guidance is based on lessons learned in downturns of the past, especially the banking crisis of the late 1980s and the early 1990s. • FIL-104-2005, Joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (www.fdic.gov/news/news/financial/2006/fil06104.html) • 12 CFR 365, Real Estate Lending Standards and Interagency Guidelines for Real Estate Lending Policies (www.fdic.gov/regulations/laws/rules/2000-8700.html) • 12 CFR 323, Appraisals (www.fdic.gov/regulations/laws/rules/2000-4300.html) • Interagency Appraisal and Evaluation Guidelines (www.fdic.gov/news/news/financial/2003/fil0384b.html) • FIL-90-2005, Residential Tract Development Lending (www.fdic.gov/news/news/financial/2005/fil9005.html) • FIL-94-1999, Interagency Guidance on High Loan-to-Value Residential Real Estate Lending (www.fdic.gov/news/news/financial/1999/fil9994.html)

23 Supervisory Insights Winter 2007