According to its Semiannual Risk Perspective for Spring 2016 (the “Semiannual Risk Report”), the National Risk Committee of the Office of the Comptroller of the Currency (the “OCC”) has escalated its oversight of commercial real estate risk from “ordinary” monitoring to “additional emphasis.” The escalation of oversight is a response to the recent rapid growth of the real estate lending market fueled by a low interest rate environment, combined with the easing of underwriting standards due to increased competitive pressure within such lending market. Based on the 2015 financial data of those national banks and federal savings associations supervised by the OCC, the Semiannual Risk Report warns of trends in the commercial real estate market similar to those that appeared in 2007 prior to the recession. The OCC wants to avoid a repeat of the market’s bottom falling out as it did in 2007 and is taking steps now to force conservatism in CRE lending.
In the fall of 2005, the OCC, the Board of Governors of the Federal Reserve System (the “FRB”) and the Federal Deposit Insurance Corporation (“FDIC,” together with the OCC and the FRB, the “Banking Agencies”) became concerned that the community banks were overexposed to the real estate market. The Banking Agencies issued interagency guidance in December 2006 entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices” stating that a bank regulated by a Banking Agency needed to have in place enhanced credit risk controls if:
the amount of its construction and land development loans (“CLD Loans”) represented more than 100% of such bank’s risk-based capital; or
the aggregate amount of its commercial real estate loans (excluding owner-occupied real estate) represented more than 300% of such bank’s risk-based capital and had increased by 50% or more during the prior thirty-six months.
According to a study conducted by the Banking Agencies, by the beginning of the recession in December 2007, 31% of the banks regulated by the Banking Agencies exceeded at least one of the thresholds outlined by the Banking Agencies (the “Concentration Criteria”) and 13% of the banks that exceeded the Concentration Criterion based on CLD Loans failed or had significant decline in market value during the recession. In addition, the banks exceeding one or more of the Concentration Criteria accounted for an estimated 80% of the losses of the FDIC insurance fund from 2007 to 2011.
Market Factors Behind Concentration Criteria
The Concentration Criteria are based on the unique characteristics of commercial real estate. The most distinguishing factor being the likelihood that a bank could lose more than 100% of the amount of a real estate loan upon such loan going into default. Liquidating commercial real estate is time-consuming and can require the bank to use its own money to operate the property during such liquidation or, in connection with a CDL Loan, to complete construction of the improvements. If a bank chooses to shut-down operations at the property or terminate construction instead, it takes the risk that the value of the property will decline even further.
For these reasons, it is important for the banks to balance their commercial real estate loans with loans secured by other classes of assets, and even balance their CLD Loans with other types of commercial real estate loans.
According to data compiled by the FDIC as of June 30, 2016, the total volume of commercial real estate loans made by banks is two percent higher than the volume going into the summer of 2007. Based on the First Annual American Bankers Association Commercial Real Estate Survey Report, dated April 2016, out of 136 banks surveyed, 19% of the banks have exceeded the CLD Loan Concentration Criterion and 9% percent of the banks have exceeded the other Concentration Criterion. In addition, the OCC found 406 banks whose commercial real estate loan portfolios more than doubled over the last thirty-six months.
This is consistent with observations made by the Banking Agencies in their December 2015 guidance, in which the Banking Agencies identified the following recent trends:
Increasing investor demand for CRE and the current interest rate environment are contributing to historically low capitalization rates and significant increases in property values in many markets.
CRE concentration levels have been rising at many institutions, influenced in part by continued strong demand for CRE credit, earnings pressures, and reassuring trends in asset-quality metrics, such as low rates of delinquency and charge-offs.
The competition for loans has resulted in an easing of underwriting standards and increases in underwriting exceptions.
Intended Agency Action
The Banking Agencies want lenders to tighten up their CRE lending standards. They plan to focus their attention on those banks who have recently experienced, or whose lending strategy plans for, substantial growth in commercial real estate lending. In reviewing such banks, the Banking Agencies will analyze, among other things, the following risk management processes of such banks:
Board and Management Oversight – Has the board of the bank approved a commercial real estate lending strategy regarding the level and nature of commercial real estate exposure?
Portfolio Management – Does the bank have a contingency plan to reduce or mitigate concentrations in the event of adverse commercial real estate market conditions, such as loan sales, participations or securitization?
Management Information Systems (MIS) – Does the bank’s MIS include sufficient information about each loan, the collateral securing such loan and borrower of such loan in order to accurately calculate the concentration risk?
Market Analysis – Does the bank perform periodic market analysis for various property types and geographic markets represented in its portfolio?
Credit Underwriting Standards – To determine if a bank has loosened its underwriting standards, the Banking Agencies will review the loan agreements for the commercial real estate loans in the bank’s portfolio to see how often such bank has agreed to:
o Longer term loans
o Interest-only periods
o Limited guarantor requirements
o Less restrictive covenants
o Deficient stress-testing practices
Portfolio Stress Testing and Sensitivity Analysis – Does the bank’s stress testing and sensitivity analysis take into account the size, complexity and risk characteristics of the commercial real estate loans within the portfolio?
Credit Risk Review Function – Does the bank review the risk ratings regularly?
U.S. Comptroller of the Currency, Thomas Curry, described the new guidelines as prophylactic. They are “meant to flag the issue for the banks so they can take corrective action now on their own before going through any type of examination cycle."