It covers market monitoring and analysis, credit underwriting and administration, portfolio management, credit risk rating and review, and stress testing. Columbia, MO, Tracy E. Fitzgerald Loan agreements should clearly communicate draw schedules, release provisions, and repayment requirements. Credit Underwriting Standards and Administration. Granularity is also necessary to provide an accurate assessment of portfolio risk. The number of Banks with CRE Ratios greater than 300% of RBC-Risk-Based Capital is essentially unchanged, the median asset level of these banks is bigger â¦ In addition to the changes regarding appraisals, the federal banking agencies, along with the Office of Thrift Supervision (OTS), have established underwriting and risk management requirements.5 A pillar of these requirements is loan-to-value (LTV) limits for different CRE property types. However, investing in assets that management does not understand can also carry significant risks. Supervisory Examiner, At a minimum, the risk rating system should rank order risk in the portfolio and provide enough grades so that the vast majority of loans do not fall into just one grade. Demand for CRE lending—a traditional core business for many community banks—has been very strong in recent years, and a growing number of banks have CRE concentrations that are high by historical standards and rising. The guidance is not intended to limit banks' CRE lending, as the agencies recognize that banks serve a vital role in their communities by supplying credit for business and real estate development. Minimum prompt corrective action capital levels, as a result, are not typically appropriate for banks with concentrations.3Likewise, banks with a significant exposure to a particular loan type, market, or industry should incorporate the likelihood of strong correlations among the loans when determining the appropriate allowance for loan â¦ The federal banking regulators have issued statements and guidance encouraging banks to continue lending to creditworthy borrowers and explaining how banks can work with troubled borrowers. 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. Recursos del seguro de depósito en español, FDIC National Survey of Unbanked and Underbanked Households, Money Smart - A Financial Education Program, Risk Management Manual of Examination Policies, Bank Secrecy Act and Anti-Money Laundering, FFIEC Information Technology Examination Handbook, Consumer Compliance Supervisory Highlights, Organization Directory and Office Contacts, www.fdic.gov/news/news/financial/2006/fil06104.html, www.fdic.gov/regulations/laws/rules/2000-8700.html, www.fdic.gov/regulations/laws/rules/2000-4300.html, www.fdic.gov/news/news/financial/2003/fil0384b.html, www.fdic.gov/news/news/financial/2005/fil9005.html, www.fdic.gov/news/news/financial/1999/fil9994.html, www.fdic.gov/bank/historical/history/contents.html, Freedom of Information Act (FOIA) Service Center, Relatively low borrowing costs and the easy availability of credit, Government policy, including income tax benefits, Long gestation periods that allowed supply-and-demand dynamics to change before a project’s completion, Nonrecourse lending and legal structures that shielded project sponsors from risk, Out-of-area lending, including the purchase of loan participations from out-of-area lenders, An unregulated real estate appraisal industry that often used inflated assumptions and relied on inexperienced appraisers, Total loans reported on the Report of Condition for construction, land development, and other land represent 100 percent or more of the institution’s total capital; or. While measuring risk-based capital, growth and asset quality across these various concentration segments is a great starting point, the guidance recommends: Incorporating this concentration analysis within the allowance for loan and lease loss (ALLL) calculations, The Federal Reserve Board's Division of Consumer and Community Affairs issues Consumer Affairs (CA) letters addressing policy and procedural matters of continuing relevance to the Fedâs consumer compliance supervisory responsibilities. A bank can have significant diversification within its CRE portfolio or have a concentration within a specific CRE category. Consequently, the real benefit of implementing systems to identify and control CRE concentrations lies in limiting the level of risk brought on by those concentrations when markets begin to falter. Portfolio liquidity (ability to sell or securitize exposures on the secondary market).”. Adjustments to the historical loss rates may be necessary to account for differences in the current portfolio. Loan agreements, collateral documentation, and appraisal practices—Robust loan agreements and collateral documentation are expected. The guidance “focuses on those CRE loans for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment or through abundance of caution.”6 The target of the guidance, then, generally would include development and construction loans for which repayment is dependent upon the sale of the property as well as properties for which repayment is dependent upon rental income. (See, for example, the discussion of planning for contingencies in “Liquidity Analysis: Decades of Change” in this issue of Supervisory Insights.). Consumer Compliance An Overview of the Interagency Guidance The interagency guidance, " Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (SR7-1)," was issued in 2006. The secure Internet channel for FDIC-insured institutions to conduct business and exchange information with the FDIC. In December 2015, the joint regulators issued a statement on prudent commercial real estate (CRE) lending that reminded financial institutions of existing regulatory guidance for Commercial Real Estate â¦ need further clarification. Real estate lending represents one of the major components of credit risk at many banks. Plans and budgets are also needed to establish disbursement/draw schedules. Many banks fail to collect the data necessary to produce the reports listed above. 1. FIL-104-2005, Joint Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (, 12 CFR 365, Real Estate Lending Standards and Interagency Guidelines for Real Estate Lending Policies (, Interagency Appraisal and Evaluation Guidelines (, FIL-90-2005, Residential Tract Development Lending (, FIL-94-1999, Interagency Guidance on High Loan-to-Value Residential Real Estate Lending (. Many de novo banks in areas with significant job and population growth (predominately in East and West Coast states) have used ADC loans as the primary asset class to drive growth and meet pre-opening projections. Banks should hold capital and reserves commensurate with that risk to protect against the higher chance of loss. Robust risk management systems can also track the number of exceptions by type and amount to help point out areas of policy that may need permanent amendment or that need to be reinforced by the institution’s board of directors. For example, the appraisal industry is now regulated, and appraisal quality is far superior to what it was in the 1980s. â¢ Total commercial and residential real estate loans secured by real estate with LTVs in excess of FDICIA guidelines should not exceed 100% of capital. Debt service coverage analysis—Debt service coverage thresholds as well as presold or preleased standards are useful tools to control the risks in a CRE transaction. 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). In light of the possibility of significant losses in CRE portfolios, banks with concentrations in CRE can use stress testing to assess the extent of their exposure to a downturn in CRE markets. While it may be easy to manage a concentration during the good times, managing one once market demand has slowed is much more challenging. Examination Specialist, However, the guidance does not provide specific minimum expectations. "Regulatory Guidance on Commercial Real Estate Risk" (April 2007) explains the guidance and the seven key areas. This becomes increasingly important as the bank grows and more people are involved in the risk rating process. Reporting systems should be sufficiently detailed to identify situations where the strategy is not being followed. The guidance states, “in evaluating CRE concentrations, the Agencies will consider the institution’s own analysis of its CRE portfolio, including consideration of factors such as: These factors could mitigate the risk posed by the concentration. Federal Register proposed guidance entitled âConcentrations in Commercial Real Estate Lending, Sound Risk Management Practicesâ (Guidance).3 Eleven months, one congressional hearing, and over 5,700 comment letters later, the Guidance was issued in final.4 This Article summarizes what transpired during these eleven months, including the Regulators have removed a key commercial real estate concentration limit for New York Community Bancorp in Westbury, N.Y. How are My Deposit Accounts Insured by the FDIC? The CRE guidance provides several internal and external factors that should be considered when establishing policies, such as market position, historical experience, present and prospective trade area, probable future loan and funding trends, staff capabilities, and technology resources. Banks identified as having CRE concentrations possess an additional level of risk and complexity that should be considered when evaluating the risk rating and review system. Testing each credit in the portfolio, considering the current status of each project against the impact of the sensitivity analysis forecasts. Sponsor/developer experience level—Institutions should establish standards to ensure that the sponsor/developer as well as the underlying contractor has a proven track record and sufficient experience in the market and in the property type being developed to complete the proposed project. The remainder of this article provides context and additional information for some of the topics addressed in the CRE guidance. In particular, small to mid-sizâ¦ Reiteration of Interagency Guidance on CRE-Commercial Real Estate Concentrations has had limited impact on Banking Industry. CRE loan segmentations (to determine diversification within a portfolio), Established concentration limits (for CRE in aggregate as well as by subcategory), Presold (considered lowest risk, but purchaser deposit amounts should be considered), Speculative (no sales contract or prelease agreement exists), Portfolio or borrower aging (age of CRE inventory by portfolio or borrower), Aggregate by market (CRE inventory broken down by market or submarket), Aggregate by price range (CRE inventory broken down by price range), Borrower concentration reports, including guidance line (informal, uncommitted) limits, Loan underwriting exception reports (CRE loans requiring loan policy exception approvals), Number and volume of exceptions by nature, justification, and trends, Performance of exception loans compared with loans underwritten within guidelines. Adhering to these regulatory LTV limits should make institutions less vulnerable to downturns in CRE markets, as borrowers will have more tangible equity in the collateral real estate to cushion against declining values. Online tool that helps depositors determine how the insurance rules and limits apply to a specific group of deposit accounts — what's insured and what portion (if any) exceeds coverage limits at that bank. Additionally, banks that have experienced recent, significant growth in CRE lending will receive closer regulatory review than those that have demonstrated a successful track record of managing the risks of CRE concentrations. Level of pre-sold units or other types of take-out commitments on construction loans. In addition to being used to determine capital levels, adequacy of the allowance for loan and lease losses, and loan pricing strategy, risk ratings can be used as a parameter for setting concentration limits and sublimits. (For practical purposes, it may be necessary to establish a materiality threshold.). See section titled “Loans in Excess of the Supervisory Loan-to-Value Limits.”. Individuals outside the lending process should evaluate and validate the entire process. The level of CRE monitoring required can differ among institutions depending on exposure level or perceived risk in a product type or geographic area. A heat map can serve as a quick reference to identify whether the strategy for a particular market or product type is to grow, maintain, or reduce exposure. When compared to the current ratings, the effect of a market downturn could be measured (see Table 2). stress tests may be useful for planning purposes and to identify potential vulnerabilities. The Agencies have observed that commercial real estate (CRE) concentrations have been rising over the past several years and have reached levels that could create safety and soundness concerns in the event of a significant economic downturn. Loss rates may lag the downturn by a number of months or years. The granularity warranted may be product-by-product, location-by-location or some other degree (e.g., price point, speculative versus presold), depending upon the institution’s markets and product types. Tulsa, OK, Charles M. Foster Loan disbursement practices—They should be based on engineering or inspection reports, requirements for lien waivers from subcontractors, etc. The Federal Reserve, the central bank of the United States, provides the nation with a safe, flexible, and stable monetary and financial system. Real estate investors who really want control over their investments must dig into the industry, know their market and understand the risks and â¦ Total CRE loans as defined in the CRE guidance represent 300 percent or more of the institution’s total capital, and the outstanding balance of the institution’s CRE loan portfolio has increased by 50 percent or more during the prior 36 months. If agreement with a high percentage of assigned credit ratings cannot be achieved, the rating guidelines may While loan-level sensitivity analysis is a valuable tool for all banks originating CRE loans, this type of analysis could be performed on a portfolio-wide basis. Figure 1. Transparency is generally evaluated by reading the bank’s rating policy guidelines and conducting transaction testing. 2 See FDIC’s History of the Eighties—Lessons for the Future, December 1997, at www.fdic.gov/bank/historical/history/contents.html. The Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation are jointly issuing the attached Interagency Guidance on Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices (guidance). Many institutions will want to expand the level of information captured to specifically include underwriting characteristics, such as LTVs, debt service coverage levels, speculative versus presold units, etc., to allow for more enhanced reporting and analysis. One solution does not and should not fit all banks—the risk rating and review process should be commensurate with the bank’s size and complexity. The following is the next installment in RMAâs Credit Risk Council 2017 Industry Insights: Perspectives from the Front Line.. The CRE guidance includes a general expectation that an institution with CRE concentrations will conduct portfolio stress testing consistent with the size, complexity, and risk characteristics of its CRE loan portfolio. The key is to have someone other than the original credit analyst attempt to come to the same conclusion using the tools provided by policy. The trickle-down effect of the layoffs could spread across CRE property types if local businesses’ revenues slowed and tenants were unable to make their lease payments. This interagency supervisory guidance was developed to reinforce sound risk-management practices for institutions with high and increasing concentrations of commercial real estate loans on their balance â¦ Adjusting those limits when market fundamentals change is also a prudent risk management tool. The concentration consists of 4 courses (12 credits). This is especially true if the data for the reference portfolio lack granularity. They may never have learned the lessons of the 1980s or may view them as distant history that “can’t happen again.” Industry and regulatory changes that arose from the tumult of the 1980s remain intact and are intended to prevent a re-occurrence of the ill-conceived practices of the past. Real Estate Financial Modeling, A.CRE 101 - Basic Concepts in Commercial Real Estate, Audio Series, Season 2, Real Estate Case Studies The âSecretâ to Learning Real Estate Financial Modeling Just like any skill in life, there are tips and tricks to learning that skill. A CRE concentration increases the importance of sound lending policies. Stressed loss rate testing entails determining loss rates at levels that could be expected during CRE market downturns and forecasting the ultimate effect of these losses on capital. Concentrations, as previously noted, mean higher inherent risk. Residential Real Estate and Mortgages The guidance âfocuses on those CRE loans for which the cash flow from the real estate is the primary source of repayment rather than loans to a borrower for which real estate collateral is taken as a secondary source of repayment or through abundance of caution.â 6 The target of the guidance, then, generally would include development and construction loans for which repayment is dependent upon â¦ Most institutions that specialize in CRE lending, and especially ADC lending, are accustomed to running analyses to determine loan and project exposure as part of the underwriting process. In these areas, in-house knowledge and communication with local builders, developers, real estate agents, and civic leaders may be the primary tools for gathering information on market activity and gauging market conditions. Larger banks often use rating systems that assign separate ratings for default risk and loss severity. The stressed loss rates would be developed through an analysis akin to the following: If the bank has not previously experienced significant CRE downturns, using external data may be more appropriate than using internal data. Management first needs to identify the drivers that will affect segmentation at origination and then capture those data fields on the system. After all, how beneficial can market monitoring and analysis be if concentration limits and exposures are not adjusted when that market information indicates a change in market conditions? Unfortunately, the importance of CRE portfolio management and appropriate concentration limits becomes most apparent only when the bank’s market enters a downturn. Underwriting weakens to unreasonable levels or to levels banks previously would not have approved (e.g., deposits for qualifying presold condominium units are reduced by half to entice enough preconstruction buyers to demonstrate demand for a project). Portfolio diversification across property types. Many lenders found during the CRE downturn of the 1980s and early 1990s that the “first loss is the best loss,” meaning that it would have been cheaper in the long run to have disposed of distressed CRE assets earlier rather than later. Senior Examination Specialist, For example, the institution may create a CRE risk management function that is responsible for establishing CRE concentration risk limits (approved by the institution’s board) and overseeing compliance with those limits. Following are examples of the types of stress tests commonly used in banks. The policies should provide clear and measurable underwriting standards that enable lending staff to evaluate all relevant credit and market factors. (See Figure 1.) 9 See Statistics on Depository Institutions at www2.fdic.gov/sdi/index.asp. Information can be captured on mainframe systems or other systems—including the use of simple spreadsheets—but should be retained in a form that can be readily accessed for analysis purposes. The level of losses will generally depend on the quality of loan underwriting and the breadth and depth of the CRE market downturn. The guidance does not state that the supervisory cri teria should be viewed as a hard cap on CRE concen tration levels. The risks posed by concentrations of credit risk in general, and Commercial Real Estate concentrations in particular, have long been an area of focus for bank regulators. For risk management purposes, a bank may develop stress scenarios customized to its circumstances to make assumptions about how its CRE portfolio would react. d. Risk management staff should provide its analysis of market data to senior management in a manner they can use to develop a comprehensive lending and risk mitigation strategy. As banks grow, this process is typically brought in-house. To ensure that risk management and lending are working in concert, the two functions must communicate. PDF ATTACHED: FIG Partners Industry Analysis 9-7-16 â Impact of CRE Concentration Guidance. Reserves for maintenance and improvements. Another major expense often overlooked is the opportunity cost of holding a large volume of nonearning assets. Outside of large MSAs, vendor data are often unavailable. Given that some of the assumptions interact with other assumptions, a range of outcomes may be used to determine if the loan meets the institution’s underwriting criteria and lending standards. Concentrations of credit exposures add a dimension of risk that compounds the risk inherent in individual loans. One of the most prevalent pieces of commercial real estate (CRE) guidance is, "Concentrations in CRE Lending, Sound Risk-Management Practices (PDF)," which was issued on December 6, 2006. â¢ Total commercial real estate loans should not exceed 300% of capital. They may have separate legacy systems that do not aggregate data efficiently, if at all. Thus far, the examples cited have not necessarily been related to a particular, perhaps local, event. Sound risk management strategies are â¦ The Guidance reminds institutions â¦ Developing sensitivity analysis forecasts, such as increased vacancy rates in the market by product type, slower absorption rates, reduced sales prices, higher capitalization rates, or higher interest rates. For example, the ADC loss history on the reference portfolio is for a geographically diverse group of loans, but the current portfolio is largely concentrated in one location. The proposed Guidance sets forth thresholds for assessing whether an institution has a CRE concentration and should employ heightened risk management practices. Banks may tend to believe that the losses during that time were much more severe than they would ever again encounter. Commâ¦ Students use lease and market information to develop pro forma cash flow projections for a given property and evaluate the risk and return associated with investment. Identify the similarities or differences between the bank’s current portfolio and the historical reference portfolio, and adjust the loss rates appropriately. Specifically, the agencies reiterated the need for strong risk management practices to comply with Supervision and Regulation (SR) letter 07-1, âInteragency Guidance on Concentrations in Commercial Real Estate.â 3 This guidance does not set limits on the size of CRE concentrations but instead highlights strong risk management practices that are necessary for a bank with a high CRE credit â¦ In markets where demand is very strong, management may instruct lending staff to pursue additional opportunities and adjust pricing and other terms to attract additional business. Each year a percentage of credits (obligors in cases of banks with two-dimensional rating systems) improves, remains the same, or declines. The guidance reminds institutions that strong risk management practices and appropriate levels of capital are essential elements of a sound commercial real estate (CRE) lending program, particularly when an institution has a concentration in CRE loans. Monitoring speculative single-family housing development can be especially challenging. Like an aggregate transactional sensitivity analysis, stressed loss rate testing can provide useful input to a bank’s capital, earnings, and liquidity planning. In many larger metropolitan statistical areas (MSAs), institutions can obtain market data for CRE other than single-family residential properties from national providers such as Property & Portfolio Research, Real Estate Investment Services, and Torto-Wheaton Research. Typical loan production and performance reports by type, region, officer, etc. In banks with more limited CRE lending experience, the data may be at higher levels, such as all types of ADC loans or even all CRE loans. The regulatory agencies have gone on record stating that 'concentrations are bank killers' - and that most of the banks that failed during the great recession were 'CRE Concentrated'. Lenders often severely underestimate the length of time necessary for the sale of foreclosed assets in a distressed market. Examination Specialist, Much has changed in CRE lending since the last downturn. Banks and thrifts must now follow federal appraisal regulations, and regulators require banks to establish an effective real estate appraisal and evaluation program to ensure independence and improve quality.3 4. 3. The CRE guidance provides a good framework to assist banks in addressing the concentration risk and also helps establish the federal banking agencies’ expectations during subsequent risk management examinations. Steven G. Johnson The CRE guidance recognizes that diversification can be achieved within CRE portfolios and differentiates risk in different types of CRE loans. The Interagency CRE Statement reminds financial institutions to re-examine existing regulations and guidance related to Commercial Real Estate (CRE) lending. 2 Capital generally is defined as a bankâs long-term source of funding, contributed largely by the bankâs equity stockholders and its own returns in the form of retained earnings. Account officers, loan review personnel, and regulatory examination staff should be able to review rating guidelines and reach the same conclusion on the rating grade assigned to individual credits. In December 2015 the regulators isâ¦ Speculators drive prices to unwarranted levels (e.g., home prices increase by 30 percent year-over-year for an extended period, while inventory is expected to grow to unprecedented levels). And interest rates and LTV ratios inferred from capitalization rates, are analyzed. Estate ( CRE ) loans comprise a major portion of many banks to... 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