Comments on Avoiding Losses in the Current Credit Cycle by Comptroller of the Currency John C. Dugan and FDIC Chairman Sheila Bair
Two federal banking regulators have recently urged lenders to take quick action to avoid a surge in losses tied to the weakening credit cycle, according to an article by Damian Paletta, writing in The Wall Street Journal. The chairman of the Federal Deposit Insurance Corporation has also forecast an increase in U.S. bank failures.
Comptroller of the Currency John C.Dugan told a meeting of the Florida Bankers Association meeting in Miami that the “OCC is focusing increased attention on problems arising from high community bank concentrations in commercial real estate (CRE) at a time of significant market disruptions and declining house and condominium sales and values.”
Dugan said, “The combination of these conditions is putting considerable stress on one particular category of commercial real estate lending: residential construction and development - and other categories of CRE loans will feel similar stress if general economic activity slows materially.”
In the area of construction and development (C&D) loans, nonperforming loans in community national banks amounted to 1.96% of the total at the end of the third quarter of 2007, double the rate of the year before.
“Although starting from an admittedly very low baseline, an increase like this - over 100 percent in a single year - is clearly a trend that we need to monitor closely,” Dugan said.
According to the FDIC, commercial banks and thrifts wrote off $524 million in construction and development loans in the third quarter of 2007, almost nine times the amount of the third quarter of 2006. It was also the highest quarterly charge off since 1993, and “the numbers are expected to worsen,” according to Paletta’s article.
Dugan told the Florida bankers that the OCC will take a number of steps to deal with the problem. “There will be more frequent interaction between supervisors and banks with concentrations in CRE loans that are declining in quality. There will be more criticized assets; increases to loan loss reserves; and more problem banks.”
Dugan emphasized that the OCC’s objective has been to “get at problems early when they’re smaller and more easily managed, and to keep communication lines open as we do.”
The OCC expects banks with CRE concentrations to make realistic assessments of their portfolio based on current market conditions, and to make necessary adjustments as market conditions change.
In recent years, the Comptroller said, banks have become too complacent regarding the potential for significant stresses in these markets, and CRE concentrations have risen significantly in many banks. The ratio of CRE to capital has nearly doubled in the past six years, he said.
“Over a third of the nation’s community banks have commercial real estate concentrations exceeding 300 percent of their capital, and almost 30 percent have construction and development loans exceeding 100 percent of capital,” Dugan said.
The OCC has been closely monitoring commercial real estate lending for the past four years, and assigned highly experienced examiners to look horizontally across banks with higher CRE concentrations as a means of identifying the best practices and evaluating asset quality in this lending area.
While the OCC has found signs of improvement in some risk management practices, Dugan said, examiners have also continued to observe a number of risk management deficiencies that are a cause for concern. In particular, banks with significant CRE concentrations have not updated appraisals regularly, which makes it hard to assess credit quality.
Dugan also said, “... we expect bank management to be realistic about identifying problem assets themselves, so that our examiners are not forced into the position of having to do this for them. The idea is to recognize problems early and manage through them, with good and continual communication between examiners and bankers, before the problems fester and get worse.”
Separately, FDIC Chairman Sheila Bair recently told the Senate Banking Committee that lenders must act to slow foreclosures on residential borrowers with interest-only and other nontraditional mortgages. Bair said that loan servicers should quickly formulate a plan to deal with the 1.7 million outstanding nontraditional mortgages, many of which are expected to reset into new interest rates next year. According to Paletta’s article, these mortgages aren’t included in the industry-led plan to modify the terms of subprime adjustable-rate loans, which frequently reset into higher monthly payments after the first two or three years.
Bair said, “Waiting to confront the next reset problems will once again create the risk of falling behind a fast-moving trend.”
Additional comments on the subject of loan modification can be found in the article - “The Case for Loan Modification: With a foreword by Sheila C, Bair, Chairman, Federal Deposit Insurance Corporation.” The article is in the current issue of FDIC Quarterly, released January 10, 2008. Visit www.fdic.gov/bank/analytical/quarterly/index.html .
