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Interagency CRE Guidance Update

Interagency CRE Guidance Update

February 4, 2016

Authored by: Jerry Blanchard

In the ancient world kings and emperors regularly sought advice from the Oracle at Delphi when making important decisions. The Oracle would respond to questions, sometimes in poetry, other times in prose, in a manner that sometimes required some interpreting. For example, King Croesus of Lydia asked about the wisdom of his taking on the Persian empire. The Oracle replied that “If you attack you will destroy a great kingdom.” Proving that one should always ask for details, Croesus lost the battle and the Persians, under Cyrus the Great, conquered his kingdom.

Some say that the closest thing we have to the Oracle at Delphi today is the triumvirate of the federal banking regulators, the Federal Reserve, the FDIC and the OCC. The “Oracle” prognosticates and bankers guide their business activities accordingly. Well, perhaps. There was that prediction back in 2006 called “Concentrations in Commercial Real Estate Lending, Sound Risk Management Policies” when the regulators pointed out that CRE concentration levels at community banks had increased from 156% of total risk based capital in 1993 to 318% in the third quarter of 2006. They noted that some banks had begun to relax underwriting standards as a result of strong completion for such loans. Overall, the guidance was a “soft” sort of warning that bankers needed to make sure they understood how to manage the risk they were undertaking. A year or so later the economy was collapsing and banks beginning to fail.

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The New Deposit Insurance Proposal

A Quick Overview and a Note on Construction Lending

On June 16, 2015, the FDIC issued a notice of proposed rulemaking to revise its calculations for deposit insurance assessments for banks with under $10 billion in assets (excluding de novo banks and foreign branches).  The rules would go into effect the quarter after they are finalized but by their terms would not be applicable until after the designated reserve ratio of the Deposit Insurance Fund reaches 1.15%.

At almost 150 pages, there are many facets to the proposed rule that must be carefully analyzed.  At the outset, we give credit to the FDIC for attempting to fine tune deposit insurance assessments beyond the blunt instrument that they have always been.  We have long held the position that the FDIC should adopt more careful underwriting procedures, similar to private insurers, in order to better serve its function in the industry.

Under the proposal, a number of factors are used in a model to calculate a bank’s deposit insurance assessment rates:  CAMELS ratings, Leverage Ratio, net income, non-performing loan ratios, OREO Ratios, core deposit ratios, one year asset growth (excluding growth through M&A, thankfully), and a loan mix index.  All of these factors are intended to predict a bank’s risk of future failure, and all are worthy of discussion.
Putting aside our overall hesitancy to fully support faceless numerical models to draw important conclusions (anyone remember subprime lending?), we were initially drawn to the proposed implementation of the “loan mix index” as a factor for calculating deposit insurance assessment rates.  As we have previously discussed, construction lenders have recently been disadvantaged by the new HVCRE rules under the Basel III capital standards.  Once again, construction loans are the focus of regulatory scorn.

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HVCRE Update – New Interagency FAQ

As previously mentioned, the federal banking regulators have been working on a FAQ on the topic. The interagency FAQ was published on April 6, 2015. While there were no surprises in what was published there were a number of takeaways from the FAQ that lenders need to keep in mind and I have added those to my previous list of FAQ. Under Basel III, as a general rule, a lender applies a 100% risk weighting to all corporate exposures, including bonds and loans. There are various exceptions to that rule, one of which involves what is referred to as “High Volatility Commercial Real Estate” (“HVCRE”) loans. Simply put, acquisition, development and construction loans are viewed as a more risky subset of commercial real estate loans and are assigned a risk weighting of 150%.

HVCRE is defined to include credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances:

  1. One- to four-family residential properties;
  2. Real property that would qualify as a community development investment;
  3. agricultural land; or
  4. Commercial real estate projects in which:
    • The loan-to-value ratio is less than or equal to the applicable regulator’s maximum amount (i.e., 80% for many commercial bank transactions);
    • The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised ‘‘as completed’’ value; and
    • The borrower contributed the amount of capital before the lender advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.
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High Volatility CRE Rules and Contributed Capital

The new risk weighting rules applicable to commercial real estate are now fully in effect for all banks. The rule flows out of the new capital rulemaking carried out by the federal banking agencies as a result of Basel III. As a general rule, the agencies agreed to apply a 100% risk weighting to all corporate exposures, including bonds and loans. There were various exceptions to that rule, one of which involves what is referred to as “High Volatility Commercial Real Estate” (“HVCRE”) loans. Simply put, acquisition, development and construction loans are viewed as a more risky subset of commercial real estate loans and are assigned a risk weighting of 150%.

HVCRE is defined to include credit facility that, prior to conversion to permanent financing, finances or has financed the acquisition, development, or construction (ADC) of real property, unless the facility finances:

  1. One- to four-family residential properties;
  2. Real property that would qualify as a community development investment;
  3. agricultural land; or
  4. Commercial real estate projects in which:
    • The loan-to-value ratio is less than or equal to the applicable regulator’s maximum amount (i.e., 80% for many commercial bank transactions);
    • The borrower has contributed capital to the project in the form of cash or unencumbered readily marketable assets (or has paid development expenses out-of-pocket) of at least 15 percent of the real estate’s appraised ‘‘as completed’’ value; and
    • The borrower contributed the amount of capital before the lender advances funds under the credit facility, and the capital contributed by the borrower, or internally generated by the project, is contractually required to remain in the project throughout the life of the project.

Developers and lenders have been looking at the guidance and applying it to real world situations.  Here are some of the issues:

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GAO Opines that Enhanced CRE Guidance Needed

On May 19, 2011, the Government Accountability Office published its report on the federal banking regulators’ 2006 interagency guidance on commercial real estate concentrations.  The GAO report concludes that federal banking regulators should enhance or supplement the 2006 CRE concentration guidance and take steps to better ensure that such guidance is consistently applied.

The GAO report indicates that the OCC and Federal Reserve agree with its recommendations, while the FDIC insists that it has already implemented strategies to supplement the 2006 guidance.  A closer review of the OCC and Federal Reserve positions, however, would seem to suggest that the OCC and Federal Reserve agree the 2006 guidance should be enhanced, but don’t seem to have any issue with the inconsistent application of the current guidance, and may even suggest that over-reaching application of the 2006 guidance is necessary since it, in their opinions, doesn’t go far enough.  Both the OCC and Federal Reserve indicated that they were reviewing whether higher capital requirements should be set for banks that have higher CRE concentrations.

The GAO report is a good read for any banker looking for the current collective position of the federal regulators with regard to commercial real estate concentrations (and especially with respect to how the 2006 guidance should be interpreted), but ultimately only highlights the discretion vested in each agency (as well as each examiner).

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Pictorial Perspective of Atlanta Real Estate Market

SunTrust Robinson Humphrey has created a depressing slideshow of Atlanta’s residential and CRE properties in development (or in lack of development).  From the SunTrust Robinson Humphrey report:

While the city’s residential real estate lot inventory woes are well known to the investment community, we believe the extent of inventory in CRE property types like office and retail centers is not fully appreciated.  We took some photos of residential and CRE properties around Atlanta, which is admittedly a small sample.  Based on our observations and the statistics, we believe there are significant and growing vacancies around the city, particularly in the outer suburban areas like Alpharetta and Cumming (North of Atlanta).  We witnessed particularly high vacancy rates in numerous outer suburb strip and neighborhood retail centers.  Atlanta’s retail vacancy rate was 9.9% at the end of 1Q09, compared to the national average rate of 7.2% and Atlanta’s 4Q08 level of 9.0%.  This is the sixth highest level of retail vacancy among the 63 major U.S. retail markets.  Moreover, Atlanta led all major U.S. markets in aggregate retail space delivered during 1Q09, with 1.7 million square feet hitting the market.

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