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Comptroller: CRE Loans Still Present Risk to Banks

In a ""speech"":http://www.occ.gov/news-issuances/speeches/2012/pub-speech-2012-89.pdf before the ""Commercial Real Estate (CRE) Finance Council"":http://www.crefc.org/ on Wednesday, Comptroller of the Currency ""Thomas Curry"":http://occ.gov/ warned banks and thrifts not to keep their eggs in one basket with CRE loans.

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Following up on his ""remarks in May"":http://www.occ.treas.gov/news-issuances/speeches/2012/pub-speech-2012-77.pdf about operational risk in banking institutions, Curry stressed that CRE credit is still a significant core risk area for banks and thrifts.

Curry pointed out that national banks and federally chartered thrifts hold over $700 billion in total CRE loans, an amount that comprises 14 percent of their aggregate loan portfolios. For smaller community banks and thrifts, CRE accounts for 37 percent of the total loan portfolio. While CRE may be a ""bread-and-butter product"" for community banks in less diverse markets, concentrations can lead to significant losses, Curry said.

""The fortunes of a community institution in the farm belt might depend almost entirely on the price of corn, for example, no matter what kinds of loans it makes, and that's just a reflection of where it does business,"" he said. ""Thus, concentrations have to be evaluated in context, and a vital element of that context is how institutions manage these concentrations and the capital they retain as a buffer against losses.""

The greatest past indicators for the likely failure of both national and community banks were concentrations in construction and development (C&D) loans, which were the worst performers in the financial crisis. In March 2007, nearly 2,000 banks held C&D loans that exceed their capital. By September 2011, 13 percent of those banks had failed.

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""If you expand the view to look at excessive real estate lending, look through the lens of the real estate guidance the regulatory agencies jointly issued in 2006,"" said Curry. ""That guidance set thresholds of 100 percent of capital for construction lending and 300 percent of capital for total CRE. Where banks were in excess of those concentration thresholds, 23 percent failed. Where banks were within those thresholds only about one-half of one percent failed. That is a stark difference: one-half of one percent versus 23 percent.""

As far as large banks went, Curry had good news and bad. While their CRE portfolios performed worse than those of smaller institutions, the diversity in product lines and market areas made CRE a much lower percentage of their total loans or capital.

The comptroller's outlook for CRE was similarly mixed. The OCC has seen ""real and tangible"" signs of improvement in CRE markets and loan performance. Demand for office buildings is growing moderately, reflecting the slow growth in employment. Increased consumption has also led to an increase in demand for retail and warehouse space, but the growth in Internet retail is hurting some segments of the market.

Commercial mortgage loans have performed better than C&D loans, but they are currently benefiting from very low interest rates, Curry said. If these rates rise, loans will start to suffer. Property valuations are projected to recover very slowly, which will make it difficult to refinance loans if net operating income does not improve.

While CRE markets seem to be improving, Curry encouraged banks and thrifts to keep appropriate reserves and capital in the events of losses. He also warned them not to take an upturn in CRE as a green light to aggressively expand their portfolios.

""Despite the remaining obstacles, we know the environment will eventually improve, and it's important that we learn from the mistakes of the financial crisis and the recent recession before it does. Booms don't last, and bubbles inevitably burst,"" he said. ""When the economy is growing, demand for all kinds of commercial real estate, from office buildings to warehouses, increases quickly, and rental income begins to grow rapidly. At that point, it will be tempting for lenders to grow their CRE portfolios. Again, this is an essential product for community banks, and CRE growth can lead to very healthy-looking profits in the short run.""

""But the short run is, well, short.""

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