[Federal Register Volume 71, Number 240 (Thursday, December 14, 2006)]
[Notices]
[Pages 75294-75301]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E6-21148]


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DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

[No. 2006-50]


Concentrations in Commercial Real Estate Lending, Sound Risk 
Management Practices

AGENCY: The Office of Thrift Supervision, Treasury (OTS).

[[Page 75295]]


ACTION: Final guidance.

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SUMMARY: OTS is issuing final guidance: Concentrations in Commercial 
Real Estate (CRE) Lending, Sound Risk Management Practices (guidance). 
OTS developed this Guidance to clarify that institutions actively 
engaged in CRE lending should assess their concentration risk and 
implement appropriate risk management policies and procedures to 
identify, monitor, manage, and control their concentration risks.

EFFECTIVE DATE: The final Guidance is effective December 14, 2006.

FOR FURTHER INFORMATION CONTACT: OTS: William Magrini, Senior Project 
Manger, (202) 906-5744, or Fred Phillips-Patrick, Director, Credit 
Policy, (202) 906-7295.

SUPPLEMENTARY INFORMATION:

I. Background

    OTS has observed that some institutions have high and increasing 
concentrations of CRE loans on their balance sheets and is concerned 
that these concentrations may cause some savings associations to be 
more vulnerable to cyclical CRE markets. In the past, concentrations in 
CRE lending coupled with weak loan underwriting and depressed CRE 
markets contributed to significant credit losses in the banking system. 
While underwriting standards are generally stronger than during 
previous CRE cycles, OTS has observed an increasing trend in the number 
of institutions with concentrations in CRE loans. These concentrations 
could cause institutions to be more vulnerable to cyclical CRE markets. 
Moreover, OTS believes an institution's risk management practices 
should be commensurate with its CRE concentrations.
    In response to those concerns, OTS, together with the Office of the 
Comptroller of the Currency (OCC), The Federal Reserve Board (FRB), and 
the Federal Deposit Insurance Corporation (FDIC) (collectively 
``Agencies'') published for notice and comment, proposed interagency 
guidance, ``Concentrations in Commercial Real Estate Lending, Sound 
Risk Management Practices,'' 71 FR 2302 (January 13, 2006).
    The Agencies sought public comment on all aspects of the proposed 
guidance. In particular, the Agencies requested comment on the scope of 
the definition of CRE and on the appropriateness of using thresholds 
for determining elevated concentration risk. For the purposes of the 
proposed guidance, the Agencies focused on concentrations in those 
types of CRE loans that are particularly vulnerable to cyclical CRE 
markets. These include CRE exposures where the source of repayment 
primarily depends upon rental income or the sale, refinancing, or 
permanent financing of the property. Loans to REITs and unsecured loans 
to developers that closely correlate to the inherent risk in CRE 
markets would also have been considered CRE loans for purposes of the 
proposed guidance.
    The proposed guidance set forth thresholds for assessing an 
institution's CRE concentrations that would require heightened risk 
management practices. The proposed Guidance also reminded institutions 
with CRE concentrations that they should hold capital higher than 
regulatory minimums and commensurate with the level of risk in their 
CRE lending portfolios. In assessing the adequacy of an institution's 
capital, the proposed Guidance stated that the Agencies would take into 
account the level of inherent risk in its CRE portfolio and the quality 
of its risk management practices.
    Collectively, the Agencies received approximately 4,400 comment 
letters from financial institutions, their trade associations, state 
banking regulators, and other members of the public. OTS received 
approximately 1,300 comment letters. The vast majority of commenters 
were opposed to the Guidance as proposed.

II. Overview of Public Comments

    The vast majority of commenters expressed strong opposition to the 
proposed CRE concentration Guidance and stated that the agencies should 
address the issue of concentration risk on a case-by-case basis as part 
of the examination process. Commenters stated that existing regulations 
and Guidance are sufficient to address the agencies' concerns regarding 
CRE concentration risk and the adequacy of an institution's risk 
management practices and capital. Many commenters asked that the 
Agencies either substantially revise the proposed Guidance or withdraw 
it.
    Specifically, commenters expressed concern about the following 
areas of the proposal:
     That the definition of CRE inappropriately includes 
multifamily and one-to four-family construction loans;
     That the thresholds of 100 percent of the institution's 
capital for construction loans and 300 percent of capital for aggregate 
CRE loans would be viewed as limits; and
     That all institutions would be required to adopt intense 
risk management systems, regardless of their level of CRE lending.
    Several commenters asserted that today's lending environment is 
significantly different than the late 1980s and early 1990s when banks 
and thrifts suffered losses from their real estate lending activities 
due to weak underwriting standards and risk management practices. 
Commenters stated that the underwriting practices of banks and thrifts 
are now much stronger, and capital levels are higher.
    Comments from community banks raised serious opposition to the 
proposed Guidance and suggested that the proposed Guidance would 
discourage community banks from engaging in CRE. These commenters also 
noted that if community banks were forced to reduce their CRE lending, 
it could create a downturn in the economy and lead to systemic problems 
greater than any potential risks in CRE loans.
    While smaller institutions acknowledge that many community banks 
and small thrifts have concentrations in CRE loans, they contend that 
there are few other lending opportunities in which community banks can 
successfully compete against larger financial institutions. Community 
banks commented that secured real estate lending has been their ``bread 
and butter'' business and, if required to reduce their CRE lending 
activity, they would have to look to other types of lending, which are 
historically more risky. Moreover, these commenters noted that 
community-based institutions have in depth knowledge of their local 
communities and markets, which affords them a significant advantage 
when competing for CRE loan business. Community banks also noted that 
their lending opportunities have diminished due to competition from 
other types of financial institutions, such as finance companies, Farm 
Credit banks, and credit unions.
    The following summarizes the final Guidance and how OTS addressed 
specific aspects of commenter concerns about the proposed Guidance.

III. Final Guidance

    Significant comments on the specific provisions of the proposed 
guidance, OTS's responses, and changes to the proposed guidance are 
discussed as follows.

Scope of the Guidance

    The proposed guidance set forth two benchmarks for identifying 
institutions with CRE loan concentrations that may

[[Page 75296]]

warrant greater supervisory scrutiny. Specifically, if loans for 
construction, land development, and other land exceed 100 percent of 
total capital, the institution would be considered to have a CRE 
concentration. Also, if loans secured by multi-family and non-farm 
nonresidential property, where the primary source of repayment is 
derived from rental income or the proceeds of the sale, refinancing, or 
permanent financing, combined with construction, development, and land 
loans, exceed 300 percent of total capital, the institution would be 
considered to have a CRE concentration. Institutions with 
concentrations would be expected to employ heightened risk management 
practices.

General Comments on the Benchmarks

    Most commenters disagreed with the establishment of these 
benchmarks. Many of the commenters questioned the basis for the 
benchmarks and asserted that a rigid, arbitrary concentration test 
should be eliminated. By establishing CRE concentration benchmarks, 
many commenters noted that examiners would perceive such benchmarks as 
de facto limits on an institution's CRE lending activity.
    Commenters noted that the proposed benchmarks did not recognize the 
different segments in an institution's CRE portfolio and treated all 
CRE loans as having equal risk. A commenter noted that a concentration 
test cannot reflect the distinct risk profile within an institution's 
loan portfolio and that the risk profile is a function of many 
intangibles, including the institution's risk tolerance, portfolio 
diversification, the prevalence of guarantees and secondary collateral, 
and the condition of the regional economy.
    Commenters noted that the benchmarks would not accurately identify 
banks and thrifts that might be adversely affected by their CRE 
portfolio in an economic downturn. One commenter noted that proposed 
benchmarks mixed together real estate loans with vastly different 
potential for loss and, therefore, would fail to accomplish the 
Agencies' goal of identifying institutions that might be affected by a 
downturn.
    Several commenters noted that the benchmarks did not consider the 
loan-to-value (LTV) ratio of a CRE loan as an indication of risk and 
that interagency real estate lending standards exist that limit high 
LTV loans.\1\ A commenter noted that there is a vast difference in risk 
between a loan conservatively underwritten where the borrower has a 
large investment at stake and a loan offering overly generous terms 
where the borrower has little to lose if the project should fail. One 
commenter stated that a bank or thrift with no high LTV CRE loans but 
with a concentration in CRE loans would be presumed to have a higher 
risk CRE portfolio than a bank or thrift with a lower concentration but 
with a significant number of high LTV CRE loans.
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    \1\ Interagency Guidelines for Real Estate Lending Policies 
(Appendix to OTS 12 CFR 560.100-101) state that the aggregate amount 
of commercial, agricultural, multifamily, or other non-one- to four-
family loans should not exceed 30 percent of an institution's total 
capital if they exceed supervisory loan-to-value limits.
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    Commenters stated that, if the agencies were to adopt the guidance 
with benchmarks, the concentration test should consider the 
institution's asset size, geographic dispersion of its loans, CRE 
product concentrations, its underwriting standards, and lending 
experience. Further, a commenter stated that the guidance should be 
focused on those types of speculative CRE loans that are most 
susceptible to economic downturn.
    The 100 percent Construction Benchmark: Those commenters expressing 
an opinion on the 100 percent construction benchmark found the 
benchmark too low, and several suggested that it should be at least 200 
percent. Several commenters recommended that presold one-to four-family 
residential construction loans, commercial construction loans for 
owner-occupied businesses, and commercial construction loans with firm 
takeouts should be specifically excluded as such loans are 
significantly less risky. One commenter noted that construction loans 
on presold versus speculative residential properties should be treated 
differently as presold properties have construction risk but not real 
estate market risk, which was the concern of the Agencies.
    The 300 percent CRE Benchmark: Commenters asserted that 300 percent 
aggregate concentration benchmark was too low and that a benchmark in 
the range of 400 to 600 percent of capital would be more appropriate. 
Commenters also noted that the benchmark mixed together all types of 
CRE loans that have vastly different potential for loss, and that an 
assessment of concentration risk based on the Agencies' benchmark did 
not consider the risk characteristics of the subcategories of CRE 
loans. One commenter noted that the proposal did not differentiate the 
risks posed by a loan on a speculative office building versus a fully 
occupied apartment building.
    To address commenter concerns, OTS revised the focus of this final 
guidance. Instead of using numerical thresholds to identify 
institutions with CRE concentrations, the Guidance now states that all 
institutions actively engaged in CRE lending should assess their own 
CRE concentration risk. Accordingly, institutions should implement 
sound risk management procedures commensurate with the size and risks 
of their CRE portfolios and also establish internal concentration 
thresholds for internal reporting and monitoring.
    For the reasons described herein, there are no numerical thresholds 
or screens in this Guidance. OTS monitors compliance with statutory 
lending limits, CRE, and other lending activity in off-site analyses of 
Thrift Financial Reports as well as in the scope of OTS's risk-focused 
examinations. Institutions that have recently experienced rapid growth 
in CRE lending or have a notable exposure to a specific type of CRE may 
be identified for closer review. Examiners will determine whether 
savings associations actively engaged in CRE lending have performed an 
assessment of their CRE credit and concentration risks and have 
implemented appropriate risk management systems and controls to 
mitigate such risks.

The Definition of CRE Loans

    For the purposes of the proposed guidance, the Agencies focused on 
CRE loans that may expose an institution to unanticipated earnings and 
capital volatility due to adverse changes in the general CRE market. 
This includes CRE exposures where the primary source of repayment is 
derived from rental income associated with the property or the proceeds 
of the sale, refinancing, or permanent financing of the property. Loans 
to REITs and unsecured loans to developers that closely correlate to 
the inherent risk in the CRE market would also be considered CRE loans 
for purposes of the proposed guidance. However, loans secured by owner-
occupied properties where less than 50 percent of the source of 
repayment comes from third party, non-affiliated, rental income were 
excluded from the CRE definition as the risk profile of these loans is 
less influenced by the condition of the general CRE market.
    Commenters asked for clarification on the scope of the definition 
of CRE loans. Several commenters noted that the proposed definition 
combined several different types of CRE loans and ignored the very 
different risk profiles of these loans. Many of the commenters found

[[Page 75297]]

the proposed definition too broad and grouped together loans on 
stabilized properties with those under development into the same risk 
category.
    Commenters raised questions as to whether the agencies intended to 
include in the CRE loan definition loans secured by motels, hotels, 
mini-storage warehouse facilities, and apartment complexes where the 
primary source of repayment is rental or lease income. One commenter 
asked for clarification as to whether the CRE loan definition included 
loans on small-to medium-sized business properties where the borrower 
leased the property to a business entity in which the borrower held an 
ownership interest. The commenter noted that a narrow interpretation of 
the definition of owner-occupied would include these types of loans in 
the scope of the CRE definition even though such loans exhibit the same 
risk profile as an owner-occupied property.
    A number of commenters contended that loans on certain types of CRE 
properties should not be considered CRE loans for purposes of the 
proposed guidance, including:
    Presold One- to Four-Family Residential Construction Loans: 
Commenters recommended that the proposed guidance should not cover 
residential construction loans where homes have been sold to qualified 
borrowers prior to the start of the construction. These commenters 
argued that presold one- to four-family residential construction loans 
carry far less risk than speculative home construction loans as the 
homeowners are known and have had their credit evaluated as being 
satisfactory prior to the commencement of construction. Commenters 
noted that their rationale for excluding presold one- to four-family 
residential construction is consistent with the proposal's exclusion of 
CRE loans on owner-occupied properties. As another indicator of risk, 
commenters noted that presold one- to four-family residential 
construction loans were subject to only a 50 percent risk weight under 
the current risk-based capital rules.
    Multifamily Residential Loans: Commenters recommended that 
multifamily construction loans with firm takeouts or loans on completed 
multifamily properties, including assisted living complexes, with 
established rent rolls be excluded from the proposed CRE definition. In 
making this recommendation, commenters contend that multifamily 
residential loans have much less risk than CRE loans that have no firm 
takeout or established cash flow history. One commenter noted that in 
an economic downturn, multifamily loan performance tends to move 
counter-cyclically to other types of real estate, such as single-family 
mortgages, because potential homebuyers are more likely to rent than to 
purchase a home. Another commenter noted that over the last 20 years, 
institutions have incurred minimal losses on multifamily loans and 
attributed this performance to strong underwriting and stability in 
rental properties.
    Treatment of REITs: The commenter, representing REITS, sought 
clarification as to whether the proposed guidance would apply to both 
secured and unsecured loans to REITs. This commenter asserted that 
unsecured loans to REITs should not be considered a CRE loan for 
purposes of the proposed guidance as the risk of an unsecured loan to a 
REIT is mitigated by diversified sources of repayment because the 
rental income from one property or even a collection of properties is 
not the only source of revenue available to a REIT to repay the 
unsecured loan. Further, the commenter argued that, in general, a loan 
to a large, well-diversified equity REIT (whether secured or unsecured) 
does not carry the same credit risk as a secured loan on a single asset 
and that the proposed guidance should allow a lending institution to 
consider the REIT's property diversification and overall financial 
strength. Therefore, the commenter sought clarification that a bank or 
thrift need not treat a REIT as merely a collection of single 
properties, but rather a geographically and product diverse operating 
company with a diversified revenue stream.
    Reliance on the Call and Thrift Financial Reports: Commenters noted 
that the identification of CRE loans in the current Call Reports and 
Thrift Financial Reports did not correspond to the scope of the CRE 
definition in the proposed guidance and did not constitute an accurate 
measurement of the volume of an institution's CRE loans that would be 
vulnerable to cyclical CRE markets. Commenters did acknowledge that the 
revisions to the Call Reports and Thrift Financial Reports, effective 
March 2007, would address the separation of CRE loans for owner-
occupied properties.
    While OTS agrees that risks vary among the various CRE property 
types, geographical area, and lending standards, it is important to 
note that the definition only serves as a high level indicator of 
possible concentration risk. Moreover, because OTS removed the proposed 
thresholds and numerical screens that would have mandated institutions 
to adopt more stringent risk management practices, maintaining the 
proposed definition will not trigger additional or unwarranted risk 
management if concentration risk is minimal.

Appropriateness of the Risk Management Practices

    The proposed guidance reinforces sound risk management practices 
for a bank or thrift with a concentration in CRE lending. The proposal 
reminds an institution's board of directors and management of their 
ultimate responsibility for the level of risk undertaken by their 
institution and reinforces and builds upon existing real estate lending 
standards, regulations, and guidelines. The proposed guidance describes 
key risk management elements for an institution's CRE lending activity 
with a particular emphasis on those components of the risk management 
process that are more generally applicable to an institution with a CRE 
concentration. The proposed risk management expectations are discussed 
along the following frameworks: board and management oversight, 
strategic planning, underwriting, risk assessment, monitoring of CRE 
loans, portfolio risk management, management information systems, 
market analysis, and stress testing. In the proposal, the agencies 
acknowledged that the sophistication of risk management practices 
should be consistent with the size and complexity of the institution's 
CRE portfolio.
    Commenters noted that the proposed risk management principles have 
been in effect for some time and are generally acknowledged as prudent 
industry standards that should be used by an institution engaged in CRE 
lending. While there was general agreement with the appropriateness of 
the risk management principles, commenters noted that the agencies 
should consider an institution's size and complexity of its lending 
activity in assessing the adequacy of its risk management practices. 
The majority of commenters noted that the recommended practices, 
particularly with regard to the management information systems and 
portfolio stress testing, would place a great deal of additional burden 
on smaller institutions at a time when they are already faced with Bank 
Secrecy Act and information security compliance requirements.
    To address commenter concern, OTS clarified that after performing 
their own self-assessment of CRE concentration risk, institutions would 
be expected to implement risk management policies and procedures 
appropriate for the size,

[[Page 75298]]

complexity, and risk of their CRE exposure.

Capital Adequacy and ALLL

    The proposed guidance noted that institutions should hold capital 
commensurate with the level and nature of the risks to which they are 
exposed and that institutions with high CRE concentrations would be 
expected to operate well above regulatory capital minimums. Further, as 
part of internal capital analysis, the proposed guidance reminded 
institutions that the results of any stress testing and quantitative 
and qualitative analysis should be used to assess the adequacy of 
capital. The proposed guidance also reminded institutions that they 
should consider CRE concentrations in their assessment of the adequacy 
of allowance for loan and lease losses (ALLL), consistent with existing 
interagency guidance.
    Overall, commenters found the proposed capital discussion too 
restrictive and that it did not take into account the institution's 
lending and risk management practices. Moreover, commenters asserted 
that many institutions already hold capital at levels above minimum 
standards and should not be required to raise additional capital simply 
because their CRE concentrations exceed a threshold. There was also 
concern expressed that the proposal would give examiners the ability to 
arbitrarily assess additional capital requirements solely due to a high 
concentration. Comments from smaller institutions noted that the 
proposal would unfairly burden them as they do not have the opportunity 
to raise capital or diversify their portfolio to the extent to that 
large regional banks or thrifts are able.
    Commenters called into question the consistency of the proposed 
guidance with current risk-based capital requirements that assess 
capital adequacy based on the risk inherent in an asset class and tie 
capital requirements to loan-to-value ratios. Several commenters 
suggested that any discussion on capital adequacy issues arising from 
CRE lending should be best addressed within the context of the 
Agencies' risk-based capital framework, which several commenters noted 
is currently being revised by the agencies.
    Commenters noted that allowance for loan and lease losses is 
another means of protection for an institution and, therefore, should 
be considered in determining the effects of potential concentrations on 
the adequacy of capital. Further, commenters viewed the proposed 
guidance as imposing arbitrary tests to determine reserves that, based 
on the amount of CRE loans in an institution's CRE portfolio, may not 
be a true indicator of risk.
    As provided in the proposed guidance, the final Guidance states 
that such institutions should also have in place capital levels 
appropriate to the risk associated with CRE concentrations. To address 
commenter concerns, OTS revised the capital section of the guidance to 
make it clear that most institutions with CRE meet current capital 
expectations so additional capital will not be expected. In assessing 
the adequacy of an institution's capital, the Guidance states that OTS 
will take into account the level of inherent risk in its CRE portfolio 
and the quality of its risk management practices.
    The final Guidance does not have a separate section concerning 
ALLL. The language in the Guidance, however, serves as a reminder that 
ALLL levels for CRE loans should reflect the collectability of loans in 
the CRE portfolio. This is a requirement under generally accepted 
accounting principles and interagency ALLL policy.
    The Agencies worked together to develop the final guidance and made 
a number of changes to the proposed guidance to respond to commenters' 
concerns and provide additional clarity to address commenter concerns. 
The OCC, FRB, and FDIC are concurrently issuing separate guidance for 
banks. OTS is issuing separate guidance for savings associations that 
is similar to the guidance issued for banks. The primary focus of this 
guidance is to remind savings associations of the importance of 
performing an assessment of their CRE concentration risk and the need 
to implement appropriate risk management procedures to monitor and 
control such risks.
    Unlike statutory investment requirements for other federal 
financial institutions, the Home Owner's Loan Act sets various limits 
on certain loans and investments made by savings associations [12 
U.S.C. 1464 (5)(c)(2)(B)]. This includes a 400 percent of capital 
statutory investment limit on loans secured by nonresidential real 
estate. As a result, OTS engages in extensive monitoring to determine 
when savings associations approach the legal lending limit for these 
and other loans subject to HOLA investment limits. Accordingly, given 
the statutory investment limit applicable to savings associations, and 
the significantly different risk characteristics of various types of 
CRE, OTS's guidance does not include numerical or supervisory screens.

V. Text of Final Guidance

    The text of the OTS Guidance on Concentrations in Commercial Real 
Estate Lending, Sound Risk Management Practices follows:

Concentrations in Commercial Real Estate Lending, Sound Risk Management 
Practices

Purpose
    The Office of Thrift Supervision (OTS) is issuing this Guidance to 
address concentrations of commercial real estate (CRE) loans in savings 
associations. Concentrations of credit can add a dimension of risk that 
compounds the risk inherent in individual loans.
    The Guidance reminds savings associations that strong risk 
management practices and appropriate levels of capital are essential 
elements of a sound CRE lending program, particularly when an 
institution maintains a concentration in CRE loans. The Guidance 
reinforces and enhances OTS's existing regulations and guidelines for 
real estate lending \2\ and loan portfolio management. The Guidance 
does not establish specific CRE lending limits; rather, it seeks to 
promote sound risk management practices that will enable savings 
associations to continue to pursue CRE lending in a safe and sound 
manner.
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    \2\ Refer to OTS's regulations on real estate lending standards 
and the Interagency Guidelines for Real Estate Lending Policies: 12 
CFR 560.100-101 and the Interagency Guidelines Establishing 
Standards for Safety and Soundness: 12 CFR 570, appendix A.
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Background
    OTS recognizes that savings associations play a vital role in 
providing credit for business and real estate development. In the past, 
concentrations in CRE lending coupled with weak loan underwriting and 
depressed CRE markets contributed to significant credit losses in the 
banking system. While underwriting standards are generally stronger 
than during previous CRE cycles, there has been an increasing trend in 
the number of institutions with concentrations in CRE loans. These 
concentrations may make such institutions more vulnerable to cyclical 
CRE markets. Moreover, some institutions' risk management practices are 
not evolving with their increasing CRE concentrations. Therefore, this 
Guidance reminds savings associations with concentrations in CRE loans 
that their risk management practices and capital levels should be 
commensurate with the level and nature of the risks that concentrations 
pose.

[[Page 75299]]

Scope
    In developing this Guidance, OTS recognized that different types of 
CRE lending present different levels of risk, and that consideration 
should be given to the lower risk profiles and historically superior 
performance of certain types of CRE, such as well-structured 
multifamily housing finance, when compared to others, such as 
speculative office space construction. As discussed under ``CRE 
Concentration Assessments,'' institutions are encouraged to segment 
their CRE portfolios to acknowledge these distinctions for risk 
management purposes.
    This 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 an abundance of caution. Thus, 
for purposes of this Guidance, CRE loans are those loans with risk 
profiles sensitive to the condition of the general CRE market (e.g., 
market demand, changes in capitalization rates, vacancy rates, or 
rents). CRE loans include land development and construction loans 
(including one-to four-family residential and commercial construction) 
and loans secured by raw land, multifamily property, and nonfarm 
nonresidential property where the primary or a significant source of 
repayment is derived from rental income associated with the property 
(that is, loans for which 50 percent or more of the source of repayment 
comes from third party, nonaffiliated, rental income) or the proceeds 
of the sale, refinancing, or permanent financing of the property. Loans 
secured by owner-occupied nonfarm nonresidential properties where the 
primary or significant source of repayment is the cash flow from the 
ongoing operations and activities conducted by the party, or affiliate 
of the party, who owns the property are excluded from the scope of this 
Guidance. Loans to Real Estate Investment Trusts (REITs) and unsecured 
loans to developers should also be considered CRE loans for purposes of 
this Guidance if their performance is closely linked to performance of 
CRE markets.
CRE Concentration Assessments
    Credit concentrations are groups or classes of credit exposures 
that share common risk characteristics or sensitivities to economic, 
financial, or business developments. Therefore, savings associations 
with an accumulation of such exposures should be able to quantify the 
additional risk such credit concentrations may pose. Savings 
associations actively involved in CRE lending should also perform 
ongoing risk assessments to identify any changes in the risk of their 
CRE portfolios resulting from growth in the amount of their exposures 
or changes in underwriting standards or the economic environment. The 
risk assessment should identify potential concentration risk by 
stratifying the CRE portfolio into segments that have common risk 
characteristics or would be affected by similar external events. An 
institution's CRE portfolio stratification should be reasonable and 
supportable. The CRE portfolio should not be divided into multiple 
segments simply to avoid the appearance of concentration risk.
    OTS recognizes that risk characteristics differ among property 
types of CRE loans. A manageable level of CRE concentration risk will 
vary by institution depending on the portfolio risk characteristics, 
the quality of risk management processes, and capital levels. 
Therefore, the Guidance does not establish a CRE concentration limit or 
an implication that any particular level is undesirable. Rather, the 
Guidance encourages savings associations to: identify and monitor 
credit concentrations and the additional risk that they may pose, 
establish internal concentration limits, and report all concentration 
risks to management and the board of directors on a periodic basis. 
Depending on the results of its internal risk assessment, the 
institution may need to enhance its risk management systems as 
described below.
Risk Management
    The sophistication of a savings association's risk management 
processes should be appropriate to the size of the portfolio, as well 
as the level and nature of concentrations and the associated risk to 
the institution. Savings associations should address the following key 
elements in establishing a risk management framework that effectively 
identifies, monitors, and controls CRE concentration risk:
     Board and management oversight
     Portfolio management
     Management information systems
     Market analysis
     Credit underwriting standards
     Portfolio stress testing and sensitivity analysis
     Credit risk review function
Board and Management Oversight
    An institution's board of directors has ultimate responsibility for 
the level of risk assumed by the institution, including both its credit 
and concentration risks. An institution's strategic plan should address 
the rationale for any CRE concentration in relation to its overall 
growth objectives, financial targets, and capital plan. In addition, 
OTS's real estate lending regulations require that each institution 
adopt and maintain a written policy that establishes appropriate limits 
and standards for all extensions of credit that are secured by liens on 
or interests in real estate, including CRE loans. Therefore, the board 
of directors or a designated committee thereof should:
     Establish policy guidelines and approve an overall CRE 
lending strategy regarding the level and nature of CRE concentration 
risk acceptable to the institution, including any binding commitments 
to particular borrowers or CRE property types.
     Ensure that management implements procedures and controls 
to effectively adhere to and monitor compliance with the institution's 
lending policies and strategies.
     Receive information that identifies and quantifies the 
nature and level of risk presented by the CRE concentration, including 
reports that describe changes in CRE market conditions in which the 
institution lends.
     Periodically review and approve CRE risk exposure limits 
and appropriate sublimits (for example, by nature of concentration) to 
conform to any changes in the institution's strategies and to respond 
to changes in market conditions.
Portfolio Management
    Savings associations with CRE concentrations need to manage not 
only the risk of individual loans but also the additional portfolio 
risk that may arise from an overall exposure to a single economic risk 
factor. Even when individual CRE loans are prudently underwritten, 
concentrations of loans that are similarly affected by cyclical changes 
in the CRE market can expose an institution to an unacceptable level of 
risk if not properly managed. Management should regularly evaluate the 
degree of correlation between related real estate sectors and establish 
internal lending guidelines and concentration limits that control the 
institution's overall risk exposure.
    In the presence of concentration risk, management should develop 
appropriate strategies for managing concentration levels, including a 
contingency plan to reduce concentrations or mitigate concentration 
risk in the event of adverse market

[[Page 75300]]

conditions. Loan participations, whole loan sales, and securitizations 
are a few examples of strategies for actively managing concentration 
levels without curtailing new originations. If the contingency plan 
includes selling or securitizing CRE loans, management should assess 
the marketability of the portfolio. This should include an evaluation 
of the institution's ability to access the secondary market and a 
comparison of its underwriting standards with those that exist in the 
secondary market.
Management Information Systems
    A strong management information system (MIS) is key to effective 
portfolio management. The sophistication of MIS will necessarily vary 
with the risk associated with concentrations and the complexity of the 
institution. MIS should provide management with sufficient information 
to identify, measure, monitor, and manage CRE concentration risk. This 
includes meaningful information on CRE portfolio characteristics that 
is relevant to the institution's lending strategy, underwriting 
standards, and risk tolerances. An institution should periodically 
assess the adequacy of MIS in light of growth in CRE loans and changes 
in its risk profile.
    Savings associations are encouraged to stratify the CRE portfolio 
by property type, geographic market, tenant concentrations, tenant 
industries, developer concentrations, and risk rating. Other useful 
stratifications may include loan structure (for example, fixed rate or 
adjustable), loan purpose (for example, construction, short-term, or 
permanent), loan-to-value limits, debt service coverage, policy 
exceptions on newly underwritten credit facilities, and affiliated 
loans (for example, loans to tenants). Another useful stratification 
may be a determination if property is considered owner-occupied. If 50 
percent or more of the property's rental income comes from third party, 
non-affiliated, rental income, the property would not be considered 
owner-occupied.\3\ An institution should also be able to identify and 
aggregate exposures to a borrower, including its credit exposure 
relating to derivatives.
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    \3\ The determination as to whether a property is considered 
``owner-occupied'' should be made upon origination or purchase of 
the loan. This is consistent with the new reporting items adopted by 
OTS in the revisions to the Thrift Financial Report published 
December 1, 2006, 71 FR 69619.
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    Management reporting should be timely and in a format that clearly 
indicates changes in the portfolio's risk profile, including risk-
rating migrations. In addition, management reporting should include a 
well-defined process through which management reviews and evaluates 
concentration and risk management reports, as well as special ad hoc 
analyses in response to potential market events that could affect the 
CRE loan portfolio.
Market Analysis
    Market analysis should provide the institution's management and the 
board of directors with information to assess whether its CRE lending 
strategy and policies continue to be appropriate in light of changes in 
CRE market conditions. An institution should perform periodic market 
analyses for the various property types and geographic markets 
represented in its portfolio.
    Market analysis is particularly important as an institution 
considers decisions about entering new markets, pursuing new lending 
activities or expanding in existing markets. Market information may 
also be useful for developing sensitivity analysis or stress tests to 
assess portfolio risk.
    Sources of market information may include published research data, 
real estate appraisers and agents, information maintained by the 
property taxing authority, local contractors, builders, investors, and 
community development groups. The sophistication of an institution's 
analysis will vary by its market share and exposure as well as the 
availability of market data. While an institution operating in non-
metropolitan markets may have access to fewer sources of detailed 
market data than an institution operating in large, metropolitan 
markets, an institution should be able to demonstrate that it has an 
understanding of the economic and business factors influencing its 
lending markets.
Credit Underwriting Standards
    An institution's lending policies should reflect the level of risk 
that is acceptable to its board of directors and should provide clear 
and measurable underwriting standards that enable the institution's 
lending staff to evaluate all relevant credit factors. When an 
institution has a CRE concentration, the importance of sound lending 
policies becomes even more critical and should consider both internal 
and external factors, such as its market position, historical 
experience, present and prospective trade area, probable future loan 
and funding trends, staff capabilities, and technology resources. 
Consistent with interagency real estate lending guidelines, CRE lending 
policies should address the following underwriting standards:
     Maximum loan amount by type of property
     Loan terms
     Pricing structures
     Collateral valuation \4\
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    \4\ Refer to OTS's appraisal regulations: 12 CFR part 564.
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     LTV limits by property type
     Requirements for feasibility studies and sensitivity 
analysis or stress testing
     Minimum requirements for initial investment and 
maintenance of hard equity by the borrower
     Minimum standards for borrower net worth, property cash 
flow, and debt service coverage for the property
    An institution's lending policies should permit exceptions to 
underwriting standards only on a limited basis. When an institution 
does permit an exception, it should document how the transaction does 
not conform to the institution's policy or underwriting standards, 
obtain appropriate management approvals, and provide reports to the 
board of directors or designated committee detailing the number, 
nature, justifications, and trends for exceptions. Exceptions to both 
the institution's internal lending standards and interagency 
supervisory LTV limits \5\ should be monitored and reported on a 
regular basis. Further, savings associations should analyze trends in 
exceptions to ensure that risk remains within the institution's 
established risk tolerance limits.
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    \5\ The Interagency Guidelines for Real Estate Lending (12 CFR 
560.100-101) state that loans exceeding the supervisory loan-to-
value (LTV) guidelines should be recorded in the institution's 
records and reported to the board at least quarterly.
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    Credit analysis should reflect both the borrower's overall 
creditworthiness and project specific considerations as appropriate. In 
addition, for development and construction loans, the institution 
should have policies and procedures governing loan disbursements to 
ensure that the institution's minimum equity requirements by the 
borrower are maintained throughout the development and construction 
periods. Prudent controls should include an inspection process, 
documentation on construction progress, tracking pre-sold units, pre-
leasing activity, and exception monitoring and reporting.
Portfolio Stress Testing and Sensitivity Analysis
    An institution with CRE concentration risk should perform portfolio 
level stress tests or sensitivity analysis to quantify the impact of 
changing economic conditions on asset quality, earnings, and capital. 
Further, an institution should consider the

[[Page 75301]]

sensitivity of portfolio segments with common risk characteristics to 
potential market conditions. The sophistication of stress testing 
practices and sensitivity analysis should be consistent with the 
complexity of the institution and risk characteristics of its CRE loan 
portfolio. For example, well-margined and seasoned performing loans on 
multifamily housing normally would require significantly less robust 
stress testing than most acquisition, development, and construction 
loans.
    Portfolio stress testing and sensitivity analysis may not 
necessarily require the use of a sophisticated portfolio model. 
Depending on the risk characteristics of the CRE portfolio, stress 
testing may be as simple as analyzing the potential effect of stressed 
loss rates on the CRE portfolio, capital, and earnings. The analysis 
should focus on the more vulnerable segments of an institution's CRE 
portfolio, taking into consideration the prevailing market environment 
and the institution's business strategy.
Credit Risk Review Function
    A strong credit risk review function is critical for an 
institution's self-assessment of emerging risks. An effective, 
accurate, and timely risk-rating system provides a foundation for the 
institution's credit risk review function to assess credit quality and, 
ultimately, to identify problem loans. Risk ratings should also be risk 
sensitive, objective, and appropriate for the types of CRE loans 
underwritten by the institution. Further, risk ratings should be 
regularly reviewed for appropriateness.
Supervisory Oversight
    As part of its ongoing supervisory monitoring processes, OTS uses 
certain criteria to identify savings associations that may have CRE 
concentration risk. These include savings associations that:
     Are approaching their HOLA investment limits.
     Have experienced rapid growth in CRE lending.
     Have notable exposure to a specific type of or high-risk 
CRE.
     Were subject to supervisory concern over CRE lending 
during preceding examinations.
     Have experienced significant levels of delinquencies or 
charge-offs in their CRE portfolio.
    A savings association that exhibits any of the risk elements 
described above may receive further supervisory analysis to ascertain 
whether its internal concentration risk assessment and resulting risk 
management practices are commensurate with of the level and nature of 
its CRE exposure.
    OTS will use the above criteria as a preliminary step to identify 
savings associations that may have CRE concentration risk.\6\ Because 
regulatory reports capture a broad range of CRE loans with varying risk 
characteristics, the supervisory monitoring criteria are intended to 
serve as high-level indicators to identify savings associations 
potentially exposed to CRE concentration risk.
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    \6\ Savings associations are reminded that this guidance does 
not affect the existing statutory investment limitations as set 
forth in 12 CFR 560.30. The statutory investment limit for loans 
secured by nonresidential properties is 400 percent of total 
capital.
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    For some types of CRE exposures, concentration risk may be present 
well before the statutory limit is reached. The statutory investment 
limit of 400 percent of total capital for non-residential real estate 
should not be considered a ``safe harbor'' for savings associations 
with smaller commercial real estate exposures. OTS expects all savings 
associations that are actively engaged in CRE lending to assess their 
concentration risk and maintain adequate risk management policies and 
procedures to control such risks.
Evaluation of CRE Concentration Risk
    The effectiveness of an institution's risk management practices 
will be a key component of the supervisory evaluation of its CRE 
concentration risk. Examiners will evaluate an institution's internal 
CRE analysis and engage in a dialogue with the institution's management 
to assess CRE exposure levels and risk management practices. Savings 
associations that have experienced recent, significant growth in CRE 
lending will receive closer supervisory review than those that have 
demonstrated a successful track record of managing the risks in CRE 
concentrations.
    In evaluating the level of risk, OTS will consider the 
institution's own analysis of its CRE portfolio including the presence 
of mitigating factors, such as:
     Portfolio diversification across property types
     Geographic dispersion of CRE loans
     Portfolio performance
     Underwriting standards
     Level of pre-sold units or other types of take-out 
commitments on construction loans
     Portfolio liquidity (ability to sell or securitize 
exposures on the secondary market)
Assessment of Capital Adequacy
    OTS's existing capital adequacy guidelines note that an institution 
should hold capital commensurate with the level and nature of the risks 
to which it is exposed. Accordingly, savings associations with CRE 
concentration risks are reminded that their capital levels should be 
commensurate with the risk profile of their CRE portfolios that 
includes both credit and concentration risks. In assessing the adequacy 
of an institution's capital, OTS will consider the level and nature of 
inherent risk in the CRE portfolio as well as management expertise, 
historical performance, underwriting standards, risk management 
practices, and market conditions. Most savings associations currently 
meet this expectation and will not be expected to increase their 
capital levels. However, an institution with inadequate capital to 
serve as a buffer against unexpected losses from a CRE concentration 
should develop a plan for reducing its CRE concentrations or for 
maintaining capital appropriate for the level and nature of its CRE 
concentration risk.
    This concludes the text of the Guidance entitled, Concentrations in 
Commercial Real Estate Lending, Sound Risk Management Practices.

    Dated: December 7, 2006.

    By the Office of Thrift Supervision.
John M. Reich,
Director.
 [FR Doc. E6-21148 Filed 12-13-06; 8:45 am]
BILLING CODE 6720-01-P