[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
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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