Chief National Bank Examiner Tim Long assesses the current situation
By Steve Cocheo, executive editor,
The first phase of the current crunch broke new ground, says OCC’s Tim Long. Much of the second, however, follows a familiar script
Tim Long, senior deputy comptroller for bank supervision policy, has been involved with just about every level of bank examination, from multinationals to community banks, over his 30 years at the Office of the Comptroller of the Currency. He assumed his current post, which also makes him Chief National Bank Examiner, in April 2008. Because of his experience, he anticipated some of what has happened. But other parts hit him as a complete surprise.
“I break this thing into two pieces,” says Long, who was interviewed in mid July, “the last 18 months and what I see coming for the next 18 months.”
The earlier period saw a complete shutdown of certain markets, “not just across the country, but worldwide,” Long explains. The asset-backed commercial paper market shut down and the effects cascaded through the financial system.
“Clearly, I don’t think any of us have ever lived through that kind of liquidity crunch with that magnitude spread and that spread with that velocity,” says Long. “It ranged all the way across the world. That’s something I would not have anticipated. And it was very difficult to deal with.”
But now, Long says, that tidal wave of trouble has begun to recede. “I feel like the programs that the government has used, and that the regulators have put in place, have made the market disruption stabilize a bit.” Liquidity is returning and markets are beginning to work again. That’s the good news.
“Now I feel like we’re getting into more of a traditional credit cycle issue,” says Long. “We’re in the midst of a recession. We’ve got significant asset quality problems in the banking system. At OCC, we’re anticipating that we’re going to be dealing with this for quite some time.”
A natural question is, how long is “quite some time”? Two, three years?
Long says he’s no economist, and declines to project. However, he says experience demonstrates certain trends. Even when the economic types decide that the recession is over—as some already have—it won’t be over for banks. “The trauma in bank portfolios will generally continue for a number of quarters beyond that,” says Long.
Banking’s ride into the valley
One of the jobs of bank examiners, especially in the midst of such turmoil as we have now, is to keep in touch with their book of examined banks and “make sure your bankers are not in denial and that they are looking at their portfolios realistically,” says Long. Beyond that, the bankers must be acting—looking at commercial real estate and commercial and industrial credits that are in trouble. Examiners need to make sure, says Long, that bankers are “working with the borrowers and figuring out either exit strategies or workout strategies—some way to get paid back.”
Long’s comment implies that there are bankers who either didn’t see, or still haven’t seen, the troubles in their portfolios.
“I think all of the regulators have probably witnessed some denial over the last couple of years,” says Long, “and we’ve been pretty vocal about that. So it’s a case of reality setting in and bankers realizing they in some cases really do have some serious problems, and that it’s going to take a while to work out of this.”
Long believes the most recent growth period—with it’s long and steady rise in lending and profits—led to the deterioration of credit cultures.
“When you have an extended period of good times, where you really don’t have any kind of downturn at all, there comes a complacency to underwriting,” Long says. “Standards start to slip. Competition grows. You see a lot of banks being chartered. You’ve got loan officers inside those banks who have never seen real estate values go down.”
Long says OCC made it clear early in the cycle that it had concerns about growing CRE concentrations, especially in residential developer credits.
“It’s not like this ‘just happened’,” says Long. “Some [national banks] probably felt we were being a little aggressive. There are many financial institutions out there, and I will say that there are some that got it quicker than others. That will be to their benefit. And some stayed in denial a little longer than they should have.”
The job of the examiner in such times, says Long, is to go into bank boardrooms, while record earnings are being reported, and announce that things are slipping, that they are growing too loose.
“That’s a difficult thing for an examiner to do,” says Long, “but very clearly that took place.”
Indeed, Long believes this second 18-month half of the crunch doesn’t differ that much from past crunches, in many regards.
“Credit doesn’t change that much,” says Long. “The complexity of products may grow, but the granting of credit is still pretty basic blocking and tackling. Some fundamental truisms about credit have held for 50 years and they still hold true today.”
United regulators weren’t enough
What happened at the bank level went on at the national level, too, says Long. He says the regulators’ efforts to rein things in early, especially on the commercial real estate front, were rebuffed, and to a degree that surprised him.
Interagency guidance on CRE, Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, was issued in December 2006, and banker feelings about that document ran high, and often hot.
“We got a lot of blowback on that when we put it out,” recalls Long. “I think it was pretty benign guidance, honestly. It really was. It shouldn’t have been real controversial. But we did get a lot of blowback.”
Asked why such controversy resulted, Long believes multiple factors played a part in the industry’s resistance.
Competitive worries were one big factor. “Many community banks felt like many of their products had been commoditized by some of the larger banks,” says Long, “so they felt as if this—commercial real estate—was the only place that they could to go make money.”
Beyond that, CRE had considerable appeal in the short-term, notes Long. The banking system was awash in liquidity. The economy was strong. Interest rates were low.
“It looked like a pretty good market and it looked like there was a lot of money to be made, so many of them jumped in,” says Long. And then, in time, three classic factors bit them: eroding underwriting, credit exceptions, and concentration risk.
But one more factor played a part that was different, in Long’s view.
Liquidity issues and deposit shifts
That new factor concerns funding of community bank lending.
Long says that a structural change in community banks’ balance sheets over the last 15 years was the increasing reliance on leverage and obtaining funding from wholesale sources.
This funding fueled more lending, and once it got embedded, the velocity of the problem picked up quickly.
Long hastens to make clear that this isn’t as much of a criticism as it sounds like.
“There’s a lot of community banks, and while we have a lot of problems, we’ve got a lot of banks that didn’t get into trouble,” says Long.
“For the most part,” he continues, “I think community bankers do a pretty good job of banking. They understand their communities. They do the best they can to compete. But over the last 15 years, their situation changed.
Their funding. Their margins. Their ability to compete. Their ability to make an adequate return. It’s gotten tougher for them.”
Regulators’ increasingly strong feelings about wholesale funds has been subject of much debate. It’s one of the items that show up in enforcement orders, for instance, and is often mentioned when failed banks are discussed. (For an “op-ed” on this issue, see George Darling’s column, “Wholesale funding isn’t toxic!”, on our website at http://tinyurl.com/NotToxic.)
During ABA’s Leadership Meeting in late July, a midwestern banker stood up during an open mike period and said he worried that regulators were attempting to push community bankers back towards their traditional core-funding base. Over time, he concluded, this would create a classic short-term/long-term funding mismatch, and spell disaster for community banks.
Asked about this banker’s premise, Long acknowledged that core deposits are much harder to come by these days. But he disputed the premise otherwise.
“I would disagree that the regulators are telling community banks that they can only be core funded,” says Long.
“We’re not naïve enough to think that that will work with the business model today. We know that’s not going to work.
“We want every bank to do a good job of managing its funding base, and making sure that if it does enter into a leverage program with a Federal Home Loan Bank or if it gets brokered deposits or internet deposits, that it understands the potential risk: That those deposits may leave at the first sign of trouble,” Long says.
This, he notes, is where a “liquidity failure” arises—the depositors rapidly pull out and the institution lacks funding and can’t close the books that night.
Every bank is different and the appropriate funding mix for each will vary. But Long underscores this point: A deposit base dominated by brokered deposits, is one where “there’s really no franchise value.” He says when such institutions get into trouble, there isn’t anything left to sell.
Making it through rough times
If there is any good side at all to a recession, for troubled banks, it’s that it is hard to dig deeper in the course of trying to get out of a bad spot, according to Long.
“In an environment like this, it is tough to do a quick fix,” says Long. “You’re in a recession—there’s not a lot of loan demand out there. Not good loan demand. So it’s kind of hard to ‘double down’.” A bank with a high levels of classified loans may have capital and funding issues going on as well. Long says such institutions are not likely to be able to go into businesses that they lack expertise in.
“In many of the cases where banks have gotten themselves into trouble, some of the commercial real estate concentrations are so massive on their balance sheet that there’s just not a lot of room for them to maneuver right now.”
For the bank facing a rough time, Long says that the range of options available has more to do with where in the cycle the economy is, than any other factor.
Right now, he says, “there’s just nothing moving. People aren’t looking for new developments nor for strip malls. And if you have them, it’s pretty hard to get rid of them.”
Sure, there are buyers out there offering ten cents on the dollar, Long says. Perhaps, if the bank has the capital with which to hold out, it may realize more—40, 50, 60 cents on the dollar.
“That’s a decision that management has to make,” says Long. Trying to unload everything bad generally isn’t practical. Fire-sale prices being offered now may not be supported by capital. Or they may be so low that shareholder’s interests won’t be served.
Long says the Comptroller’s Office expects most banks to hold onto assets and work with the borrowers.
“Many of these borrowers will survive the recession,” says Long. “They will be back and they will be good customers.
Long says that’s actually the advantage of a bank versus a hedge fund in a recession, the ability to work with troubled customers.
“The way banks get through recessions and help the country get through recessions is they work with borrowers and have some patience,” says Long. ”They do a workout plan and they hang in with them.”
Look at appraisals with jaundiced eye
What, then, is the role of an examiner in such times?
In good times, says Long, the examiner reviews underwriting and risk management, but in times like these, they review classifications, non-accruals, valuations, provisioning, and more.
Take appraisals. “If their valuations and adjustments to appraisals are reasonable,” he says, “we will accept them. We expect them to look at this stuff with a jaundiced eye.”
Long adds: “But if our examiners have to go in and start running the numbers for them, there’s going to be a problem.”
Some banks have complained about other lenders dumping properties on the market, driving down values and necessitating more appraisals on properties securing banks’ loans.
Long explains that when a property value appears to be down, the borrower’s situation has changed significantly, and the loan can no longer cash flow, the lender knows they now have a problem borrower.
In that case, says Long, “they either need to get a new appraisal, or at least start making some adjustments to the valuation to figure out what the carrying value of that loan is, and exactly where they are with that borrower.”
“So they will be doing more appraisals,” says Long. “But more importantly, I hope they have a good system of internal appraisal review. Something that will take a look at these situations, double check this stuff, and make sure that things are being carried reasonably.” BJ
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj0909/index.php?startid=4