|CRE pain (December 2009)|
The recession has clobbered commercial real estate. Bankers are hoping—but skeptical—that new regulatory guidance will ease procyclical exam pressures.
Will regulators be "kinder and gentler" on commercial real estate exams as a result of new guidance?
"We'll believe it when we see it," is the view of many community bankers for whom there is a great deal of exasperation over exams and appraisals. Others regard the guidance as constructive. Either way, there's a lot of pain to go around in this market segment.
That banks’ commercial real estate lending sector is having a rough ride and is in for more is certain. There has already been an impact on many institutions’ earnings and capital, and there will be more pain before the real estate cycle begins to bring things back. All indications are that the problem will continue to hit regional and community banks hardest.
The question is whether examiners and appraisers, toeing their professional standards religiously and conservatively in a period where all players face quick blame from Washington, are going to moderate their approach in accordance with new CRE workout guidance, or “stay the course.”
In a series of extensive telephone interviews and face-to-face meetings with bankers, real estate experts, appraisers, and attorneys from around the country, as well as regulatory input, a picture is forming of a situation in flux. A generally positive regulatory document may or may not be enough to quench the effects of gasoline being dribbled onto a smoldering fire by field examiners playing hardball.
Picture of a roiling sector
On Nov. 24, two days before Thanksgiving, FDIC announced quarterly industry earnings.
In a press conference, Chairman Sheila Bair had been speaking of the industry’s high provisioning for loan losses, because of the growing levels of problem loans and chargeoffs. She spoke of the industry’s progress in charging off problem loans, and in building capital and reserves. Then she turned to something that had surprised many in the industry about three weeks earlier—the interagency “Policy Statement on Prudent Commercial Real Estate Loan Workouts.”
“This policy statement encourages banks to continue making good loans to commercial real estate borrowers, many of which are small businesses, and to prudently work with borrowers who are having difficulties because of economic conditions,” said Bair. “At the same time, examiners are instructed to take a balanced approach in assessing an institutions’ risk management practices for workouts. We feel that this guidance can help address the economic dislocations that are hurting both small business borrowers and their lenders.” (See “Guidance at a glance,” page 20, for the key points in the document.)
A ranking FDIC official had given some tidbits about the new document in late October, during a session at ABA’s Annual Meeting in Chicago.
More than 3,000 banks had exceeded either one or both of the threshold figures contained in the CRE lending guidelines issued a few years back, noted Steven Fritts, associate director in FDIC’s Division of Supervision and Consumer Protection.
“Most of those 3,000 banks are working through this,” Fritts told assembled bankers. “They aren’t going to fail, and the great majority of them aren’t going to wind up on our problem list.”
But Fritts added that times like these revealed those who hadn’t underwritten CRE loans as well as others.
“How they were underwritten shows up now,” said Fritts. “We saw this coming, and as regulators we probably didn’t do as good a job on this as we should have.”
Skeptical reception…and why
The Oct. 30 guidance—released in final form, as a policy statement, rather than as a rule that would have required notice and comment periods—was welcomed, but regarded with considerable skepticism by community bankers questioned. A senior regulatory analyst who read the document concluded that examiners retain considerable “wiggle room.”
Some bankers are simply not ready to believe that a policy statement will bring meaningful change in the field.
“So the regulators are going to be kinder and gentler on CRE?” asked a North Carolina community banker rhetorically at a recent industry meeting. “Well, if you believe that, I have some land to sell you.” He was not alone in that view.
What is it that has bred this level of cynicism? The matter goes deeper than just a mistrust of Washington agency statements. That is almost a hereditary right of bankers.
No, what is driving much of this attitude is pain—pain caused by examiners, appraisers, and an overinflated commercial real estate market that is blowing off air in a hurry.
There is also simply regulatory fatigue. Many bankers speak of a disconnect between Washington and field examiners. And they live with the field force.
Underlying much of the trouble is the CRE appraisal process. Walt Moeling, banking partner in the Atlanta office of Bryan Cave LLP, summarizes the issue: “We have sanctified appraisals as something predictive and special. Appraisers in this environment aren’t going to step up and give you any big numbers. They have every incentive to protect themselves.”
But the borrower is paying us!
The top complaint among bankers is short and not so sweet. No matter where collateral values are, they say, if a borrower is faithfully fulfilling the terms of their loan, doesn’t that count? The recent policy statement in part addresses this, but bankers approach it with a bitter taste in their mouths.
One Connecticut lender who requested anonymity said that the examiner looking at the bank’s construction portfolio cited several loans that he “didn’t like.”
“These are people we’ve been doing business with for 25 years,” the banker said.
In the wake of the exam—it’s a familiar story—the bank had to add millions to its allowance for loan and lease losses.
“We’re shoveling money into the reserve right now,” the banker said. “Someday, we’re going to have recoveries. But in the meantime, this is going to yo-yo bank performance.”
“Between the regulators and the appraisal industry,” the Connecticut banker continued, “they are going to kill community banks.”
“My view is that appraisers are gun shy,” said commercial real estate consultant Patrick O’Keefe, O’Keefe & Associates, Grand Rapids, Mich. “Having been accused of overinflated appraisals [in good times], they now err on the other side—almost useless.”
“You’re overthinking the process”
Craig Emerson, senior vice-president and chief credit administrator at $270 million-assets Syringa Bank, Boise, Idaho, says his institution has a unique kind of loan, a trio of large residential lots, which a developer planned to divide into 11 lots. The original appraised value came to $1.8 million. With a later change in plan, the bank had the property reappraised as the trio of larger lots, which have seen the greatest declines in the current environment. The examiner evaluating the new appraisal insisted that the bank write down the loan to the new value—$475,000.
“I argued with the examiner,” recalls Emerson. “I said that distressed market sales weren’t producing a fair value for the property.”
“You’re overthinking the process,” the examiner told him, repeating the order to write down the loan by almost 75%.
Emerson told his board about the writedown, and, in a symbolic gesture, five directors raised their hands as being willing to buy the parcel at such a bargain.
This is a situation being repeated around the country, to varying degrees.
“It’s procyclical behavior,” said an angry Ohio banker. “It is causing the kind of spiral that feeds on itself.”
“They are pushing things too far,” said Doug Scherrer, senior vice-president and senior lender at Brighton, Colo.’s $239.2 million-assets Valley Bank & Trust. He said he has seen even some larger community banks in his markets pull out of CRE lending, in order to reduce their concentrations to meet examiner demands for compliance.
Indeed, bankers face the curious challenge of doing some of this to themselves, too. Dan Blanton is president and CEO of Southeastern Bank Financial Corp., Augusta, Ga., a two-bank, two-state holding company of $1.5 billion-assets. The Augusta market is relatively stable, though values in the nearby Athens, Ga., market “are plummeting,” said Blanton.
Blanton’s philosophy through the crunch has been to make the decision to have a bad year, get through it, and put it behind the company. As a result, the company has been proactive about obtaining re-appraisals, when warranted, and marking loans down.
“It’s a little bit of a Catch 22,” said Blanton, “regarding how often you re-appraise and then how much to write them down. You cut your own throat. You could re-appraise every quarter, and mark them down every quarter.”
“Don’t fight us”
Another community bank had seen enough difficulty in commercial real estate that it had voluntarily made a significant addition to its loan-loss reserve, and thought this met all regulatory and accounting expectations. But when examiners came in, they told the CEO that they believed collateral values in the market were down by a certain high percentage, and they began ordering writedowns and further additions to the reserve. The banker resisted. He pointed to appraisals he had that supported less-drastic writedowns. He received the equivalent of a whack across the snout.
“The agency didn’t care,” said the banker, who requested anonymity. “We want a lot more reserves and we want them now” is what he heard. It was made very clear who was setting the agenda and the rules.
The behavior seen in this story is the most extreme heard in the course of research, but there’s been a common theme. “The examiners in the field are playing hardball,” said Robert Chapman, president and CEO at $833 million-assets United Bancorp, Inc., a two-bank holding company in Michigan. “The regulators, when they come in, do a real deep dive, and are much more critical of banks. They are not stupid, and they see the crunch that’s coming as collateral values dissipate.”
Some flexibility seen
In some cases, bankers have been able to go up the line to ask for a change in treatment beyond an examiner’s fiat. Kate Marcum, president of $73.6 million-assets Millbury (Mass.) National Bank, saw OCC examiners in August. “They were aggressive about writing down the values,” she said, “and I’ve had some appraisals that were extraordinarily low (area values have fallen around 20% recently). Appraisers are really afraid to say anything positive.”
However, Marcum said the examiner in charge told her she could adjust values accordingly if she could make a case for higher ones. She was able to obtain some redress as well by calling the region’s Assistant Deputy Comptroller.
Overall, though, Marcum said that the process has “decimated guarantors. Quite frankly, [examiners] don’t want to be caught with a bank with a problem that they didn’t identify.” While the message from Washington has been to make new loans and to support and work with troubled borrowers, Marcum said the field force message has been, “protect the bank.”
Indeed, there are some bankers who question the regulators’ stance. “It’s a little ironic to be pushing banks in the direction of doing more C&I lending, which typically has less hard collateral when you get in trouble, in my experience, than you have with commercial real estate,” said Stewart McClure, Jr., president and CEO at $308.9 million-assets Somerset Hills Bank, Bernardsville, N.J.
Cheap as dirt, literally
An unfortunate phenomenon being seen in different forms around the country is the raw-land property zoned for residential, commercial, or mixed use that was selected for a project that hasn’t panned out.
“We’re going to have lots of subdivisions that return to nature, or homes with unusually large backyards,” said Walt Moeling of some Georgia markets. But this has been seen in other markets, as well.
“That’s happening in the Central Valley,” in California, according to Walt Mix, Los Angeles-based managing director for global financial services at LECG and former commissioner for the California Department of Financial Institutions. One failed bank made a specialty here. “They were turning farmland into homes, and then the music stopped,” said Mix. Land values, and therefore appraisals, fell precipitously.
Syringa Bank’s Craig Emerson said that he’s seen some land zone for mixed-use development default back to farmland value—which has cut back appraised value by as much as 95%.
“With current market conditions, appraisers are whining that there are no comparable values,” said Emerson. Further, they are looking at markets and declaring that the absorption rates for new properties are such that newly zoned farmland won’t be used for as much as a decade. That renders its current “highest and best use,” in appraisal parlance, to be farmland, once again.
From the appraiser’s seat
Unsurprised by such tensions is George Mann, formerly chief appraiser and vice-president at Fifth Third Bank and now managing director of Collateral Evaluation Services, LLC, Cincinnati, a review appraisal consultancy to banks. He said he’s seen this arise among his nationwide clientele, sometimes even in urban areas. In fact, he said, the original, higher value, “could have been a case of an appraiser getting caught up in the bubble … drops of 90% are not unusual and in most cases it is justified.”
In his career as an appraiser, Mann said he himself has made such slashing cuts and faced lender objections.
“I’ve always told people who argued, ‘Go ahead, list it, and prove me wrong’.”
In fact, Mann, who is also an instructor on CRE appraisals for the Appraisal Institute, and who will be conducting related training under ABA auspices, thinks bankers who are blaming the industry’s difficulties on appraisers have got it wrong.
“The appraisers are just reflecting the market data,” said Mann, “which is that low and still trending lower. The appraisers have no reason to hurt their clients. But they have to go with the data that is available.”
Continuing, Mann explained that “all appraisers really do is look at market data and analyze it. The marketplace has gone down. It’s not like appraisers just make up values. It’s ironic, because banks were screaming at appraisers to get the values up [during the boom]. Now, that’s not to say that appraisers, like the marketplace, may not go too far south.”
Yet bankers aren’t the only skeptics. Constantine “Tino” Korologos, managing director in the Real Estate Consulting Practice at Deloitte FAS, himself an appraiser by training and experience, said, “it’s really hard to figure out what things are worth, in this market. If you are not a distressed seller, why would you sell in this market? You wouldn’t sell now—unless you had a gun to your head. And a distressed sale will probably show a significant drop from what the project appraised for at the outset.”
Yet there’s another kind of skepticism out there, too: That appraisers may not be negative enough.
Steven Leonard is senior vice-president and partner at NAI BT Commercial, a commercial real estate brokerage in San Rafael, Calif., and a director at Circle Bank, Novato, Calif. And he sees this other view.
“In many markets, there is still a disconnect between appraised value and what someone would really pay for a property,” Leonard explains. “I don’t think appraisers have adjusted down yet, because they base their appraisals on comp values.” And comps, by definition, are in the past tense.
“Everything is worth nothing,” is the problem in many markets, according to Deloitte’s Korologos.
“Extending, not pretending”
While some dispute the sweeping nature of Korologos’ statement (George Mann says there are sufficient sales in many markets to find adequate “comps”) bankers are feeling more than a little pain, and worry about the immediate future.
That ushered in the new policy statement mentioned earlier. When previewing it at the ABA Annual Meeting, FDIC’s Steve Fritts told bankers that, “We support workouts. Workouts should be based on a realistic assessment of the borrower’s and the project’s staying power, and on long-term payment ability, and not just on the value of the collateral.”
He continued, stating that, “We’re going to be looking at how you manage what you are doing [in workouts] and we’re not going to focus on the current valuation of the collateral as you might think. Part of the reason we’re in the problem that we’re in is overreliance on collateral.”
So, Fritts said, the regulators were backing the idea of “extending, but not pretending.” In fact, in a whiff of optimism that doesn’t usually come from a regulator, Fritts pointed out that “experience has proven [that commercial real estate] will always cycle back.”
He added, however, that “the answer will be recalibrated for each one of your customers.”
While there is some optimism in the industry about the new guidelines, that has to be kept in perspective.
“It’s not a silver bullet,” said Korologos. The essential problem is too much debt on too many assets.
“You would need to have a huge recovery or huge inflation to get the deals refinanced with the debt that’s in place,” said Korologos. For many community banks, he continued, the policy statement’s best impact may be as a guide to performing triage on the CRE portfolio.
This will aid both bankers and examiners, Korologos suggested. “This will help with loans that are being marked down because of other loans in the portfolio, that are not necessarily in trouble themselves,” he explained. “It will also help the marginal loans. But my concern is are we institutionalizing ‘pretend and extend’? Are we really dealing with the ultimate problem?”
Reason for optimism
Despite the guidelines’ many skeptics, there are other bankers who view them positively. For example, the banker who related the earlier story of hard-nosed examiners said he saw value in the policy statement, because it clarifies that examiners aren’t supposed to mark down loans just because the collateral value falls.
Colorado’s Doug Scherrer added, “I’m hoping it will allow me to work with the customer who is still making their payments on time.”
But this is no free pass. Former California regulator Walt Mix pointed out that the burden, clearly, in the new statement remains with the banker to get a questioned credit out of purgatory. “And the real problem, that can’t be addressed in the guidance, is the bid-asked differential for the property,” said Mix. No regulatory document is going to improve the market’s view of underlying collateral.
Indeed, he agrees with consultant Patrick O’Keefe, who pointed out that, for all the talk about there being investor money out there for CRE, “it’s there to bottom feed, not to support a stable economy.”
In fact, bankers and other observers of the CRE scene question the implication in the policy statement that CRE investors presently in deals are going to pony up more money in order to improve the status of a deal.
Real-estate types are typically cash-poor, and property-rich, so, with lower values, many would be reaching for thinner wallets today.
In addition, as attorney Walt Moeling put it, “there’s no real estate developer, commercial or residential, who ever intends to repay a loan. If the project pays it, that’s fine. But don’t look to them.”
Workout expert Paul Donohue, partner at Alston & Bird, LLP, added that among the large banks he works with on CRE deals, “you’re finding to a significant extent a lot of kicking the can, in terms of modification and extensions.” But fresh capital, he said, “that’s the rarest word around, from both the owner and the lender perspective, in terms of being willing to put fresh capital into the property.”
There is a sense of waiting for another shoe to drop.
Worrisome predictions are being made by some analysts about the near-term future of CRE. For instance, while lending to owner-occupied projects is typically voiced as a huge positive by community bankers, a recent presentation by Deutsche Bank’s Richard Parkus, head of commercial real estate debt research, called that claim into question.
He stated that 45% of core CRE loans in bank portfolios are classified as owner-occupied. Among the downsides cited: they are likely to be small, special-purpose properties in tertiary markets; they often have an undiversified base of tenants—and are often single tenanted; recourse is typically to an entity with few assets; and, in the event of default, the loss is likely to be very significant.
Add to this such other factors as: a moribund commercial-mortgage-backed securities market, questions about sources of refinancing of CRE loans a few years off, and projections that valuations won’t improve for years. Fitch Ratings recently stated that “Valuations are not likely to improve markedly between now and 2013 when most of the these loans outstanding will come up for renewal. Thus, while banks can delay recognition of the problem, the magnitude of the problem will not change with the simple passage of time.”
ABA economist Keith Leggett recently told a banker group that $400 to $500 billion in CRE credit will need to be refinanced each year through 2012. This is at a time when large banks are pulling back, and community bankers say that they study resultant new opportunities carefully.
To end on a less-bad note, however, commercial broker Steven Leonard thinks there will not be “horrible doom and gloom.” Leonard says that “people will be hurt, but it’s not going to turn the economy on its ear.” BJ
The electronic version of this article available at: http://www.nxtbook.com/nxtbooks/sb/ababj1209/index.php?startid=16
| TechTopics Plus