s week, MortgageOrb spoke with Doug Keipper, the national risk manager of commercial real estate (CRE) for North Hollywood, Calif.-based Banker's Toolbox[/b]. The company provides software to help financial institutions improve risk management with anti-money laundering, fraud detection and CRE portfolio analysis tools. Keipper explains the dangers now lurking in CRE portfolios and how the industry can better manage risk going forward. [b]Q:[/b] What steps should be taken in the industry at large to increase mortgage risk awareness and understanding for banks when the market recovers and commercial mortgage-backed securities return? [b]Doug Keipper:[/b] Increased risk awareness and better portfolio management are vital in helping banks avoid further loan loss and recover more quickly as the market turns around. The two steps in this process are, first, understanding your CRE loan portfolio and, second, applying stress testing to that portfolio. Bank lenders should really get to know their CRE loan portfolio. This doesn't mean simply chatting occasionally with the principals involved. It means really understanding the business in which they are involved. Lenders should know the product being manufactured or the service being provided, as well as its business cycle. More specifically, obtain current financial statements and tax returns on both the business and the guarantors. Analyze and understand the financials thoroughly, making sure that entries on the tax returns are accounted for in the financial statements. Calculate net worth for liquid assets and do not rely on investments in real estate, joint ventures and partnerships to service the debt payments at your institution. Maintain current values at all times. This does not necessarily entail spending money on a new appraisal. By maintaining current rent rolls, any lender with a financial calculator can arrive at a current value. As a follow-up, verify this information with frequent on-site inspections. After achieving a better understanding of a CRE loan portfolio, turn to the future. CRE stress testing, which should not be confused with the regulators' stress testing the nation's largest institutions, evaluates how individual segments, as well as the total CRE portfolio, will respond to changes in projected gross income, vacancy rates and interest rates. Lenders should stress test at least every quarter and adjust payments and/or the borrower's equity position when contractually able to accommodate any changes. Also, use this information in the methodology for calculating the loan loss reserve as well as the capital planning and budgeting processes. [b]Q:[/b] How far along into the commercial mortgage refi crisis do you think we are? How much more pain is ahead for borrowers and lenders? [b]Keipper:[/b] Lenders continue to be challenged by an economy still in recession and high levels of unemployment. These factors contribute to increasing loan delinquencies – not only in the CRE market (including the multifamily sector) but also in C&I lending. [u][link=http://web.mit.edu/cre/research/credl/rca.html]Moodys/REAL Commercial Property Price Index[/link][/u] could stop falling as early as the end of the year. The bad news is that recovery will be slow for commercial mortgage lenders. The good news is that stress testing now can help CRE lenders know what they are up against and to form risk awareness and portfolio-management plans to increase survival through these tumultuous times. [b]Q:[/b] What should a bank keep in mind when shopping for a stress-test software system (or any piece of new software)? What are the possible pitfalls? [b]Keipper:[/b] There are several commonsense factors that should be considered when shopping for a stress-test software system: The vendor's reputation and track record of success. Is the vendor SAS-70 certified? Will they provide company financials and references? [list]*The software's ability to perform testing on your timetable and frequency. *The software's ability to stress test multiple factors. A stable downtown apartment loan may warrant a milder stress for vacancy, because there are long-term leases with low turnover. *The software's ability to analyze the effects on asset quality, earnings and capital. This language is specifically detailed in the Interagency Guidance, as well as in numerous cease and desist orders issued against institutions and pursuant to Section 8b of the FDI Act. [/list] CRE stress testing is simple, but that does not mean a bank can afford to purchase the bare minimum. A common pitfall is purchasing technology that does not have the adequate customer and technical support – software that doesn't actually protect. With a bank's livelihood potentially resting on CRE risk management, the bank must know that their software was developed and is supported by former FDIC examiners, bankers and regulatory experts. If a bank is not fortunate enough to have these people on staff, then they should make sure their vendors do. [b]Q:[/b] What important patterns are emerging in trouble spots that banks are now finding in their portfolios (e.g., loan type, geographic distribution, property sector, etc.)? [b]Keipper:[/b] Due to the increase in unemployment and decrease in consumer spending, retail and service businesses are suffering the most. Vacancies are rising, starting with retail strip malls, and will spread to industrial and office buildings. As unemployed or under-employed people look for roommates or move back to their parents' houses, vacancies in apartment buildings will rise. Banks will continue to see trouble spots in their acquisition and development portfolios, as many projects have failed, and lenders are asking borrowers to continue to pay interest out-of-pocket or face foreclosure. Owner-occupied CRE was built in anticipation of other development projects, and when the developments failed, all businesses around it suffered similar fates. Another indicator of CRE trouble spots is seen in areas of the country hit hardest by the residential mortgage crisis. These cities and states showed the first signs of the CRE crisis. [u][link=http://www.bankerstoolbox.com/application/charts.html]Here[/link][/u] is a list of the top 10 states with the highest rise in CRE loan delinquencies. (Please note, the graph, which was compiled from FDIC call reports, excludes states with less than $10 billion in CRE loans.) [b]Q:[/b] In general, how are community banks and other smaller institutions faring in the CRE downturn? Are they more immune than the larger players? [b]Keipper:[/b] As of July 31, the FDIC had closed a total of 69 financial institutions. Fifty-nine of those met the regulatory definition of a ‘small bank,’ with assets of $1.109 billion or less. As [u][link=http://www.bankerstoolbox.com/application/charts.html]this chart[/link][/u] demonstrates, community banks and smaller financial institutions are experiencing more CRE delinquencies than banks with more than $1 billion in assets. In a down market, class A or high-rise buildings will do better than individually owned class B or C buildings. Class A buildings, which typically receive their loans from regional or nationwide banks, will lower their rents by offering free rent, rather than lower per-square-foot rent to reduce their vacancy rate. Tenants in class B and C buildings now find that class A buildings are more affordable and are moving their offices. Therefore, class B and C buildings have higher vacancy rates. Community banks may also be exposed to great CRE delinquency due to the nature of their business. Community-based financial institutions typically finance credits on a relationship basis. Often, these credits are not as strong on paper, and lenders rely on the character of the principal and/or guarantors. When the economy declines, these businesses are hit hard. Community banks also have less access to the capital markets. Typically, their only source of capital is the personal net worth of the board of directors. These individuals may have businesses that are suffering, and they may be unable or unwilling to invest more of their assets in the institu
