Loan losses: are they lurking where you're looking? Credit officers discuss the issues

After witnessing dramatic market changes in the lending environment over the past 14 years, some credit professionals have come to view commercial real estate as relatively safe. Others see CRE as a wolf in sheep's clothing, citing slippage in underwriting standards and pricing as well as marginal players moving back into the market. Panelists at RMA's Annual Risk Management Conference representing the large regional banks in the Southeast, Midwest, and West Coast, discussed the current credit for offices, retail, warehouses, and multifamily commercial real estate. They then moved to the consumer portfolio, Basel II and other compliance issues, incentives and compensation, and more.

Commercial Real Estate

"BB&T's experience in commercial real estate has been excellent--right through the recession and continuing today," said Ken Chalk, chief credit officer. "CRE loan losses have been a lot lower than for C&I, in the low single digits and practically no nonperformers." Chalk felt this to be the case for most banks. "The financial and Fed information we've seen as well as some studies from Moody's all show that our commercial real estate portfolios are performing exceedingly well." BB&T is a $97.9 billion financial holding company headquartered in Winston-Salem, North Carolina.

Why? Chalk pointed to better, more cautious underwriting than was seen back in the 1980s and 1990s, with deals requiring more equity now than 12-15 years ago. More care is taken with appraisals.

"But you also have to consider the external factors," he said. The capital markets have added liquidity and discipline, which was not the case during the previous recession, when CRE was a problem. Low interest rates also have been a strong factor, and any future problems are more about rising interest rates and oversupply than banks' portfolio management.

"If the scenario back in 1991 was driven by the perfect storm, I think the scenario in 2002-03 must be the perfect day," said Kevin Blakely, EVP and chief credit policy officer of Cleveland, Ohio-based KeyCorp, a $90 billion company. "We're not experiencing much in the way of credit quality issues anywhere in the industry, and there is much to be said about the disciplinary effect of the capital markets on publicly traded entities. The availability of conduits allows us to unload products into the market, while at the same time helping to set underwriting standards to ensure we don't get too far out of line." Blakely acknowledged, however, that low interest rates have created an environment that can mask a lot of mistakes; as interest rates rise, so will problems. He also noted some deterioration in underwriting standards--less recourse being given and less equity going into deals. "The condo market is beginning to look a little spooky, particularly in the Southeast," he said. But he believed the overall picture remains strong.

"The argument we hear from the line is that balance sheets are stronger," said James Henry, SEVP and chief credit officer of Bank of the West, a $40 billion California-based commercial bank. "But I'm seeing looser structures in the past 18 months and equity falling to minuscule levels." Henry admitted that his bank's portfolio is mimicking those of BB&T and KeyCorp, but added, "It's where we go from here [that concerns me]."

Henry said that in the West, a number of smaller developers are being acquired. "The mid-level developers are almost all gone because the public companies and the larger private companies cannot get entitlements quickly enough to keep producing the profit levels that they want to produce," he said. "So there has been pressure to work with larger developers on their programs; keeping up to speed with them has been difficult because of the positive aspects of the California and West Coast real estate market."

Chalk said that single-family housing has performed better than other CRE portfolios. With more people moving to the Southeast, the demographics favor single-family construction; low interest rates are another factor in the expansion of single-family housing construction. "Our builders have been selling houses as fast at they can build them," said Chalk. "Also, there is a limit on the supply, because it now takes longer to go through the permitting process--the hurdles of subdivision approval are keeping the supply lower in some of the faster-growing markets." Rising housing prices could be a problem in the long term, but currently demand and supply are about equal.

Blakely agreed that single-family housing has been a very robust market. "I do worry about the effect of rising interest rates," he said, which could cause a considerable slowdown in that market, although it could help multifamily housing. "I think one reason multifamily has been having difficulty is because low interest rates have allowed more people to afford a single-family home." He recalled having lived in the Washington, D.C. market in 1990, where he witnessed the market going from one or two days' worth of product in April to more than a year's worth by the following August. "It can change dramatically over a short period of time, so we need to keep a close watch on these two markets as interest rates begin to shift," he said.

Leveraged Lending

Leverage is moving up dramatically both in large deals and middle-market deals, Blakely observed. "The junk bond market is as frothy as ever and, in fact, it reminds me of the environment in 1998," he said. "If you look at some of the big deals of recent weeks, one fairly large deal had a leverage multiple of 7.5 times. That deal was oversubscribed, which tells me that the market has rebounded very, very quickly. The blood is hardly dry on the floor after the last round, and already we've jumped back up to where we were in 1998. The junk debt market provides a lot of liquidity to leveraged loans right now, but that market is here today and gone tomorrow. All it takes is a real shock to the system. If there is a terrorist attack, for example, you'll see the junk bond market shut down just as it did in 1998 when the Russian debt crisis hit. The junk bond market is a source of liquidity for restructuring leveraged loans--particularly for problem leveraged loans. It just amazes me how quickly we've forgotten the lessons of 2000."

Blakely recalled a comment from an earlier presentation at the conference to the effect that increased multiples being applied to these deals are just continuing to go up.

Retail

Economist Susan Hudson-Wilson had delivered a keynote address earlier in the conference that outlined regional successes and failures but stressed the concern all institutions should have about the increasingly stressed consumer. Henry said Bank of the West's $9 billion consumer portfolio, which constitutes more than a third of the bank's asset portfolio, is at all-time lows in delinquencies. "We participate only in the A market and maybe a little bit in the B market. Credit scores are going up even as our credit losses remain static," he said. "And it's unbelievable the amount of recoveries we're having. We don't know why, but the consumer is holding up well, and ours is a national portfolio with a variety of specialties." Recalling his own earlier comment, however, Henry said, "It's pretty scary not to know where we're going to go from here."

Chalk said he believes the consumer portfolio to be the one that "scares me the most, and it's not because of current performance. If you review the roots of problems of the 1980s, high leverage and fast loan growth were like mirror images. Remember the LBOs [leveraged buyouts]? We had high leverage and fast growth followed by credit problems. Then in the late 1990s the corporate market was getting more leveraged, which was the source of banks' growth. Credit problems then followed. And now we're seeing leverage with the consumer; if you look at most banks' balance sheets, you'll see that's where we're getting much of our growth. There will be a change. Ultimately after this fast growth, high leverage will have its impact on our portfolios. Not that things are going to break down tomorrow or immediately, but look out in 2005 or 2006."

On the other hand, Blakely said, "The overall performance of the consumer portfolio has been very good, and it continues to get better. It's sort of a phenomenon--I keep hearing about the consumer being so leveraged, and yet the performance keeps getting better and better. Our quarter-over-quarter, month-over-month, and year-over-year performance continues to do better in just about every category we have. So many people point to the consumer as the next battlefield; we're all focused on it, we're all worried about it, and you know what that means? That means the consumer is not where the problem's going to come from. It always comes from some place where we're not focused. The consumer portfolio is performing so well right now, we could take on more delinquency and losses for quite some time before it really gets to a bad point."

Blakely commented that inasmuch as the amount of capital that's assigned to consumer loans tends to be relatively low because expected losses are more consistent and less volatile than in commercial portfolios. Recognizing this, banking regulators understand that unexpected losses, which are covered by capital, can actually be less than many commercial portfolios. Chalk did not sense movement toward greater capital requirements for the consumer portfolio, either, and Henry added that even with the "Basel effect" [of heightened data- and loss-methodology requirements to keep heightened capital requirements at bay], he felt Bank of the West was in good shape already. "We have a culture and a strategy built around [good risk management], and we're going to execute on those because that's what our staff is trained to do."

Compliance

With regulators currently focusing on anti-money-laundering processes, corporate governance, and consumer privacy, Blakely felt other concerns would be pushed to a back burner for the foreseeable future. Congress is very focused on those areas, he said, and when regulators don't exhibit the same degree of focus, Congress begins to criticize them for it, sometimes even threatening to take away their authority. Chalk agreed, saying BB&T is devoting much of its time now on BSA [Bank Secrecy Act], the Patriot Act, and fair lending compliance issues. "One other thing we're hearing about now, though, is economic capital," he said. "We're not a Basel opt-in bank, yet our regulators are asking a lot of questions about economic capital. I believe this emphasis will filter down to even the smaller banks. So every bank must prove its case for how much capital it is allocating to various lines of business and various products."

Blakely agrees that banks will be expected to move down the path toward getting ready for Basel II. In fact, he believes that pressure will build to the point that Basel II begins to set best-practices expectations. "Part of Basel II is the disclosure of information, and I can guarantee that as we sec the mandatory and optin banks begin to disclose more and more information about the content of their risk, there is going to be enormous pressure on those that have not opted in to disclose the same kind of information. Here's another example of this kind of pressure: Let's say BB&T opts in and proceeds to develop an excellent economic capital model with a 20-grade, two-dimensional grading system. The regulators are likely to take a look and decide that if BB&T can do it, others should be doing it, too. If you're already being pressured for greater disclosure and other 'best practices,' you may as well jump in and get the potential benefits of Basel II."

Meanwhile, Henry believes that "regulators are playing off the Sarbanes-Oxley attitude of 'show me--don't tell me' concerning operational policies and procedures," said Henry, adding that understanding the level of operational risk exposure soon will be elevated to the need to understand the level of credit risk exposure. "Our stance is we're going to wait for it, however. We'll wait for the industry consultants and software people who create the 'plug-and-play' version after the leaders figure out how to do it--hopefully, at a third of the price."

"Regardless, at least a third, maybe half, of my time now is spent on Sarbanes-Oxley, Patriot Act, BSA, and other operational risk compliance issues," said Chalk, echoing the thoughts of many chief credit officers. "I used to come to work every day to address one main question: Are we making good loans? Now a tremendous amount of time is devoted to compliance, although there is no choice but to do it, so it's just part of the job. My concern, though, is that this shifts our attention from economic risks, which most certainly are risks to your shareholders as well."

"Compliance checks require far greater scrutiny now," said Henry. "Our compliance people posted the bank's first intranet compliance check-off list; I completed it and sent it in, only to had to include a comment on every line item.

This list had been developed for us--at no small expense--by consultants for our CPAs to sign off on, but it's not what's needed for SOX. So we have a relatively useless document, one that I do not feel comfortable signing off on."

Compensation and Incentives

For better or worse, it's fairly uniform for institutions to pay credit officers less than they pay line lenders, noted Chalk. He believes part of that is because banks had few lenders on board during the recession and then had to scramble to get talent. Many institutions cut back on training and on hiring in 2000-2001 and are spending that money and more in incentives. "There are not enough qualified commercial lenders, so the industry is adding more and more incentive compensation for the line lenders," said Chalk. "The challenge is to have a balance between discipline and incentives. So part of BB&T's incentive matrix is related to growth and production, but we're keeping a component that's related to loan pricing and profitability, and a third component that's related to asset quality."

KeyCorp has recently begun a program called DHP--Designated High Performer. Key begins with an incentive pool driven 50% by performance of the line of business and 50% by performance of the corporation itself. Once the size of the pool has been determined, the DHP process numerically rates people on a variety of criteria, including teamwork for credit people and relationships for lenders, credit quality, the performance of the line of business, and so forth.

Their peers, bosses, and the line rate credit staffs. Peers, supervisors, and credit staffs like wise rate lenders. "If you're a lender or a credit officer, your numeric score ranks you according to everybody else," explained Blakely. "If you're at the top end of the score bracket, you get a greater share of the overall pool; if you're at the bottom end of that bracket, you're quite likely going to get nothing. In fact, it's part of the plan that the bottom 10% won't get anything." Blakely agreed with Chalk that credit people routinely believe they are paid less than lenders, but noted that both groups believe they are paid less than investment bankers.

Syndicated Lending

Blakely believes that the ethical issues surrounding some syndicated lending have come to the fore in this lending facet. In the case of derivatives, Blakely said, "suppose that you're an underwriter of a $500 million deal, and you take down a larger portion than in the past because this relationship is important to you. So perhaps you sell $350 million of it to participating banks, and you're left with $150 million on your books. You feel uncomfortable with that size of an exposure, so you buy a credit derivative to bring down that exposure, to cover $100-125 million or $125 million. What happens when your client gets into trouble? You're on the horns of a dilemma: Do you hope that the client goes under so that your credit derivative pays off, or do you work hard to ensure that you're looking after the client, as well as all your syndication banks? Similarly, if you buy into a large piece of a syndicated deal and buy a credit derivative to protect yourself, does that make you more obstinate when it comes to a workout of that deal because you want it to collapse so that your credit derivative will pay off? This development in the credit derivatives market is creating some interesting dynamics in syndicated lending."

While none of the participants is heavily involved in the syndicated market, Chalk allowed that BB&T has been approached about it. Because of consolidation in the banking industry as well as among corporate clients, Citibank, Bank of America, JPMorgan Chase, and Wachovia now dominate syndicated lending. "More of our clients or prospective clients are asking us to join a syndication," said Chalk. "We have rules about anti-tying; well, the reverse of that is clients telling us that if we hold any kind of noncredit business with their companies, we must be in the syndication. I suspect that a number of regional banks could be getting involved in syndicated lending now. So our challenge is to maintain our discipline and to have the same hold limits for syndicated credits that we would for credits we've made on our own."

Contact Beverly Foster by e-mail at [email protected].

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