Watchdog Says FDIC Failed On Commercial Loans

Bloomberg

The Federal Deposit Insurance Corp. failed to enforce its own guidelines to rein in excessive commercial real estate lending by at least 20 banks that later collapsed, reports by the agency’s watchdog show.

The FDIC’s Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency’s examiners didn’t identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed. The findings are in separate reports posted this year on the inspector general’s Web site.

“It’s often we’ll see in our reports that the FDIC detected problems in the bank in a timely fashion, but in some cases forceful corrective action wasn’t required by the FDIC to be taken quickly enough,” Jon Rymer, the FDIC’s inspector general, said in a telephone interview.

The failure to follow up on the 2006 recommendation, that banks avoid letting commercial real-estate holdings exceed 300 percent of capital, has emerged as FDIC Chairman Sheila Bair steps up her effort to expand the agency’s role in regulating the financial-services industry.

Bair, a 55-year-old appointed by President George W. Bush, is lobbying the Democratic-led Congress to give the FDIC the authority to unwind any failing bank holding companies. The FDIC’s powers are limited to disassembling commercial banks and thrifts, and it lacks authority to unwind Federal Reserve- regulated holding companies such as New York-based Citigroup Inc. and Bank of America Corp. in Charlotte, North Carolina, that have businesses beyond taking deposits and making loans.

‘Stopped It’

“We should ask the prudential regulators why they did not do more to push banks to pay attention to their guidance,” Representative Brad Miller, a Democrat from North Carolina, said in an interview. “If they thought their conduct was unsafe, it’s unsound, they certainly should have stopped it.”

Miller sits on the House Financial Services Committee, which oversees the FDIC and the banking industry.

“We are in process of addressing any existing gaps in supervisory policy with respect to commercial real estate lending,” FDIC spokesman Andrew Gray said in a prepared statement. “The FDIC has also stepped up our off-site surveillance program to assist our examiners in targeting those institutions with elevated risk profiles so that corrective action programs are instituted in a timely and constructive manner.”

Fed, OCC, OTS

The Federal Reserve, Office of the Comptroller of the Currency and Office of Thrift Supervision have been faulted this year by their watchdogs for not reining in commercial real estate lending in reports issued on failed banks they supervised. Inspector generals for the regulators released 12 reports, about half the number completed by the FDIC’s watchdog.

Regulators have closed 99 financial institutions this year, the most since the 179 in 1992 during the savings-and-loan crisis. Matthew Anderson, a partner with Oakland, California- based Foresight Analytics LLC, a real-estate market consulting firm, said the number of failed banks will climb rapidly in part because delinquency rates on commercial real estate mortgages are “rising substantially.”

Defaults on commercial real estate loans totaled $110 billion, or 6 percent of all such loans, in the second quarter. That’s about 11 times the level in the fourth quarter of 2006 when the guidelines were released. Defaults may rise to $170 billion by the fourth quarter of 2010, Foresight Analytics said.

Community Banks

The risks are greater for community banks with assets of $10 billion or less, Anderson said, because commercial real estate loans make up a bigger percentage of their business. Smaller banks don’t have the capital to compete with large banks for mortgages and consumer loans, so they turn to local-market lending, where they have an advantage.

Commercial real estate loans will pose the biggest risk to banks for several quarters, Bair told Congress on Oct. 14.

Declining real-estate values caused by rising vacancies, falling rental rates and weak sales are contributing to losses, Comptroller of the Currency John Dugan, the regulator of national banks, said at the same congressional hearing.

Along with Dugan and the Federal Reserve, the FDIC in 2006 set a threshold -- 300 percent of a bank’s capital -- for safe levels of commercial real estate loans. The guidance was aimed at helping regulators identify banks with high loan concentrations that warranted greater supervisory scrutiny.

At the time, smaller and mid-sized banks opposed the guidelines. Bankers said they feared federal examiners would treat the thresholds as absolute limits, threatening a lucrative business for community lenders.

‘Boom Times’

The regulators said the thresholds were not limits and that federal bank examiners would use the guidelines to identify lenders with risky levels of such loans.

“The guidance was put out in boom times,” said Kevin Petrasic, a lawyer at Paul, Hastings, Janofsky & Walker LLP in Washington and former special counsel at the Office of Thrift Supervision. “Profits were very high. There wasn’t a full realization of what we were staring at.”

The FDIC reiterated the importance of strong capital and risk-management practices for banks with high concentrations of commercial real-estate loans in a March 2008 letter.

By September 2008, commercial real-estate loans represented 1,329 percent of total capital at Security Pacific Bank in Los Angeles, a bank that collapsed two months later. The level “far exceeded the capital criteria thresholds for additional supervisory oversight,” according to a review in May by the FDIC inspector general.

The bank’s failure cost the FDIC fund about $210 million.

FirstBank Financial

In December 2007, FirstBank Financial Services of McDonough, Georgia, had concentrations of 645 percent, more than double the recommendation.

The FDIC didn’t take any enforcement action until 2008 “when there were significant and quantifiable losses in the bank’s loan portfolio,” the inspector general found. The bank failed in February, costing the FDIC fund about $111 million.

The FDIC and state regulators were slow resolving banks with other issues. It took almost two years to shut New Frontier Bank, the largest lender in northern Colorado with $2 billion in assets, after agencies identified in mid-2007 a rise in soured loans, increased reliance on volatile funding and weak management. State regulators shut the bank April 10.

Bair, Dugan and Timothy Ward, the Office of Thrift Supervision’s deputy director of examinations, supervision and consumer protection, said last week they are planning to issue guidelines on how to modify troubled commercial real-estate loans to reduce defaults.

$1.8 Trillion

U.S. banks held $1.8 trillion in commercial real-estate loans as of the second quarter, representing 24 percent of outstanding bank loans, according to Foresight Analytics. Commercial real estate loans represent 39 percent of the $4.7 trillion in total real-estate loans.

Of 95 U.S. bank failures before September, 71 were caused by non-performing commercial real-estate loans, said Chip MacDonald, a partner specializing in financial services at Atlanta-based law firm Jones Day.

“The supervisory process has to have more consistency in the good times and not just in the bad times,” said John Bovenzi, a partner at Oliver Wyman, a New York-based management consulting firm, and FDIC chief operating officer until this year. “It’s historically been harder to show effectively that changes need to be made when times are good.”

Deposit Fund

A surge in bank closings pushed the FDIC deposit insurance fund, which pays the cost of unwinding failed institutions, into a deficit, requiring the FDIC to replenish the reserve without overburdening hobbled banks. Last month, it proposed that banks prepay three years of premiums to raise $45 billion.

Bair told a Senate subcommittee on Oct. 14 that bank failures will continue to rise, reaching a peak next year, while costing the fund $100 billion through 2013.

Some analysts are more pessimistic. Christopher Whalen, managing director of Institutional Risk Analytics, a Torrance, California, firm that evaluates banks for investors, said the deposit fund will run a deficit of $300 billion to $400 billion and about 1,000 banks will fail or be merged through 2012.

The FDIC supervised 5,039 banks of the 8,195 commercial banks and savings institutions as of June 30, according to the agency. The FDIC and state regulators share oversight, and each sends examiners to the banks on average every other year.

“We should have been more strict,” Joseph Smith, North Carolina’s bank commissioner and chairman of the Conference of State Bank Supervisors, said in a telephone interview. Two banks have failed in Smith’s state this year.

“Had we required the reduction of CRE lending, it would have been thought of as an intrusion by regulators into the businesses of banks and to the operations of local economies,” Smith said. “Yes, it would have been the right thing to do. It would have caused a firestorm then. That might have been better than a firestorm now.”