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The probing eyes of the regulators.

It is probably safe to say that people still making a living in today's commercial real estate market--lenders, investors, brokers and servicers included--have lerned to function under the weight of severe psychological stress--even to the point where they can remain alert despite nightly bouts of chronic insomnia and near-crippling indigestion.

Battle-hardened and street tough, they have seen the worst and survived, almost...maybe. They look toward the future and it's cloudy, at best. In their world, turmoil and confusion reign. Fortunes have been decimated, major financial institutions blown away and billions of dollars in precious capital swallowed by the black hole of "special assets" departments.

Even the "healthy" lending institutions have become increasingly unnerved, even paranoid, suspecting that deep inside their state's bureaucratic jungle, some fresh-faced examiner may be diligently at work preparing a case against them. Or, it might be their own internal audit committee planning a surprise visit. Everywhere, commercial real estate departments have become targets of "investigations," "fact-finding missions" and "special reports." And it seems to be getting worse day by day.

The questions fly like scuds over the Gulf. What is the current net operating income, debt coverage ratio, discounted cash flow and net realizable value calculations on this property? Have you noticed any significant deterioration in the net worth of your number-six develop client? What makes you think the cash flows on that strip shopping center in Atlanta will improve over the next six months? What are you doing about it?

Everybody wants to know the answers: the Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS), rating agencies, stockholders, investment bankers, your board of directors, asset-liability committee and credit "czar," as well as the media, customers and employees. Even your normally nonexistent Aunt Margaret, who placed her entire life savings with your trust department (at your recommendation, of course) inquires about the status of your loan-loss ratio and net-interest margin.

So, just when did this horror show begin?

Some would say April 12, 1990, the day the OCC released the news that it was "tightening up on real estate lending." OCC officials said that while the rules have not changed, economic conditions have. With the reverberations of the S&L catastrophe ringing in its ears, the OCC decided to significantly upgrade and re-energize its inspection process. It would begin to dig deeper into loan files, dissect departmental policies and procedures and more keenly judge organizational effectiveness and performance. Penalties would be levied; institutions closed.

Like peals of thunder over a Kansas sky, the announcements hit the press. OCC inspections uncovered huge potential losses in regional bank portfolios, requiring massive write-downs. Instead of distributing stock dividends this year, banks had to allocate earnings to loan-loss reserves and, in the same breath, maintain new core and risk-based capital standards. Bank stocks got hit by all the bad news. A major regional bank failed. Insurance companies came under fire; they too were forced to defend a decade of real estate investment decisions.

OCC crackdown

Ric Tomlinson, president of Univest Financial Group, an Atlanta-based loan portfolio services firm said, "In many cases, the OCC audits uncovered cases of sloppy underwriting and poorly constructed covenants. Mistakes can happen, but what really upset the examiners was that many departments lacked access to critical loan information--or it was never collected in the first place," he said.

Of course, this was not uniformly the case, but the regulators developed their own perception of the problems, with the acute memory of regulatory failure in terms of the thrift crisis still fresh in their minds.

"Without information, loan officers were unable to detect the early warning signals, such as failure to pay taxes, declining rent rolls, special concessions or crashing local absorption rates. Even if the information was available in the files, it wasn't used to identify or track market- or property-specific trends. You could see many banks making the same mistakes over and over," said Tomlinson.

According to Tomlinson and others in the commercial mortgage industry, the OCC audits served to heighten the attention on internal operations; primarily, on how information was collected and analyzed and how information was used in the decision-making and business-planning process. Banks had plenty of computerized models for evaluating interest-rate and balance-sheet risk; but then they had to contend with credit risk, a more complex and dangerous beast, because several regional commercial property markets were sinking fast or, at best, holding steady.

"A year-and-a-half ago, we were still basking in the glow of a high-growth, commercial real estate market," said Nelson Hurt, banking industry analyst for the Northeast office of the OCC. "The aggressive, deal-driven, investment environment drove more and more banks to the edge of the risk threshold. The OCC was concerned that some institutions had failed to offset this go-go mentality with an equal commitment to implementing strong internal controls," Hurt said.

"When the Northeast economy slowed somewhat and rents started to drop, the loans' economic distress was magnified by the presence of severe legal and underwriting deficiencies," Hurt said. "Write-downs were inevitable, but what was particularly unsettling was that we found so many violations of what we believe is sound lending practice."

Some sources within the financial community say the banking industry was dragged "kicking and screaming" into the future by the OCC's actions. But then hindsight benefits from 20/20 vision anyway, and those same critics probably would have been the first to applaud these investments, and the banks that made them, had the go-go markets held strong.

However, as with any process of change, at first, some bank managers refused to recognize the existence of the problem. After all, traditional practices had served them well in making past lending decisions. Furthermore, senior lending officials tended to be important community figures, providers of fuel for the local economy, and often were friends and business partners with the region's leading builder-developers.

Meanwhile, deep in the heart of Texas

However, in one particular region of the country, the specter of financial disaster was very real indeed.

"In 1988 and 1989, we learned just how bad things could get; that's when the Texas real estate market hit rock bottom," says Rob Watson, president of Melson and Associates of Dallas. The management consulting firm uses its Texas experience to help lenders identify problems and develop proactive business plans.

"When we go into a shop today and look at the operation objectively, we can relate it to the experience of living through Texas, where one of the hottest real estate markets in the nation crashed and burned in a matter of microseconds," Watson said.

"In fact, until the other shoe dropped in New England, nobody believed it could happen to them, or that it could be so devastating," he said. "Now they know."

This realization, along with the added pressure of the OCC inspections, led many commercial bankers to seek third-party support from financial services management consulting firms, as well as from professional accounting and asset-management firms.

Rob Adair of BEI Real Estate Service, also based in Dallas, agrees. "To the extent the OCC turned up the heat on the examinations, they certainly commanded the attention of the banking and real estate community. In every institution, senior management and boards of directors began asking more questions, and they were the right questions, too."

edair said, "Shortly after the OCC meeting last year, we began to get calls from clients interested in how we could help prepare them for impending OCC/OTS examinations. Some had just gone through an audit and needed some refinement, while others were mildly shell-shocked."

According to Adair, BEI's real estate clients were anxious about the examiner's insatiable appetite for complex and detailed information--information that was often stored away in a vault, in another building or under a different database system--thus, it was virtually inaccessible.

A new breed of examiner, filled with the passion of reform, demanded to see the most current appraisals, preferably done by an MAI appraiser (Member, Appraisal Institute) and not prepared by in-house appraisal staff. These new examiners also requested quarterly, or better, operating statements and inspection reports and realistic assessments of "value," based on discounted cash flow and net realizable value calculations.

If a loan officer was unable to demonstrate the economic viability of a suspect property, perhaps kept alive through a series of loan modifications and restructures, interest abatements, delays of principal payment, capitalizations of unpaid interest or other similar techniques, the property was reclassified as an "insubstance foreclosure" and thrown into the special-assets pool with other troubled properties.

Depending on the number and severity of write-downs, regulators required adjustments to the bank's loan-loss reserve account, which, in turn, devoured the last morsel of profit at many institutions. The local press was quick to provide sensationalized reports on institutions' worsening financial condition: camera crews hunted down and interviewed worried depositors and annual-report writers struggled to put an upside slant to their presidents' messages.

At many institutions, an OCC audit left a trail of resignations and recriminations. But for others, it became a time of reflection; a time to reconsider the basic tenets of the commercial mortgage banking business, the role of the investor and the responsibilities of the originator and servicer.

A new perspective

Accepting this new reality, many commercial lending departments began making the transition from a "production-driven" to an "asset-management-driven" culture. At Pittsburgh National Bank for example, loan officers are now spending 90 percent of their time on issues relating to loan administration compared to just 10 percent on new production. A few years earlier, the split was 60-40 in favor of new production.

"When commercial lending became a major focus of the OCC, we had already developed our systems to the point where we could effectively manage the portfolio on a loan-by-loan and macro basis," says William Nicholson, senior vice president for commercial real estate for Pittsburgh National, the largest unit of PNC Financial, a $46 billion holding company. "All of our files had been audited, consolidated and organized, and we had begun constructing a loan-management database system with analytical capabilities."

Fvie years ago, PNC's commercial real estate group began to perform basic macro-stratifications on its portfolio, sorting by geographic concentration, property type, developer and other key factors. Nicholson says, "As a result, we developed insights into the character of our portfolio. We made smarter decisions and were able to steer more confidently through some economic rough spots. I believe our commitment to systems technology was one of the main reasons we have fared better than other banks our size."

Nicholson specifically mentioned a software package that analyzes the financial feasibility of any type of commercial development. The software provides detailed income and expense projections on a tenant-by-tenant basis for up to 31 years. It applies such factors as expenses, expense pass-throughs, growth rates, market rates, capital expenditures, commissions and payouts to produce a variety of financial and operational feasibility reports.

"Intelligent lenders balance risk with a property's potential return, then produce a matrix of risk/reward decisions in the context of prevailing market forces," Nicholson said.

"Times have changed--what worked for commercial loan departments during periods of economic growth and expansion is inappropriate in today's more selective and quality-conscious lending environment," Nicholson added.

Insurance companies remain America's leading holder of commercial real estate risk, and they, too, are becoming incresingly cautious and concerned about loan quality. Ralph Bergholtz, servicing manager for Allstate Insurance Company, Northbrook, Illinois, said that Allstate has tightened all of its standard underwriting parameters and is asking its servicers, including Holliday Fenoglio Dockerty & Gibson, Inc. of Houston, to take a closer took at the financial condition of each property, borrower and anchor tenant. Like most large institutional investors, Allstate now collects updated data from annual reviews and inspections, and the company more closely tracks operating data, lease and rent roll information.

"The insurance industry is extremely 'ratings conscious'," Bergholtz says. "Not only do we answer to the same rating agencies as the banks--Standard and Poor's, Moody's, Duff and Phelps--we are examined by Best's Review, an insurance industry ratings service that directly affects our reputation and ability to market products."

"We're looking to our correspondents and servicers for more information and more sophisticated analysis on our properties. The overall level of expertise in the mortgage servicing area will have to increase; servicing personne will have to become more professional and more attuned to the total portfolio management concept," he said.

Linda Jones, manager of Holliday Fenoglio's servicing department and a former vice chairperson of the Mortgage Bankers Association of America's (MBA) Commercial Mortgage and Asset Administration Committee, said, "We rely on our own in-house research department to provide our lenders with market-factor information by location and property type. In addition, we've beefed up our computer system to provide more detailed management reports and portfolio performance analysis."

Jones said, "The number-one project for many of our lenders is to value their loan portfolios. In fact, we are seeing an increasing number of our lenders' production staff becoming involved in this process."

Many readers may be thinking that enhanced information management and sophisticated modeling sound nice, but that more pressing problems demand their attention; an impending foreclosure, the annual profit (loss) report is due or perhaps they are in the middle of a servicing system conversion.

"The new technology is wonderful," they might say, "but I'm drowning in a sea of information as it is. Plus, I'd hate to start digging into those files--it's a "Pandora's Box'--I'm not sure I want to see everything that is in there." Industry advisors counter that if lenders don't audit their files now, they may not have a choice later.

Take out the garbage

To fully implement any information management program, institutional lenders and commercial banking operations need to invest in a complete audit of their loan files. An updated appraisal and underwriting analysis may also be necessary. Unless the audit is performed by appropriately skilled professionals, often including real estate attorneys, CPAs and MAIs, the "garbage-in, garbage-out" syndrome applies. The information generated must be pure and transportable.

A full file audit costs anywhere from $200 to $1,500 per file, depending on whether the institution wants a quick cursory review, or the works. Either the mortgage banker or a contract due-diligence firm begins by consolidating and transferring every piece of paper into a database. Outstanding data elements relating to the current operating statement, the borrower's credit position and the property's tenant base must be collected.

"We've known for a long time that 100-percent due diligence would become an industry standard for all loan portfolios," said Univest's Tomlinson. Univest uses what it considers state-of-the-art residential and commercial real estate audit and analytical methodologies.

"On the residential side, the days of random samples and two-stack audits are over. Investors won't but it; neither will [Fannie Mae or Freddie Mac] or the regulators," Tomlinson says. "Just like the residential market of the early 1980s, the commercial real estate industry is liquefying; there's more talk of standardization and securitization. In a buyer's market, sellers of mortgage product must complete loan-by-loan, page-by-page audits in order to produce creditable investor presentations. Simply put, information drives the sale and enhances any execution."

In 1986, when FSLIC made a valiant but quixotic damage-control effort during the thrift crisis, Univest helped develop a resolution process that remains in common use. "Through hard experience, and in an effort to optimize the liquidation value of regulatory-controlled assets, we continued to push the issue of 100-percent due diligence," Tomlinson said. "Every data element would be archieved on a dynamic system that could change with the times."

Recognizing the 100-percent file audits are time-and money-consuming monsters, Univest developed a fully automated, comprehensive portfolio-management process that starts with on-site due diligence and ends with a comprehensive portfolio-management system; or if the time is right, a loan sale or securitization. Tomlinson believes his management system invokes a marketing discipline on the portfolio management process, a necessary step to achieving secure financial control of assets.

To help automate the due-diligence process for commercial real estate portfolios,Univest's chief analyst and software designer, David Carroll, developed a system to retrieve information on-site via laptop computers. Information is entered into a series of computer "audit screens" that display data-field groups. Information from the servicing system is downloaded into the Univest system, so auditors can compare servicing data elements with actual file contents. They note discrepancies, documentation deficiencies, missing statements, incomplete or unacceptable appraisals, lease packages that fail to underwrite the creditworthiness of the anchor tenant, and so forth.

Attuned to the possibilities on the horizon, Tomlinson senses something in the air. HE recognizes that illiquidity continues to plague the commercial real estate market, and the promise of securitization has not yet been realized to any great extent. Still, he picks up on certain movements within the industry: regulatory and economic pressures reminiscent of earlier times.

"The commercial real estate market is moving in the same direction as the residential market of the early 1980s," Tomlinson says. "Back then, savings and loans were securitizing everything they could lay their hands on. Regulatory accounting was 'in' and through some marvelously conceived accounting practice, it actually benefited institutions to sell loans at a loss."

During those times, investment bankers were eager to help and willing to audit portfolios and recommend restructure strategies "for free" in return for the right to sell the resulting securities. Still fuzzy about the true impact of deregulation, thrifts throughout the nation were targeted by these firms and invited to lunch.

It did not take long, however, for the residential secondary market to achieve balance and stability. Fannie Mae and Freddie Mac took control of documentation and underwriting standards. As a result, today's residential market is a commodity business where cash flows are regulated like clockwork, and prepayment, default and net-interest spreads move according to modeled projections. It's close to being a perfect world.

Not so with the commercial real estate. These portfolios are anything but standard and, hence, difficult to structure and pool. They are filled with so many idiosyncrasies and intricacies that marking a trustworthy risk/reward ratio is nearly impossible. However, new data-management technologies, combined with powerful regulatory and economic forces, may drive institutions to the final stage-- to take innovative action.

Exploring secondary-market frontiers

Industry observers contend that signs point to a "reawakening" of the secondary market for commercial real estate loans. The banking reform legislation being shaped by policymakers in Washington, D.C. may play a big part in determining progress on this front. Current banking reform bills now before Congress propose to tear down legal barriers that currently separate commerce and banking. Depending on the shape of the final legislation, private corporations could be allowed to own banks, link with mortgage banking subsidiaries and plug into consumer and automobile financial networks--in much the same way that the European and Japanese financial systems work.

The Washington establishment has given guarded approval to certain "good bank/bad bank? policies. This strategy allows a bank to spin-off its troubled assets intoa limited-service bank or liquidating trust. A liquidation plan is prepared for each asset in the "bad" bank, and the asset values are marked-to-market and discounted. Investors buy the bank's securities, betting that the proceeds of the liquidation will be sufficient to repay the debt on time. In 1988, Mellon Bank set the standard for this approach with its Grant Street Bank project, successfully exorcising a $1 billion problem.

Another emerging concept is "loan-splitting." In this method, banks would be allowed to put a portion of a none-accruing loan bak on current status if it qualifies, thereby improving income. Some studies have shown that, if applied, this technique could boost bank earnings on the average of 10.4 percent for money-center banks and 5.6 percent for regional banks. Properties once categorized as totally nonperforming could regain a measure of their stature. If approved by the regulators--and that remains a big "if" --the bank could reduce its reserve requirement and liberate dollars for other uses, such as for building a stronger capital-to-asset ratio.

However, as of this writing, the loan-splitting concept already may have met an untimely death. In the present, hostile environment, taxpayers and regulators are skeptical, being recently burned by the S&L debacle. Opposition is strong. The idea sounds too much like "smoke and mirrors" and creative accounting. Suffice it to say, the financial industry, Congress and even the industry regulators seem open to suggestion.

Without doubt, the banking and insurance industries and the commercial real estate market will continue to evolve. The time is approaching when divesting of commercial real estate loans will become both economically feasible and necessary to a lending institution's existence. Portfolio-management practice, once reserved only for investment and liquidity accounts, will be applied to loan portfolios, as institutions continuously strive to optimize the productivity of capital in a capital-competitive world.

Will you be ready?

Leonard Stern is first vice president for corporate communications at Univest Financial Group, Inc., a loan portfolio management services firm based in Atlanta.
COPYRIGHT 1991 Mortgage Bankers Association of America
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Title Annotation:Office of the Comptroller of the Currency and Office of Thrift Management descend on banks and thrifts to assess extent of damage caused by the fall of the commercial real estate market
Author:Stern, Leonard
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
Previous Article:The rise and fall of the U.S. office market.
Next Article:Managing through the crisis.

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