May 19, 2011

Performing Loans Need an Act of Congress

Declining commercial real estate values are still threatening our economic recovery. The impact continues to be felt at community banks, where implementation of federal regulation is amplifying the effect of declining commercial property values.

Banks hold half of the $3.5 trillion of outstanding commercial real estate debt in the United States. Commercial Mortgage Backed Security (CMBS) conduits hold about a quarter.

While CMBS originations are up this year, they are nowhere near pre-2008 levels and are not capable of refinancing the $1.5 trillion of commercial real estate debt that will mature in the next three years. Many properties will be foreclosed upon and many others will simply be handed back to lenders. The result will be fire sales that further depress property values. And those prices will now become “comparable sales” cited by appraisers.

Current application of Federal Reserve regulations can make the situation worse. Banks are often forced to classify performing loans as “non-performing” if the underlying property values decline – even when the project’s cash flow still covers the debt service. When loans become classified as non-performing, it harms a bank’s ability to originate new loans.

Consider an office building that has a dozen tenants, with leases at market rates and maturities spread out over time. That is, picture a stabilized office building. Its cash flow has been and is projected to continue to be more than sufficient to cover the debt service and operating expenses. If EagleBank is the lender on the project, and I assure you that many loans in our portfolio match this description, I consider this a good loan.

But if the value of buildings that surround the one I just described decline, regulators may require the Bank to classify the otherwise performing loan as “non-performing”. The reason for this classification is that the loan-to-value ratio has gone up, a key criterion that regulators use to assess a loan’s risk of default.

The problem is that the current decline in property values is largely the result of short-term conditions, rather than any long-term deterioration in the underlying cash flows. Loan-to-value ratios then are far less meaningful when assessing a loan’s long-term risk of default than a project’s anticipated cash flow.

Congress needs to address this issue to ensure that performing loans continue to be treated as performing loans. This issue is especially important given the heightened demand for loan extensions and issuance of new debt.

The first step has been taken. Representative Bill Posey (R-Florida) recently introduced a bill that mandates a study by the Financial Stability Oversight Council to study how best to prevent contradictory guidance from being issued by various Federal banking regulators with respect to loan classifications and capital requirements. It also provides that a loan may be treated as performing if it (a) is current, (b) was not significantly past-due during the previous six months, (c) is an amortizing loan and (d) has its monthly payments funded by the project or out-of-pocket rather than through an interest reserve.

Now is the time for Congress to create policies that promote the issuance of credit, rather than to support action that unnecessarily restricts it.