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S. HRG. 112–2 COMMERCIAL REAL ESTATE’S IMPACT ON BANK STABILITY HEARING BEFORE THE CONGRESSIONAL OVERSIGHT PANEL ONE HUNDRED TWELFTH CONGRESS FIRST SESSION FEBRUARY 4, 2011 Printed for the use of the Congressional Oversight Panel srobinson on DSKHWCL6B1PROD with HEARING ( VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00001 Fmt 6011 Sfmt 6011 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING COMMERCIAL REAL ESTATE’S IMPACT ON BANK STABILITY VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00002 Fmt 6019 Sfmt 6019 E:\HR\OC\A083.XXX A083 S. HRG. 112–2 COMMERCIAL REAL ESTATE’S IMPACT ON BANK STABILITY HEARING BEFORE THE CONGRESSIONAL OVERSIGHT PANEL ONE HUNDRED TWELFTH CONGRESS FIRST SESSION FEBRUARY 4, 2011 Printed for the use of the Congressional Oversight Panel ( U.S. GOVERNMENT PRINTING OFFICE WASHINGTON srobinson on DSKHWCL6B1PROD with HEARING 65–083 : 2011 For sale by the Superintendent of Documents, U.S. Government Printing Office Internet: bookstore.gpo.gov Phone: toll free (866) 512–1800; DC area (202) 512–1800 Fax: (202) 512–2104 Mail: Stop IDCC, Washington, DC 20402–0001 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00003 Fmt 5011 Sfmt 5011 E:\HR\OC\A083.XXX A083 CONGRESSIONAL OVERSIGHT PANEL PANEL MEMBERS THE HONORABLE TED KAUFMAN, Chair KENNETH TROSKE J. MARK MCWATTERS RICHARD H. NEIMAN srobinson on DSKHWCL6B1PROD with HEARING DAMON SILVERS (II) VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00004 Fmt 5904 Sfmt 5904 E:\HR\OC\A083.XXX A083 CONTENTS Page srobinson on DSKHWCL6B1PROD with HEARING Statement of: Opening Statement of Hon. Ted Kaufman, U.S. Senator from Delaware ............................................................................................... Statement of J. Mark McWatters, Attorney and Certified Public Accountant .................................................................................................................. Statement of Damon Silvers, Director of Policy and Special Counsel, AFL–CIO ....................................................................................................... Statement of Kenneth Troske, William B. Sturgill Professor of Economics, University of Kentucky ................................................................................. Statement of Richard Neiman, Superintendent of Banks, New York State Banking Department .................................................................................... Statement of Sandra Thompson, Director, Division of Supervision and Consumer Protection, Federal Deposit Insurance Corporation ................ Statement of Patrick Parkinson, Director, Division of Banking Supervision and Regulation, Board of Governors of the Federal Reserve ......... Statement of David Wilson, Deputy Comptroller for Credit and Market Risk, Office of the Comptroller of the Currency ......................................... Statement of Matthew Anderson, Managing Director, Foresight Analytics, A Division of TREPP .................................................................................... Statement of Richard Parkus, Executive Director, Morgan Stanley Research ............................................................................................................. Statement of Jamie Woodwell, Vice President of Commercial Real Estate Research, Mortgage Bankers Association ................................................... (III) VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00005 Fmt 5904 Sfmt 0483 E:\HR\OC\A083.XXX A083 1 5 9 13 19 23 41 54 94 106 136 srobinson on DSKHWCL6B1PROD with HEARING VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00006 Fmt 5904 Sfmt 0483 E:\HR\OC\A083.XXX A083 HEARING ON COMMERCIAL REAL ESTATE’S IMPACT ON BANK STABILITY FRIDAY, FEBRUARY 4, 2011 U.S. CONGRESS, CONGRESSIONAL OVERSIGHT PANEL, Washington, DC. The panel met, pursuant to notice, at 10 a.m. in Room D 538, Dirksen Senate Office Building, Senator Ted Kaufman, chairman of the panel, presiding. Present: Senator Ted Kaufman [presiding], Richard H. Neiman, Damon Silvers, J. Mark McWatters, and Kenneth R. Troske. srobinson on DSKHWCL6B1PROD with HEARING OPENING STATEMENT OF HON. TED KAUFMAN, U.S. SENATOR FROM DELAWARE The Chairman. Good morning. I’m Ted Kaufman, the chairman of the Congressional Oversight Panel for the Trouble Asset Relief Program. And we’re here this morning—and I’m—welcome our witnesses and visitors—at a pivotal moment in the Nation’s economic recovery. The financial panic that plagued our country is over. The Dow Jones industrial average has exceeded its year-end peak from 2007, only a few percentage points below its all-time high. Housing prices have begun to recover. Private companies are very slowly hiring again, beginning to put our millions of unemployed friends and neighbors back to work, although we have a long way to go, as everyone knows. It’s only fitting that, at a crisis past, a government should set aside its crisis authorities. And so, Treasury’s most extraordinary authority, to stabilize our financial system, the Troubled Asset Relief Program, has ended. However, threats to the banking system and the broader economy remain. Our hearing this morning will explore one of those threats in detail: the troubled market for commercial real estate loans. Commercial mortgages are exactly what they sound like, the loans taken out by developers to buy, build, and maintain commercial properties. Almost everyone who lives in an apartment, works in an office building, or shops in a mall has spent time in a building that owes its existence to a commercial mortgage. Most commercial mortgages have terms of 3 to 10 years, but the monthly payments are too low and—to fully repay the loan in that period. At the end of the term, the entire remaining balance comes due, and the borrower must take out a new loan to finance its continued ownership of that property. Put another way, a commercial borrower must reapply for credit every few years. In today’s mar(1) VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 E:\HR\OC\A083.XXX A083 2 srobinson on DSKHWCL6B1PROD with HEARING ket, where banks remain hesitant to lend and the values of commercial properties have fallen by a third, many borrowers will be turned down. The loans at greatest risk are those made at the peak of the real estate bubble, obviously; loans that will come due for refinancing in 2011, 2012, and 2013, and beyond. In essence, the term of a commercial loan creates a lag between the moment the market collapses and the moment that the economic impact is felt. The fuse has been lit, but no one knows how much damage will occur when it finally burns down. The Congress Oversight Panel has been closely monitoring the commercial real estate market since its first hearing on the subject, in May have 2009. The panel issued a comprehensive report in February 2010. Even after almost 2 years, the panel remains deeply concerned. In fact, just last month, the missed payment rate for commercial mortgage-backed securities reached an all time high of over 9.3 percent. The commercial real estate market encompasses $3.4 trillion in debt. If borrowers default in large numbers, commercial properties could face a wave of foreclosures. Customers, businesses, and renters in those properties could face uncertainty, and even eviction. Small banks, in particular, could face insolvency, as nearly 1,300 banks nationwide are considered by regulators to have concentrations in commercial real estate. Concerns about commercial real estate also illuminate a broader theme of our oversight work, that even in a crisis, while authorities must deal with the short-term dangers, they must also be vigilant to the longer-term threats. If a small bank survived the financial crisis, thanks to the TARP, but collapses next year, due to commercial real estate losses, then TARP support will have served only to postpone the inevitable. Further, more than 500 small banks continue to hold TARP money. And the greater the degree of these banks’ exposure to commercial real estate, the lower is the likelihood that taxpayers recover all of our money. We are grateful this morning—and I truly mean grateful—to be joined by two panels of expert witnesses, who will help us to explore these concerns, including government regulators and bank analysts. We appreciate your presence and look forward to your testimony. Let me now turn to Mr. McWatters for his opening remarks. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 E:\HR\OC\A083.XXX A083 Insert offset folio 12 here 65083A.001 srobinson on DSKHWCL6B1PROD with HEARING 3 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 E:\HR\OC\A083.XXX A083 Insert offset folio 13 here 65083A.002 srobinson on DSKHWCL6B1PROD with HEARING 4 5 srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF J. MARK McWATTERS, ATTORNEY AND CERTIFIED PUBLIC ACCOUNTANT Mr. MCWATTERS. Thank you, Senator Kaufman. And welcome to our distinguished witnesses. There is little doubt that much uncertainty continues to exist within the commercial real estate, or CRE, market. In order to suggest a solution to the challenges facing the CRE market, it is critical that we thoughtfully identify the sources of the underlying difficulties. Without a proper diagnosis, it is unlikely that we may craft an inappropriately targeted remedy with adverse unintended consequences. Broadly speaking, it appears that today the CRE industry is faced with both an oversupply of overleveraged CRE facilities and an undersupply of respective tenants and purchasers. In my view, there has been a remarkable decline in demand for CRE property over the past 2 years, and many potential tenants and purchasers have withdrawn from the CRE market, not simply because rental rates and purchase prices are too high due to the excess debt load carried by many CRE properties, but because their business operations do not presently require additional CRE facilities. Over the past few years, while CRE developers have constructed new office buildings, hotels, multifamily housing, retail facilities, and industrial properties with an excess of cheap, short-term credit, the end users of such facilities have suffered the worst economic downturn in several generations. Any positive solution to the CRE focus—problem that focuses only on the oversupply of overleveraged CRE facilities, to the exclusion of the economic difficulties facing the end users of such facilities, appears less than likely to succeed. The challenges confronting the CRE market are not entirely unique to the industry, but instead are indicative of the systemic uncertainties manifest throughout the entire economy. In order to address the oversupply of overleveraged CRE facilities, developers and their creditors are currently struggling to restructure and refinance their portfolio loans. In some instances, creditors are acknowledging economic reality and writing the loans down to market value, with perhaps the retention of an equity kicker right. In other cases, lenders and borrowers are merely kicking the can down the road by refinancing problematic credits on a short-term basis at favorable rates so as to avoid loss recognition and capital impairment for lenders and adverse tax consequences for the borrowers. While each approach may offer assistance in specifically tailored instances, neither addresses the underlying reality of too few tenants and purchasers of CRE facilities. Until small and large businesses regain the confidence to hire new employees and expand their business operations, it is doubtful that the CRE market will sustain a meaningful recovery. As long as business persons are faced with the challenges of rising taxes and increasing regulatory burdens, it is less than likely that they will enthusiastically assume the entrepreneurial risk necessary for protracted economic expansion and a robust recovery of the CRE market. It is fundamental to acknowledge that the American economy grows one job and one consumer purchase at a time, and that the VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00011 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 6 srobinson on DSKHWCL6B1PROD with HEARING CRE market will recover one lease, one sale, and one financing at a time. With the expanding array of less-than-friendly rules, regulations, and taxes facing business persons and consumers, we should not be surprised that businesses remain reluctant to hire new employees, consumers remain cautious about spending, and the CRE market continues to struggle. The problems presented by today’s CRE market would be easier to address if they were solely based on the oversupply of overleveraged CRE facilities in certain well-delineated markets. In such an event, a combination of thoughtful, yet no doubt painful, restructurings, refinancings, and foreclosures would result in the material deleveraging and repricing of troubled CRE properties. Unfortunately, even though CRE properties that are appropriately leveraged and priced must also assimilate a drop in demand from prospective tenants and purchasers who have suffered a reversal in their business operations and prospects. Although some progress has been made, the Administration could further assist the recovery of the CRE market, as well as the broader U.S. economy, by sending an unambiguous message to the private sector that it will not directly or indirectly raise the taxes or increase the regulatory burden of CRE participants and other business enterprises. Without such action, the recovery of the CRE market will quite possibly proceed at a sluggish and costly pace, with further adverse consequences for those financial institutions and investors that hold CRE loans and commercial mortgagebacked securities. Thank you, and I look forward to our discussion. The CHAIRMAN. Thank you. Damon Silvers. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00012 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00013 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 18 here 65083A.003 srobinson on DSKHWCL6B1PROD with HEARING 7 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00014 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 19 here 65083A.004 srobinson on DSKHWCL6B1PROD with HEARING 8 9 srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF DAMON SILVERS, DIRECTOR OF POLICY AND SPECIAL COUNSEL, AFL–CIO Mr. SILVERS. Thank you, Mr. Chairman. Good morning. This is the third hearing this panel has conducted on the interaction of the commercial real estate market with the Troubled Asset Relief Program. Our earlier hearings looked at this issue through the experience of the New York and the Atlanta metropolitan areas. And so, this is really the first hearing that is focused on the national picture and on the viewpoint and efforts of the bank regulators in relation to issues raised by the commercial real estate market. In our February 2010 report, as my fellow panelists have noted, this panel urged the Treasury Department and the bank regulators to closely monitor commercial real estate market, out of concern that the rapid decline of this market could lead to problems for financial institutions with significant exposure to commercial real estate loans, and, in particular, could affect the small banking sector. We noted that, due to the shorter term of most commercial real estate loans compared to conventional residential mortgages, the banking system would face rollover problems for more than $2 trillion worth of commercial real estate loans between 2011 and 2017, loans whose collateral seems likely to have fallen in value dramatically when the loans become due. Today’s hearing is an opportunity for us to revisit the question of what is going to happen to smaller banks as commercial real estate loans become due, and what impact these developments will have on efforts to revive commercial lending, and on the degree of concentration in our banking system. We do this against the backdrop of smaller TARP recipient banks having significant concentrations in commercial real estate even when compared to non-TARP recipients of the same size, and against the backdrop, that we—as we have noted in other reports, of the challenges that the Treasury Department faces, in terms of constructing an exit from TARP for these smaller recipients of TARP assistance. But, this hearing is also an opportunity for us to look more broadly at the implications of the commercial real estate market for oversight of TARP as a whole. Several of our witnesses today have pointed out, in their written testimony, that commercial real estate loans are concentrated in smaller banks, and are not a problem, by and large, that threatens the stability of systemically significant institutions. We also have a substantial body of testimony today that discusses the capacity of banks and other commercial real estate lenders to restructure commercial real estate loans, and the difference that that capacity and flexibility has made, in terms of mitigating the impact of the dramatic fall of commercial real estate values. Now, neither proposition is a great comfort to me, nor, I think, would either proposition be a great comfort to the American public if the public understood the implications of these statements. Every week, the FDIC resolves more failed small banks. Those banks are shut down; their stockholders, wiped out; in many cases, their employees, laid off; the communities which they served, left without important institutions in some cases; in other cases, they continue under new names and new ownership. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00015 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 10 srobinson on DSKHWCL6B1PROD with HEARING All the—all those harmed by these actions, unavoidable as they certainly are, know that, if they had just been systemically significant, they might be well on their way to enjoying the fruits of the recent miniboom in finance. And then, consider any one of the more than 200,000 American families facing the loss of their home each month due to residential real estate foreclosures, in substantial part because of the lack of flexibility in the approach the bank have taken to residential real estate. Now, today, rather than dwell too long on these injustices that appear, at this point, to be profoundly lodged at the heart of our financial policy landscape, I would hope we could learn something practical from this hearing as to, one, whether we still have cause to be concerned about rollover risk in commercial real estate, the risk that this panel has raised in prior reports; and, two, What can we learn from the commercial real estate experience that might help us in dealing with the profoundly troubled residential real estate market? So, I look forward to hearing from our witnesses, and extend my thanks to all of you for helping us today. The CHAIRMAN. Thank you, Mr. Silvers. Dr. Troske. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00016 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00017 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 24 here 65083A.005 srobinson on DSKHWCL6B1PROD with HEARING 11 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00018 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 25 here 65083A.006 srobinson on DSKHWCL6B1PROD with HEARING 12 13 srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF KENNETH TROSKE, WILLIAM B. STURGILL PROFESSOR OF ECONOMICS, UNIVERSITY OF KENTUCKY Dr. TROSKE. Thank you, Senator Kaufman. I would like to start by thanking the witnesses for appearing before the panel today. I appreciate you coming here to help us with our oversight responsibilities. In my opening comments today, I want to touch on a topic that, while not the primary subject of today’s hearing, is certainly related. That is the role of regulation and regulatory oversight in the recent financial crisis. One common theme in the aftermath of our—the recent crisis has been that the crisis could have been prevented by more regulation. Of course, in our economic system, there are two sources of regulation, that imposed by the market and that imposed by the government. Both forms of regulation have their strengths and weakness. In my opinion, however, many of the calls for increased government regulation fail to recognize some of the inherent weaknesses in this type of regulation. It is important to start off by recognizing that regulators are human beings, not superheroes, and they respond to incentives, just like all other normal human beings. Government regulators with no skin in the game have little incentive to closely monitor the behavior of companies to ensure that they protect investors and the economy. In contrast, in a well-functioning market, shareholders and creditors have a great deal of incentive to monitor firm behavior, since they do have skin in the game. Some government regulators certainly do an exemplary job, but there are others, whose efforts will focus on merely implementing rules in a way to maintain their positions, and it is hardly—hard to know which is which before problems arise. As far as I know, no government regulator lost his or her job because the firm they regulated failed or received a bailout. In fact, many of the regulatory agencies that have received the most blame for the financial crisis received additional regulatory authority in the recent DoddFrank legislation. It seems clear that regulators have little financial incentive to develop and apply the kind of regulatory procedures that will yield maximum benefit, so we are forced to rely on regulators’ personal motivation for doing the right thing. Hardly a sound basis for effective regulation. We must also recognize that government regulators operate in a political process. When regulators try to regulate large companies, the shareholders and executives of these companies complain to their elected representatives about the undue burden of regulation, and these legislators try to limit the efficacy of regulators. We have seen this process play out time and time again in a variety of settings. When companies are making large profits, as often occurs in a price bubble, it is unreasonable to expect government regulators to have the political will to defy Members of the Congress and pop the bubble. I am not saying that the way the political process works is inappropriate, just that this dynamic must be kept in mind when thinking about the likely effectiveness of new regulation. Finally, we need to recognize how executives, shareholders, and creditors of financial firms will respond to regulation. All busi- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00019 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 14 srobinson on DSKHWCL6B1PROD with HEARING nesses, including financial firms, aim to provide the products their customers demand. Customers demanded, and continue to demand, many of the financial products that they’re—at the heart of the financial crisis, such as collateralized debt obligations and other complicated derivatives. Given new government—new government regulation will likely push firms to develop more complicated and difficult-to-regulate financial products, and move these products into an even more shadowy part of the banking sector. In addition, with an increase in government—an increase in government regulation will decrease shareholders’ and creditors’ efforts at monitoring managers, and allow their oversight to be supplanted by government regulation. Given that regulation pushes companies to hide risky investments and reduces the incentives for shareholders and creditors to monitor the behavior of executives, government regulation likely leads to a world where there are fewer crises, but those crises that do occur will be much harder to spot and much larger and more destabilizing. Is this a tradeoff we want to make? Of course the government’s guarantee that systemically important financial firms will not be allowed to fail has effectively removed any incentive creditors have to monitor the behavior of executives and shareholders. It seems to me that a much simpler and more efficient solution would simply—would be to simply eliminate the government’s guarantee, which would again provide creditors with the incentives to monitor the behavior of firms. Claims that government—claims that the lack of regulation led to the recent financial crisis are akin to claims that someone got sick because they didn’t take enough medication. Obviously, some medicine can kill you, some may prevent you from getting sick, but the correct medication is a complex function of the patient’s overall health prior to becoming ill, his behavior, and the disease he ultimately encounters. So, it is virtually impossible to design a regime of medication that will prevent someone from ever getting sick. Instead, doctors advise us to follow a few basic rules—eat a balanced diet, exercise on a regular basis, don’t smoke, avoid drinking to excess—that are designed to help build resistance to most common diseases and minimize the effects if we do become ill. However, even following these rules, people still get sick. Good regulation would follow a similar course. Establish a set of basic rules, to enhance the ability of the natural regulators, shareholders, and creditors to oversee the behavior of managers. However, even the best government regulation will not prevent the occurrence of future financial crises. The best it can do is to reduce their frequency, minimize the effects when crises occur, and make people aware of the risks so they can prepare. Responsibility for a firm’s failure does not reside with government regulators, but instead rests with the managers and owners who made poor decisions. We need to keep this in mind when trying to design optimal regulation and planning for future crises. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00020 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 15 srobinson on DSKHWCL6B1PROD with HEARING Hopefully, the testimony we hear today will help us better understand remaining problems in the market so that political leaders can continue to work towards better, more efficient regulation to ensure the stability of the financial sector. The CHAIRMAN. Thank you, Dr. Troske. Mr. Neiman. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00021 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00022 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 32 here 65083A.007 srobinson on DSKHWCL6B1PROD with HEARING 16 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00023 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 33 here 65083A.008 srobinson on DSKHWCL6B1PROD with HEARING 17 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00024 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 34 here 65083A.009 srobinson on DSKHWCL6B1PROD with HEARING 18 19 srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF RICHARD NEIMAN, SUPERINTENDENT OF BANKS, NEW YORK STATE BANKING DEPARTMENT Mr. NEIMAN. Thank you. Good morning. I want to thank our witnesses, particularly our senior Federal regulators who are appearing today at our Hearing of the Congressional Oversight Panel on Commercial Real Estate Lending. The panel first explored these issues around commercial real estate in our field hearings in New York City in 2009 and in Atlanta in January of last year. In the time since then, there is reason to remain concerned about mounting pressure in the commercial real estate sector. Financial stability overall has been returning, but this nascent recovery is still vulnerable to shocks. The concern is that the credit risk, and particularly the maturity risk embedded in commercial real estate loans, could provide such a trigger in the near term. It is estimated that hundreds of billions of dollars in commercial real estate debt will be maturing through 2014. The prospects for refinancing this debt are uncertain, as the recession and high levels of unemployment continue to put downward pressure on property values and reduce rent rolls. This could even jeopardize the viability of loans that were properly underwritten. These difficulties may weigh heavily on midsized and community banks, which are, comparatively, more concentrated in commercial real estate than larger institutions. But, the future of commercial real estate lending matters to more than just a subset of lenders and borrowers. Commercial real estate impacts every community, on multiple levels, so understanding this sector is an important aspect of stabilizing our national economy. We are talking about the office buildings, shopping malls, and hotels that shelter jobs. Mortgages that help businesses remain open are critical to economic recovery. Commercial real estate also includes multifamily and affordable housing units. For apartment buildings, in particular, there is a concern that the properties’ condition will deteriorate as the owner’s cashflow is diverted to making debt payments. Further, tenants who pay their rent on time can find themselves homeless because their landlord defaulted on the underlying commercial mortgage. Workouts for distressed loans on multifamily properties should be restructured with community preservation goals in mind. So, in my questions this morning, I will be exploring this connection between the well-being of our society and financial stability. There are many open issues, such as: What steps are being taken at the national level to protect members, renters, and multifamily properties during a foreclosure? Are tightened underwriting standards being set at the right level to ensure prudent loans, or is credit being artificially restricted? And are banks adequately prepared for additional loan losses that may be coming? I look forward to the witnesses’ response on these issues, and to hearing your innovative ideas on stabilizing commercial real estate. So, thank you, again, for joining us. The CHAIRMAN. Thank you all. I’m pleased to welcome our first witness panel, which consists of Federal bank regulators. We’re joined by Sandra Thompson, direc- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00025 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 20 srobinson on DSKHWCL6B1PROD with HEARING tor of the Division of Supervision and Consumer Protection for the FDIC; Patrick Parkinson, director of the Division of Banking Supervision and Regulation for the Federal Reserve; and David Wilson, deputy comptroller for Credit and Market Risk for the OCC. Thank you for coming this morning. We ask that you keep your oral testimony to 5 minutes so we can have adequate time for questions. Your complete written record will be printed in the official record of the hearing. And please proceed with your testimony. We’ll start with Ms. Thompson. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00026 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00027 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 39 65083A.010 srobinson on DSKHWCL6B1PROD with HEARING 21 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00028 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 40 65083A.011 srobinson on DSKHWCL6B1PROD with HEARING 22 23 srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF SANDRA THOMPSON, DIRECTOR, DIVISION OF SUPERVISION AND CONSUMER PROTECTION, FEDERAL DEPOSIT INSURANCE CORPORATION Ms. THOMPSON. Good morning. Chairman Kaufman and members of the panel, I appreciate the opportunity to testify on behalf of the FDIC regarding the condition of the commercial real estate market and its relationship to the overall stability of the financial system. The events surrounding the recent financial crisis have taken a heavy toll on economic activity across our Nation. The past 3 years have been difficult for many institutions that focused on CRE lending, especially in home construction. In 2009, there were 140 bank failures. Last year, 157 banks failed. And many of those failures were caused by losses on construction loans that were made during the boom years before the crisis. Some community banks with CRE concentrations continue to experience elevated losses. Distressed CRE loan exposures take time to work out and, in some cases, require restructuring to establish more realistic and sustainable repayment programs. Some loans may not be able to be modified and must be written off. This process of prompt loss recognition and restructuring, painful as it may be, is needed to lay the foundation for recovery in the CRE market. At the same time, it must be recognized that many institutions with CRE concentrations have weathered the financial crisis. As of the end of the year in 2008, there were over 2200 institutions that had CRE concentrations. Many of these institutions continue to operate in a safe and sound manner and serve the credit needs of their communities. It is important to note that capital levels at insured institutions are relatively strong. Of the almost 8,000 insured depository institutions reporting as of the end of last September, some 96 percent are in the well-capitalized categories. For banks with CRE concentrations, 87 percent are well-capitalized. The FDIC and the other Federal banking regulatory agencies have taken a number of steps to better understand the nature and extent of CRE concentrations. The FDIC has expanded the use of supervisory visitations at institutions with CRE concentrations. We’ve broadened our offsite surveillance programs to better capture CRE outliers. We receive more detailed information on a quarterly basis on owner-occupied CRE exposures so that we can better delineate a bank’s CRE portfolio. The FDIC has also joined with the other Federal bank regulators in encouraging lenders to continue making prudent loans and working with borrowers who are experiencing financial difficulties. Although a number of financial institutions have reported poor results for the past several years, there are emerging signs of stabilization. Year-over-year earnings have improved for five consecutive quarters through September 30th, and loan-loss provisions have declined. Additionally, noncurrent loan balances have declined, with the largest decline occurring in the construction and development lending sector. There are other signs pointing to a slow stabilization in the residential and commercial property sectors, with improvement in VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00029 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 24 srobinson on DSKHWCL6B1PROD with HEARING prices and vacancy rates. Nonetheless, while there are signs of stabilization, the CRE market is distressed and it will take some time to work through these issues. All banks, community banks in particular, play a critical role in helping local businesses fuel economic growth. And we support their efforts to make good loans in this challenging environment. Thank you. And I’ll be pleased to answer any questions from the panel. [The prepared statement of Ms. Thompson follows:] VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00030 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00031 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 45 65083A.012 srobinson on DSKHWCL6B1PROD with HEARING 25 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00032 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 46 65083A.013 srobinson on DSKHWCL6B1PROD with HEARING 26 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00033 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 47 65083A.014 srobinson on DSKHWCL6B1PROD with HEARING 27 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00034 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 48 65083A.015 srobinson on DSKHWCL6B1PROD with HEARING 28 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00035 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 49 65083A.016 srobinson on DSKHWCL6B1PROD with HEARING 29 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00036 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 50 65083A.017 srobinson on DSKHWCL6B1PROD with HEARING 30 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00037 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 51 65083A.018 srobinson on DSKHWCL6B1PROD with HEARING 31 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00038 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 52 65083A.019 srobinson on DSKHWCL6B1PROD with HEARING 32 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00039 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 53 65083A.020 srobinson on DSKHWCL6B1PROD with HEARING 33 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00040 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 54 65083A.021 srobinson on DSKHWCL6B1PROD with HEARING 34 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00041 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 55 65083A.022 srobinson on DSKHWCL6B1PROD with HEARING 35 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00042 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 56 65083A.023 srobinson on DSKHWCL6B1PROD with HEARING 36 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00043 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 57 65083A.024 srobinson on DSKHWCL6B1PROD with HEARING 37 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00044 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 58 65083A.025 srobinson on DSKHWCL6B1PROD with HEARING 38 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00045 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 59 65083A.026 srobinson on DSKHWCL6B1PROD with HEARING 39 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00046 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 60 65083A.027 srobinson on DSKHWCL6B1PROD with HEARING 40 41 The CHAIRMAN. Thank you very much. Dr. Parkinson. srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF PATRICK PARKINSON, DIRECTOR, DIVISION OF BANKING SUPERVISION AND REGULATION, BOARD OF GOVERNORS OF THE FEDERAL RESERVE Dr. PARKINSON. Chairman Kaufman, members of the panel, thank you for your invitation to discuss the current state of commercial real estate and its relationship to the overall stability of the financial system. Over the past year, the rate of deterioration for CRE market and credit conditions has leveled off, and there are some early signs of price stabilization in a number of key markets. However, weakness in real estate markets, both commercial and residential, continues to be a drag on overall growth in the economy. CRE-related issues also present ongoing problems for the banking industry, particularly for community and regional banking organizations. Losses associated with CRE, particularly residential construction and land development lending, have been the dominant reason for the high number of bank failures since the beginning of 2008. Credit losses for bank CRE loans typically continue well past the trough of recessions, and we expect this pattern to continue in this cycle. Working through the large volume of troubled CRE loans will take time as banks go through the difficult process of loan workouts and loan restructurings. However, if done prudently and effectively, loan restructuring can reduce the ultimate losses to the banking system. In addition, proper restructuring can reduce the damage done to businesses and the economy by limiting the forced liquidation of properties that would further depress prices. While we expect significant ongoing CRE-related problems, it appears that worst-case scenarios are becoming increasingly unlikely. During 2010, delinquency rates on construction and development loans began to improve slightly, falling 1 percent. Still, even if CRE delinquency metrics continue improving, there remains a sufficiently large overhang of distressed CRE at commercial banks that loss rates for this portfolio will likely stay high for some time to come. Approximately one-third of all CRE loans are scheduled to mature over the next 2 years. This circumstance represents substantial refinancing risk, as CRE loans typically have large balloon payments due at maturity. Since the passage of the October 2009 supervisory guidance on prudent loan workouts, banks have significantly increased the level of restructuring of CRE loans. Economic incentives to restructure or refinance existing loans are aided by the current low interest rate environments. Some banks with properties in healthier markets are also beginning to see a pickup in demand for high-quality properties with strong tenants. Since the beginning of 2008 through the third quarter of 2010, commercial banks have incurred almost $80 billion of losses related to CRE exposure, equating to a little over 5 percent of the average exposure outstanding during that period. Given past historical experience and the recent improvement witnessed in the broader VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00047 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 42 srobinson on DSKHWCL6B1PROD with HEARING economy, it is estimated that banks have taken roughly 40 to 50 percent of the CRE losses that they will realize over this cycle. While we can project potential losses facing banks, losses ultimately realized in this cycle will depend on macroeconomic and financial factors, especially unemployment rates and interest rates. Sensitivity of losses to those factors are why—is why we continue to emphasize the importance of stress testing as a critical element of managing risks associated with CRE concentrations. Progress on working through the overhang of distressed CRE will take time and it will depend on banks taking strong steps to ensure that losses are recognized in a timely manner, that loan-loss reserves and capital appropriately reflect risk, that loans are modified in a safe and sound manner, and that loans continue to be made available to creditworthy borrowers. To this end, the Federal Reserve will continue to work with lenders to ensure that bank management and supervisors take a balanced approach to ensuring safety and soundness in serving the credit needs of the community. Thank you. And I look forward to your questions. [The prepared statement of Mr. Parkinson follows:] VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00048 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00049 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 66 65083A.028 srobinson on DSKHWCL6B1PROD with HEARING 43 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00050 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 67 65083A.029 srobinson on DSKHWCL6B1PROD with HEARING 44 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00051 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 68 65083A.030 srobinson on DSKHWCL6B1PROD with HEARING 45 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00052 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 69 65083A.031 srobinson on DSKHWCL6B1PROD with HEARING 46 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00053 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 70 65083A.032 srobinson on DSKHWCL6B1PROD with HEARING 47 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00054 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 71 65083A.033 srobinson on DSKHWCL6B1PROD with HEARING 48 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00055 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 72 65083A.034 srobinson on DSKHWCL6B1PROD with HEARING 49 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00056 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 73 65083A.035 srobinson on DSKHWCL6B1PROD with HEARING 50 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00057 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 74 65083A.036 srobinson on DSKHWCL6B1PROD with HEARING 51 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00058 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 75 65083A.037 srobinson on DSKHWCL6B1PROD with HEARING 52 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00059 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 76 65083A.038 srobinson on DSKHWCL6B1PROD with HEARING 53 54 The CHAIRMAN. Thank you, Dr. Parkinson. Mr. Wilson. srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF DAVID WILSON, DEPUTY COMPTROLLER FOR CREDIT AND MARKET RISK, OFFICE OF THE COMPTROLLER OF THE CURRENCY Mr. WILSON. Chairman Kaufman and members of the panel, I appreciate the opportunity to discuss the OCC’s observations about the commercial real estate market and its impact on national banks. The OCC supervises about 1415 national banks, representing about 18 percent of all insured depository institutions, and approximately 63 percent of all IDI assets. Commercial real estate lending is a prominent business line for many national banks and is a sector that the OCC monitors very closely. National banks hold approximately 735 billion in outstanding CRE loans, which is about 16 and a half percent of their aggregate loan balances. While there are signs that the commercial real estate markets are beginning to stabilize, we are a long way from full recovery. Vacancy rates across major property types are starting to recover, but remain high by historical standards. We expect vacancy rates to remain elevated for at least the next 12 months. Capitalization rates, the rate of return demanded by investors, have also shown recent signs of stabilization. Cap rates fell substantially from 2002 to 2007, to a point where they often did not fully reflect the risks associated with the properties being financed. Then they increased markedly in 2008 and 2009, as investors became more risk-averse. Recently, cap rates appear to have stabilized, particularly for high-quality assets, but the spreads being demanded by investors relative to treasuries remains wide. A key driver for property values and CRE loan performance is the net operating income or cash flows generated by the underlying properties. Overall, NOI has continued to decline due to soft rental rates. While we expect the rate of decline to lessen, only apartments are expected to show meaningful NOI growth this year, with other major market segments expected to turn positive in 2012. Property prices have also shown recent signs of stabilization. The Moody’s All Property Index recorded an increase of 0.6 percent in November 2010, which was the third consecutive month of national price gains. While this trend is encouraging, we expect the prices to be volatile until underwriting market fundamentals improve consistently. The trends and performance of CRE loans within national banks mirror those in the broader CRE market. While there are some signs of stabilization in charge-off rates, nonperforming loan levels remain elevated and continue to require significant attention by bank management and supervisors. The effect of distressed commercial real estate on individual national banks varies by size, location, type of CRE loan. Because the charge-off rates for construction loans led performance problems in the sector, banks with heavier concentrations in this segment tended to experience losses at an earlier stage. Performance in this segment is expected to improve more rapidly as the pool of potentially VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00060 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 55 srobinson on DSKHWCL6B1PROD with HEARING distressed construction loans has diminished. Conversely, banks whose lending is more focused on income-producing commercial mortgages are continuing to experience increased charge-off rates. Another factor for many community and midsized banks is their CRE concentrations. Although CRE concentrations as a percentage of capital has declined recently, they are still significant for many midsized and community banks. CRE concentrations and problemloan workouts continue to be areas of emphasis and OCC examination activities, and our objectives are threefold: ensuring that the banks accurately risk-rate their loans, that they work constructively with troubled borrowers, and that they maintain adequate loan-loss reserves and capital, taking appropriate charge-offs when needed. We are also emphasizing the importance of stress testing—and are assessing whether additional supervisory policies or guidance may be needed for examiners and institutions, to more effectively deal with the risks that CRE concentrations can pose to the industry and the viability of individual financial institutions. In summary, there are modest signs of improvement, but the CRE markets still face significant headwinds. Ultimately, stabilization of the CRE markets will require restoring equilibrium between supply and demand, and will hinge on recovery of the overall economy. This process is not painless, and we expect CRE portfolios will continue to be a drag on some bank’s performance for at least the next 12 to 18 months. During this period of adjustment, the OCC will continue to take a balanced and measured approach in its supervision. [The prepared statement of Mr. Wilson follows:] VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00061 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00062 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 82 here 65083A.039 srobinson on DSKHWCL6B1PROD with HEARING 56 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00063 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 83 here 65083A.040 srobinson on DSKHWCL6B1PROD with HEARING 57 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00064 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 84 here 65083A.041 srobinson on DSKHWCL6B1PROD with HEARING 58 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00065 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 85 here 65083A.042 srobinson on DSKHWCL6B1PROD with HEARING 59 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00066 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 86 here 65083A.043 srobinson on DSKHWCL6B1PROD with HEARING 60 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00067 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 87 here 65083A.044 srobinson on DSKHWCL6B1PROD with HEARING 61 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00068 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 88 here 65083A.045 srobinson on DSKHWCL6B1PROD with HEARING 62 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00069 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 89 here 65083A.046 srobinson on DSKHWCL6B1PROD with HEARING 63 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00070 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 90 here 65083A.047 srobinson on DSKHWCL6B1PROD with HEARING 64 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00071 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 91 here 65083A.048 srobinson on DSKHWCL6B1PROD with HEARING 65 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00072 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 92 here 65083A.049 srobinson on DSKHWCL6B1PROD with HEARING 66 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00073 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 93 here 65083A.050 srobinson on DSKHWCL6B1PROD with HEARING 67 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00074 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 94 here 65083A.051 srobinson on DSKHWCL6B1PROD with HEARING 68 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00075 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 95 here 65083A.052 srobinson on DSKHWCL6B1PROD with HEARING 69 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00076 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 96 here 65083A.053 srobinson on DSKHWCL6B1PROD with HEARING 70 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00077 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 97 here 65083A.054 srobinson on DSKHWCL6B1PROD with HEARING 71 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00078 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 98 here 65083A.055 srobinson on DSKHWCL6B1PROD with HEARING 72 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00079 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 99 here 65083A.056 srobinson on DSKHWCL6B1PROD with HEARING 73 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00080 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 100 here 65083A.057 srobinson on DSKHWCL6B1PROD with HEARING 74 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00081 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 101 here 65083A.058 srobinson on DSKHWCL6B1PROD with HEARING 75 srobinson on DSKHWCL6B1PROD with HEARING 76 The CHAIRMAN. Thank you, Mr. Wilson. We have some questions. I’d like to start out talking about—primarily about small banks. And I’d like each witness to comment on how much you think— you’ve all talked about the distressed commercial real estate market—how much you think that overhang on small banks is affecting their recovery. And we’ll start with Ms. Thompson. Ms. THOMPSON. I think the overhang is impacting their recovery. But, when we issued the guidance on CRE loan workouts, we started to see a lot of restructurings. And for the banks that are in our portfolio, they have a close and good relationship with their borrowers. We have about 4,700 institutions where we are the primary Federal regulator, and our employees are located and live in the communities. The bankers that service the commercial real estate loans and their portfolio have a high touch with their borrowers, and they are familiar with the markets, and it would be a win-win for them to work out and restructure these loans. We’ve been encouraging them to do so. We’ve also been encouraging them to acknowledge when they can’t work these loans out, so that they can take the losses right away. The CHAIRMAN. Dr. Parkinson. Dr. PARKINSON. I think it is affecting the recovery. As I think all of us have been saying, we’ve really been emphasizing the importance of prudent and effective workouts, and certainly monitoring what the banks are doing in that area. But, even with prudent and effective workouts, many of them have large volumes of assets that are extremely troubled, and, in the course of working them out, further losses are going to be recognized. And, in some cases, that’s going to jeopardize their ability to pay the economic role that they need to play. And I don’t think, at this stage, there’s much we can do about that, other than make sure that they follow the workout guidance to mitigate and limit whatever damage their troubled condition would otherwise produce. The CHAIRMAN. Mr. Wilson. Mr. WILSON. Yes. I have similar comments. There are a number of severely distressed community banks that probably won’t make it. And, there is no real silver bullet. But, the best we can do is make sure that we’re fair and consistent with our workout guidance, because, in many cases, that’s the best for the bank, that’s the best for the customer, and, as was mentioned before, it’s also best for the community. The CHAIRMAN. Many times, when you talk to borrowers,—I think it’s—many, many borrowers, you have good relationships with the banks—the borrowers say the banks tell them they can’t lend them the money, they can’t extend the loan, they can’t work it out because of the regulators. I’ve heard this, time and time and time again. And so, Ms. Thompson, do you have some comments you can address to this complaint? Because it is—I mean, the person that these borrowers are blaming are not the banks that won’t lend them the money, it’s the—they blame it on the regulators. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00082 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 77 Ms. THOMPSON. You’re absolutely correct. We hear that all the time. And we really, as regulators, try to take a balanced approach to supervision. We want banks to make good, prudent loans. We don’t want them to create further problems by ‘‘kicking the can down the road.’’ We think it’s important that there are good underwriting standards. And as long as a bank is making good loans, we are encouraging that practice, both for small business lending and for residential CRE. The regulators are trying to work with institutions so that we can have a safe and sound banking system with good loans, because we all know what happens when a bad loan is made. The CHAIRMAN. Dr. Parkinson. Dr. PARKINSON. Consistent with that, we’re certainly aware of these reports, and we’ve been taking a very careful look at what our examiners are doing to try to ensure that they follow the guidance that we’ve set out and take an objective and balanced approach. We try to continue to enforce that through guidance to examiners and through training. We’re very carefully looking and monitoring the examination process, which includes local management vettings of exam findings, and reviewing a sample of exam reports to see if there are any inconsistencies with the guidance. Our monitoring, to date, suggests that by and large, the examiners are appropriately considering the guidance. And if we’ve made it clear that if a banking organization is concerned about supervisory structures imposed by our examiners, they should incur contact either the Reserve Bank or contact us, in Washington, to discuss and identify the problems. The CHAIRMAN. Mr. Wilson. Mr. WILSON. I agree with that. We do hear that a lot. We are very sensitive to it. When we try to solicit specific examples of a situation, where we can follow up, as Pat says, many times when we do get specific situations, we do believe our examiners are working appropriately. But, lots of times it’s more general, that we can’t really track it down. The CHAIRMAN. I don’t have anymore time for questions, because—I will not ask—the question I want to ask is, How many times do you think the bankers are blaming you for the fact that they don’t want to make the loan, anyway? But, I won’t ask that question. Mr. McWatters. Mr. MCWATTERS. Thank you, Senator. Let me start at a 30,000-foot altitude and ask a basic question. Back at—the last time we had a severe real estate depression was ’89 through ’94, and the answer was the Resolution Trust Authority—or Corporation. RTC purchased lots of loans, sold them at very cheap prices, although it may not have been favorable for the taxpayers, but it did lead to immediate price discovery, as to what was a fair market value of those assets. Given where we are today, is there a need for an RTC? Ms. Thompson. Ms. THOMPSON. Well, I worked at the RTC, and I think the industry and the regulators can work through this issue. We are see- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00083 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 78 ing signs of stabilization. The CMBS market is coming back; it’s not where it once was, but we saw a lot of transactions in the fourth-quarter last year. Vacancy rates are declining. And it seems like the workout process just needs time to work itself through. I’m not sure that an RTC-type entity is necessary at this point. Mr. MCWATTERS. Okay. Thank you. Dr. Parkinson. Dr. PARKINSON. Just to make an observation that the RTC was created to dispose of the assets of failed banks after they had failed and come into the FDIC’s portfolio. Mr. MCWATTERS. Right. Dr. PARKINSON. If the concern today is about this overhang of troubled assets at the banks, until they fail, there really wouldn’t be a purpose for RTC. And, if the notion was that we create a government entity to buy troubled assets from commercial banks that were still sound, you’d face the same issues they did in trying to get the original conception of the TARP program off the ground?. And how do you do that in such a way that you aren’t creating a government subsidy, on the one hand, or not giving a fair price to the troubled institution, on the other? Mr. MCWATTERS. Oh, okay. Well, let me ask you this question. Is there any need for a quasi-TARP structure? I’ve read about government-sponsored REITs, quasi-REITs, where the government purchases mortgage, purchases property, holds them in this REITtype entity—it’s not a technical REIT, under the Internal Revenue Code—holds it, sells interest in it to the public, and then ultimately, as the properties recover, disposes of the properties, probably with the public investors granting back some sort of an equity participation right to the government, so the government walks out whole. Is there any need for something like that? Dr. PARKINSON. I haven’t given that specific proposal any careful thought. But, again, I think the challenges would be many. Again, what price would the REIT purchase the assets from the institutions? Where within the government would we have the capacity to manage a REIT? But, I haven’t heard that proposal, and therefore—— Mr. MCWATTERS. Yeah. Dr. PARKINSON [continuing]. I probably can’t give you a fully satisfactory answer. Mr. MCWATTERS. Yeah. What I’m looking for is not necessarily mechanics, but whether or not governmental intervention, taxpayer funds, are needed to solve this problem, or if this is a problem that can simply be solved by the market over the next 2 or 3 years. Dr. PARKINSON. Well, I think funds have been flowing back into real estate REITs, of late. And also, another point I think all of us made was that, ultimately, the fate of these commercial real estate properties is very much going to be driven by developments in the broader economy, whether it’s the path of interest rates, unemployment. So, maybe the best thing we can do is try to support the recovery through prudent and appropriate monetary and fiscal policies. And that may be the single most effective thing to support the value of those CRE assets. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00084 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 79 Mr. MCWATTERS. Okay. Mr. Wilson. Mr. WILSON. I agree. I think there is a lot of money out there. There’s private investor money. They’re just looking for the right price. There is price discovery on some of the most distressed assets. But, I think there are many cases where it makes more sense for the bank to hang on and work with the borrower, if there is a viable source of repayment that can eventually pay the loan. So, I think that we probably can work through the process, as painful as it would be. Mr. MCWATTERS. Okay. Ms. Thompson, did you have something else to add? Ms. THOMPSON. Mr. McWatters, I think you’re referring to an equity trust transaction. This was a type of transaction that was used at the Resolution Trust Corporation. Again, that was for failed assets, where the assets were sold into a trust—there were nonperforming and some performing—and the government took a percentage share of both the downside and the upside. That seems to work well for assets from failed institutions. I’m not sure that that is necessary right now, because the market is starting to open up. Some of the problem banks are starting to raise capital. And we are seeing slow signs of asset sales. And, as I mentioned earlier, the CMBS market is slowly coming back. And, especially in the CMBS market, the special services have a lot more flexibility to work out the loans, as do banks that have commercial real estate in their portfolio. The transaction itself has been done before, and I think that it’s a good mechanism, but I’m not sure it’s necessary for—— Mr. MCWATTERS. Okay. Ms. THOMPSON [continuing]. An open market. Mr. MCWATTERS. Okay. Fair enough. My time’s up. But, my takeaway from this is that, from the FDIC, Fed, and OCC’s perspective, there is not the need—clear need, today, for direct governmental intervention of taxpayer funds to solve this problem. Thank you. The CHAIRMAN. Thank you, Mr. McWatters. Mr. Silvers. Mr. SILVERS. Thank you, Mr. Chairman. I—before I begin my questioning, I just want to observe that, in one of the—our work, as a panel, is coming to an end. This probably is our second-to-last hearing. And one of the great pleasures of having served on this panel is to be able to learn from such dedicated public servants as yourselves. And I think, particularly when we discuss motivations of folks, it’s always apparent to me that people such as yourselves have many opportunities to make lots of money elsewhere. And I just suspect, just from what I know of each of you, that you’ve spent long careers serving the public for far less than you can make in the private sector. And the motivations involved in that are clearly, perhaps, not dreamed of in economist philosophies. Now, from that high level to the more mundane. Mr.—Dr. Parkinson, in your testimony, you—in your written testimony, you observed that the commercial banks have charged off about $80 bil- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00085 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 80 lion of commercial real estate assets. Do I take from your testimony that—and this is all—to all three of you, but particularly to Dr. Parkinson—that these charge-offs have largely been, essentially, driven by—not by refinancing failures, but by the failure of the borrowers to be able to make the payments? Is that fair? Do I read that right? Dr. PARKINSON. I think it would be difficult to parse. They can’t meet the terms of the original loan, or it’s in trouble. Whether that’s because they don’t have sufficient cashflow to service the debt, outside of an event where the balloon payment comes due, or how much that was an inability to make the balloon payments, I don’t know. I’m guessing that there’s some of both. And certainly, in many cases, the fundamental problem is the lack of cashflow—— Mr. SILVERS. Right. Dr. PARKINSON [continuing]. And that, in turn, would make it very difficult for them to make the balloon payments—— Mr. SILVERS. But, the reason why the chargeoff has occurred— Mr. Wilson, you’re nodding your head—it seems likely, given just the timing of the refinancing issues and the balloon payments, that the reason why these 80 billion charge-offs have occurred is more likely to be in the routine cashflows rather than in the balloon payment. Is that—— Mr. WILSON. Yes, I would agree with that, because commercial banks, insurance companies, and really even special services and CMBS, you know, have a fair amount of ability to work with customers. And if there is cashflow there and the loan is matured, that’s an issue. But, lots of times they can work through those issues if there’s a fundamental source for repayment still with the loan. Mr. SILVERS. Ms. Thompson, do you have anything to add to this? Ms. THOMPSON. Yeah. I think much of the chargeoffs have taken place in the ADC space. Mr. SILVERS. Yes, I was getting to that. Ms. THOMPSON. Oh. Mr. SILVERS. Please continue. Ms. THOMPSON. I was just going to say—because there’s a distinction between the charge-off numbers for ADCs and the chargeoffs for owner-occupied commercial real estate. And you’d notice significant differences in them both, and significant—— Mr. SILVERS. What portion of the—— Ms. THOMPSON [continuing]. Differences in the—— Mr. SILVERS [continuing]. 80 billion in commercial bank chargeoffs do you think are ADC—meaning the development loans and the like? Ms. THOMPSON. For commercial banks and savings institutions, about $64 billion, or 70 percent of all CRE charge-offs since yearend 2007, were attributable to ADC. Mr. SILVERS. All right. Now, in—you know, this hearing has sort of already ranged widely, but it seems to me that our fundamental concern here, for starters, is that we’ve got about 34 billion in TARP assets in banks through CPP, mostly—almost entirely smaller banks. They’re exposed to the commercial real estate market disproportionately. The question is, What happens when the balloon VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00086 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 81 payments come due? The—it seems as though—do you—tell me if you disagree, but it seems though that question really—we haven’t really gotten to that question yet, that the charge-offs we have seen are predominantly due to cash flow issues and disproportionately in development loans, not in, sort of, occupied properties. Is that a fair summary of where we sit—— Ms. THOMPSON. I think—— Mr. SILVERS [continuing]. Today? Ms. THOMPSON. I think that’s fair. Mr. SILVERS. All right. So, our panel’s concern, I think—and this is the—like, the third hearing and we’ve done a couple of reports—is, What happens when the balloon payments hit? Mr. WILSON, you say that there’s a lot of flexibility here. So, let me ask you this. If I’m a C—if I’m a TARP-recipient bank, holding some of the public’s money, and I come to one or all or more of you, in a year’s time, with a bunch of loans that have come due, and, they—and the borrowers can’t make the balloon payments, and they have problems refinancing, because the price of property has fallen 40 percent, which is the typical—which is what Moody says the market’s fallen—so, I’m the—I’m a bank, and I come to you and I say, ‘‘I’d like, essentially, forbearance. I’d like to be able to rollover this loan or redo it, even though the value of the property is now—can’t—the collateral can’t support the loan, under normal underwriting standards,’’ what do you guys say? Ms. THOMPSON. We’re telling our examiners not to have banks classify loans just because the collateral value has declined. We look at the borrower’s ability to repay. So, to the extent you have a borrower, and they can make a repayment, I think that is the fundamental issue. Mr. SILVERS. But, I’m asking when the—I mean, this is a situation where the borrower literally can’t make a payment. There’s a balloon payment due, they can’t make it. They—you know. Ms. THOMPSON. They may not be able to make that payment, but there is a payment that—— Mr. SILVERS. They’re making their ongoing payments. Ms. THOMPSON. If they’re making their ongoing payments, there are flexibilities that the banks are allowed. The CRE workout guidance provides some specific examples of those types of transactions. They can modify the loan; they can extend the loan. We would focus specifically on the borrower’s ability to repay. We would encourage a modification. Mr. WILSON. Yeah, speaking broadly, for construction and development loans, if it was a failed project, you really have no cashflow; it’s a liquidation-type situation. Most of the commercial mortgage, income-producing loans, have tenants and they have cashflow. It may not be enough cashflow, but there’s an opportunity to resize the loan, bring additional equity to the table. If there is no additional equity, there’s the ability for the bank to charge it down, but not off, and restructure the loan. And so, the loss content’s not as high, in commercial mortgage, which we see is the bigger issue, going forward. Mr. SILVERS. My time is expired. Thank you. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00087 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 82 The CHAIRMAN. Dr. Troske. Dr. TROSKE. Thank you. I’d like to continue this line of questioning that Mr. Silvers has started, because I think it’s a very important one. And I guess I want to sort of more generally—it seems like—this is a fairly complicated problem, knowing when you write a property down, in a dynamic economy in which prices obviously are fluctuating, and that affects the value of the underlying property, and things like that. So, I mean, is there—are there general rules, that you can sort of provide us with, when you think it’s appropriate for a bank to write down a property and when it’s—you leave it on the books as is? And what’s the cost and benefits from taking either action? I’ll start with you, Ms. Thompson. Could you? Ms. THOMPSON. Well, I think that a borrower’s ability to repay is a big factor in the consideration of whether you modify a loan, or not. And, certainly foreclosures need to take place and writedowns need to take place. If banks take a really hard look at the borrower’s capacity, as opposed to collateral value, then they could likely restructure and modify a loan that would work for both the borrower and the bank. I do think that most institutions, especially the smaller institutions, hold these loans in portfolio, and they are very much aware of the appraisals and values that are in their specific communities. These bankers have a really good understanding of what they’re supposed to do and when they’re supposed to do it. We try not to be too prescriptive, but our view is, look at the borrower’s ability to repay and try to restructure the loan. If you can’t, then write it off as soon as you possibly can. Dr. TROSKE. Okay, thank you. Dr. Parkinson, do you have any thoughts? Dr. PARKINSON. Yes, I generally agree. Well, number one, I think you’re right, that it is a difficult question. I think Sandra is right, that the local bank probably has the best information to make a sensible judgment about that difficult question, and that the borrower’s ability to service even a restructured loan is really the critical thing. Or perhaps the bank has to ask themself, ‘‘I have two alternatives. I foreclose, then I essentially manage the property and try to maximize the value. Or, do I leave it in the hands of the original borrower? And really, the answer to that question’s going to depend on my assessment of the borrower and his capacity to really manage that property and to maximize its value, whether they can do that better than I can.’’ Dr. TROSKE. Go ahead, Mr. Wilson. Mr. WILSON. Fundamentally, when we evaluate a loan, we look first to cashflow sources to repay the loan such as the NOI from the property, bona fide guarantors that have the ability, or other viable sources. And, as long as that’s still intact, the value of the property is less important. Where the value of the property becomes important is when that primary source or those sources of cashflow are not there, or they’re insufficient, then we have to look to the value of the property and that’s sort of our benchmark for what you charge the loan down to. But, we would not do that if there’s a source of cashflow to pay the loan. The collateral is only a secondary source of repayment. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00088 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 83 Dr. TROSKE. Dr. Parkinson, I want to turn to—sort of expand on something that you sort of hinted at that’s, I guess, sort of a related issue. I mean, one of the things that we have noted, as a panel, is the concentration of these—of CRE loans in small- and medium-sized banks. Do you have sense of why? Do they have a— what is their comparative advantage in making these loans? I’m assuming that that’s why they’re all there. And there’s also—often been questions about whether it should—whether these loans should be with—you know, concentrated in these small- and medium-sized banks. I guess the alternative is that they would be made by larger banks. Give me an overall sense of how we got to this situation, where these are the banks holding their loans? And what’s their advantage in doing this? And, maybe, what’s the cost of doing it? Dr. PARKINSON. Well, just stepping back as an economist, I think these loans are ones where information asymmetries are particularly important. And if I’m a borrower from outside the local area, I’m not going to have the knowledge of the particular area and the project that the local bank does. And that’s probably what gives the local bank their competitive advantage, compared to other potential lenders of these kinds of loans. Over the years, one of the reasons smaller institutions have become concentrated in CRE is that other kinds of loans that they historically made, because of technological changes, development of securitization, et cetera, they no longer were the most efficient or effective lender, when it came to those kinds of products. So, in some sense, their concentration in CRE is a result of an adverse selection, where the other things that they used to be able to fund, they no longer can do so competitively. So, it’s understandable why they’ve ended up where they are. It does pose risk. Although one of the things that Sandra emphasized in her testimony that I think is worth emphasizing is that, while lots of banks with CRE concentrations are in deep trouble, there are also lots of banks with CRE concentrations that are managing those concentrations quite well so that—you know, that comes down to the importance, not simply of what the percentage of their portfolio is in CRE, but their capabilities for managing that portfolio. And that’s why I think a lot of our guidance has not been specified, in terms of, for example, putting arbitrary limit on the concentration, but trying to encourage the institutions to manage those concentrations effectively. Dr. TROSKE. Okay, thank you. My time’s up. The CHAIRMAN. Thank you. Mr. Neiman. Mr. NEIMAN. Dr. Troske, in his opening statement, opened the door for discussion on the role of government, and particularly financial regulators. And I think CRE is, maybe, a good example of assessing the role of bank regulators, because, you know, regulators typically do review banks at a point in time—as well as looking back over bank practices over a prior period—assessing the bank’s asset quality at a point in time, as well as its capital ratios. There’s a growing consensus that, in addition to this type of static assessment, that there should be a forward-looking approach to VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00089 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 84 supervision, as well. And I think all of you, in your written testimonies, focused on issues around stress testing, not only by the regulator, but also in what you’re expecting from the banks. And when you look at the Dodd-Frank reforms, there are additional assessments, going forward, with a forward-looking approach, whether it be living wills or the role of the FSSA. Can you talk about your views on the lessons learned here, and how regulatory supervision has changed? And is this a concept that is being grasped by regulators? Ms. THOMPSON. Yes. At the FDIC, we do have a forward-looking supervision program, where we have taken all the lessons learned from the bank failures and applied them to our supervision process. We looked at institutions that had high concentrations of commercial real estate that had volatile funding sources, and we have put together a training program, for all of our examiners that focuses on, not just the financial condition of the institution, but the practices of that institution. And we are increasing our offsite surveillance for all institutions, so that we know—especially for those that have CRE concentrations—what their financial condition is at any particular point in time. We’re very concerned about interest rates. This is a low-interestrate environment, and we want our institutions to conduct stress testing so that bank management and the FDIC can see where the bank will be if an adverse situation takes place. We’re very concerned about the health and safety and soundness of the financial sector, and we have had a good response from our bankers with regard to this forward-looking-supervision approach. Mr. NEIMAN. Dr. Parkinson, can you comment on in the CRE context as to what is expected of institutions in assessing portfolios and risk under different economic scenarios, as well as utilizing, statistical modeling for loss-reserving? Dr. PARKINSON. All right. Well, I think that’s, again, a very important emphasis in the CRE guidance that we put out in 2006. That’s all been reinforced by Dodd-Frank, with respect to the larger institution that requires the board to conduct annual stress tests and also requires banks to conduct their own stress tests on the smaller ones, on a semiannual basis; 10 to 50 billion, on an annual basis, and to actually publish reports on that. And obviously, where they have CRE concentrations, the stress testing of the CRE portfolios will have to be an important part of that. Also an important initiative that I think I mentioned is the CRE data-collection project that the agencies have embarked upon, where we’re collecting loan-level data on CRE loans; initially, from the very largest CRE lenders, and that’s being expanded somewhat. But, I think that loan-level data will give us a better insight into asset class, to understand how the values of the loans are being driven by the underlying economic variables—vacancy rate, rental rates, et cetera—and, from that, to be able to figure out better how to stress test their existing portfolios. So, I think that is an important recent cooperative supervisory initiative among the three agencies. Mr. NEIMAN. Thank you. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00090 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 85 So, the issues around data collection, we’ve talked often about data—better performance data on the residential side; it sounds like it’s just as important on the commercial side. Mr. Wilson, would you like to comment about the expectations? What you would like to see in institutions to address some of the risks, going forward, on the CRE, as well as any changes in examination approach? Mr. WILSON. Stress testing is obviously an area of focus at all levels of banks. We would size our expectations to the size of the bank. And we would also size our expectations to the level of concentrations that those banks have. So, if you’re a community bank without a concentration, don’t have a lot of hot money, things like that, we would expect a lower level. But, we are in the early stages of putting together additional guidance. We’re working with the Fed and the FDIC on that. We do have tools out there now, but we’re talking about some additional tools that, especially, our community banks can use. Mr. NEIMAN. Thank you. The CHAIRMAN. Thank you. And followup on a point raised by Dr. Troske, about the concentration of commercial real estate in the smaller banks. What impact do you think that’s having on the ability of these banks— since they have this overhang in commercial real estate, the ability to carry out the other things that the bank does? Is this—do you think this is limiting their ability to make other loans and be— stimulate the economy in other ways? And let’s start with Mr. Wilson. Mr. WILSON. I think, for a small subset of banks, the ones that are on the FDIC problem-loan list, for example, that’s a true concern, because they’re focused on working out of commercial real estate. But, we have a large number of banks, at all sizes, where they’re open for business for commercial real estate lending as well as other lending. And, you know, I think they pull back, we think rightfully so, on some of the underwriting standards that, in retrospect, got too liberal. And so, it’s a little bit of a new world for borrowers. But, we believe, there’s plenty of credit available for borrowers of creditworthy quality. The CHAIRMAN. Dr. Parkinson. Dr. PARKINSON. I’m going to build on his points. I think, where a lender or bank has a CRE concentration, and that is a concentration of loans that weren’t very well underwritten and that are suffering a lot of losses, which is impairing their condition, those banks when you look at loan growth, by the CAMEL ratings for the banks, the banks with the lowest CAMEL ratings are contracting loans at a must more rapid pace, and are recovering more slowly, in terms of their lending activity, than the stronger rated banks. So, to the extent that the commercial real estate concentration is not managed well and the bank gets into trouble, that clearly does have an adverse effect on people who rely upon that bank for credit. The CHAIRMAN. Ms. Thompson. Ms. THOMPSON. I agree with my colleagues. And I’ve mentioned that, during the crisis, the levels of lending for the larger institutions decreased, while the levels of lending for the smaller commu- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00091 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 86 nity banks, that do have the significant concentrations, did increase. The CHAIRMAN. Ms. Thompson, if the Open Market Committee were to prove an increase in the Fed funds rates, would that have a result—be a significant shock on the commercial real estate market—or do you know where the commercial real estate going to— market’s going to be? Ms. THOMPSON. I’ll defer that an answer to that to my colleague at the Federal Reserve. The CHAIRMAN. Well, he can give us the best estimate of whether it’ll happen or not—— [Laughter.] The CHAIRMAN [continuing]. Which he will not do. And I’m more interested in, if it does happen, for the banks you’re looking at, would this be a significant problem to those banks? Ms. THOMPSON. I hate to—— The CHAIRMAN. Let me put it this way. Without the open market—if interest rates start going up, do you—— Ms. THOMPSON. This is a really good environment for restructuring. It’s a really good environment for refinancing, modifications, and sales. I think that it might cause an issue or two. The CHAIRMAN. Dr. Parkinson. Dr. PARKINSON. I think it would depend on why interest rates were rising. And the reason interest rates would be rising was that the economy was recovering, unemployment was coming down, and the Fed was feeling comfortable raising its target rate. And I’d be willing to accept the risk and the adverse effect of the rising interest rates in that context, where it’s in the context of economic growth, recovering smartly. The CHAIRMAN. Got it. Mr. Wilson. Mr. WILSON. I agree totally with that. I think the disaster would be if rates went up and the economy doesn’t improve concurrent with that. But, you know, generally when rates go up, it means the economy’s getting better. And, hopefully then there’s more capacity in commercial real estate borrowers. The CHAIRMAN. Mr. Wilson, you mentioned stress tests; in fact, a number of you mentioned stress tests—all of you did, in fact— stress tests. Do you think when you do the—when stress tests come along, they should concentrate—or, what role do you think commercial real estate should play in determining stress tests on a financial institution right now? Mr. WILSON. Well, I think that the lessons that we just went through, and the lessons of the late ’80s, early ’90s, should be applied to commercial real estate portfolios. It has been pointed out by my colleagues, that some banks do come through even severe downturns and come out the other side, even though they have large concentrations. But, what we need to do is understand better and size those. For example, it seems like construction and development—we may need to pay a lot more attention to those than, maybe, the permanent commercial mortgage. But, even then, at some level, a concentration is just too much. And I think, if you have a good stress test, you can show that. The CHAIRMAN. Dr. Parkinson. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00092 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 87 Dr. PARKINSON. We talked about the importance of stress testing. I think Dave also observed that, to the extent you have a concentration in CRE, it’s obviously really important that you stress test your CRE portfolio. So, that has to be a critical part of it, if that is the profile of your institution. The Chairman. Ms. Thompson. Ms. THOMPSON. I do think stress testing is important, especially for commercial real estate. I also believe that the good underwriting underneath the loans is probably the most critical. The CHAIRMAN. Thank you. Thank you. Mr. McWatters. Mr. MCWATTERS. Thank you. You know, I don’t know of a real estate downturn that has not ultimately turned around. There’s always a point where things were overvalued, there were not enough buyers, there were not enough tenants. But, you look forward 5 years, and things are a lot different. Today, we have the added benefit of very low interest rates. Why not just kick the can down the road? Why not refinance, short-term basis, assuming interest rates are going to be down? Keep that going for 3 or 4 years. Wake up. Realize the market has recovered, prices are back up, borrowers are willing to pay more for—I mean, purchasers are willing to pay more for the property; tenants are willing to pay more in rental rates. And you’re through this mess without the banks recognizing losses, without the banks having impaired capital, and without the borrowers representing—recognizing cancellation of indebtedness income. What’s the problem with that? Ms. Thompson. Ms. THOMPSON. I just don’t think we could ignore the problems that exist today. That would be a huge prediction on an uncertain outcome. It’s important to recognize and have some transparency for the financial sector so that people know that they have good loans, or they don’t. And, it’s important to take immediate action, whether it’s modifying loans or writing the loans off, it’s either one or the other. ‘‘Kicking the can down the road’’ just doesn’t seem like it’s an acceptable outcome. Mr. MCWATTERS. Dr. Parkinson. Dr. PARKINSON. I guess, I’d just observe that that strategy of kicking it down the road doesn’t uniformly deliver success, historically. And I think the better approach, again, is to look at it loan by loan, borrower by borrower, and make an assessment as to whether they really have the capacity to service the debt. I think, if you’re just kicking it down the road, there’s a real possibility if the property is in the wrong hands, its value is just going to deteriorate, perhaps even if there is an economic recovery. So, I guess I would agree that we can’t count on kicking it down the road producing the desired outcome. Mr. MCWATTERS. Okay, but that is not being done? I mean, that’s being done some, but, as a whole, that is not being done? Dr. PARKINSON. Well, in the sense it’s simply deferring the problem, we hope it’s not being done at all. But, in some cases a loan may be restructured because that is in the best interest of both the VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00093 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 88 bank and the borrower. But, our guidance tries to make clear that just doing that automatically or routinely, to defer recognition of losses, is not a good strategy. Mr. MCWATTERS. Okay. Mr. Wilson. Mr. WILSON. I would just add that our guidance is also very clear that, if you choose to work with your borrower, number one, it has to improve the prospects for ultimate repayment; and, number two, you need to account for that loan properly. So, if there’s risk in that loan, there needs to be appropriate reserves, there needs to be appropriate accrual on the loan, chargeoff, as necessary. For the bank, it’s not kicking the can down the road, it’s that the ultimate repayment is impaired. Mr. MCWATTERS. So, the best approach is to recognize economic reality, write it down, recognize losses, take the hit to capital, and, in effect, have price discovery based upon that. Is that a fair assessment? Ms. THOMPSON. Yes. Mr. MCWATTERS. Okay. And that ties back to my first question, about RTC-type structures, bailout-type structures—is that that might not be the answer if the financial institutions that were holding the CRE were in such perilous shape they could not absorb the losses, they could have not absorbed the hits to capital, and that the borrowers could not absorb the tax hits. Is that a fair statement? Ms. THOMPSON. I think so. Mr. MCWATTERS. Okay. That’s it. The CHAIRMAN. Thank you. Mr. Silvers. Mr. SILVERS. Just to pick up where I left off in the last round. So, we have a whole bunch of small banks that still have TARP money, in the form of CPP, disproportionally exposed to commercial real estate—to the commercial real estate sector. Do any of you have thoughts on what is—if our policy goal—and it certainly—it would be, if I was the policymaker—is to avoid further concentration in our banking sector—if that’s our policy goal, which means that we would like a robust small bank sector, any particular advice to Treasury, in terms of the management of TARP’s investments in small banks over this period when these refinancings are coming due in commercial real estate? Ms. THOMPSON. Many of the smaller institutions that have TARP CPP funds are managing their portfolios adequately. The Treasury has a provision, to the extent that TARP recipients miss dividends, that the Treasury can add someone to oversee the bank’s board of directors. So, I think the measures are there. There are several institutions that have concentrations, and they’re working their way through the crisis adequately. Mr. SILVERS. Any more—any further thoughts on this subject? Mr. Wilson. Mr. WILSON. No. Mr. SILVERS. Or—— Mr. WILSON. Yeah, I’m not real close to the TARP program. But, I would say that pursuant to our 2009 guidance, we have laid out VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00094 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 89 how we would like to see these problem loans managed. And I think that applies whether the bank has TARP or not. If the bank needs to be resolved, I think it still needs to be resolved. Mr. SILVERS. My—I don’t know, it seems sort of intuitive to me, and I wonder if you all agree, that, if our goal is to try to keep the small bank sector healthy, that—during this period when small banks that have CRE exposure are going to have to manage through the rollover of these loans, that it might not be a good idea to try to compel them to pay back the—to pay the Treasury’s money back during that period. But, I’m—this is not an ideological observation, it’s a practical one. Is that right? Or would it be better to try to get them, during that period, to have—be subjected to the discipline of raising that capital privately? Dr. PARKINSON. Well, I don’t think we’ve been trying to force them to repay the TARP—— Mr. SILVERS. No, I’m—— Dr. PARKINSON. We have—— Mr. SILVERS [continuing]. Wasn’t suggesting—— Dr. PARKINSON [continuing]. We have—— Mr. SILVERS [continuing]. You had been. Dr. PARKINSON [continuing]. Lots of institutions that want to repay their TARP, but absent a substantial raise of private capital, we don’t think that they wouldn’t be safe and sound, having done that. I think that really is the issue. We look at each one of these TARP repayments, one by one, and want to satisfy ourselves that, either given the amount of capital they currently have or the amount of capital they can raise in the market post-TARP repayment, they will still have adequate capital to bear the risks that are present in their portfolio, including any risks that may be as a result of troubled CRE assets. But, at least the banks themselves feel that the sooner they can repay their TARP, the better. So, they’re quite anxious to repay. Mr. SILVERS. I see. That’s very helpful. If part of our mandate is to sort of look at these very practical aspects of TARP that I’ve just been asking about, if the other part of our mandate, I believe, is to—is that Congress wanted this rather extraordinary intervention in the financial markets; that is, TARP to be done fairly. This may be asking too much of the three of you, but I would ask you to comment on, What do we say to the executive or the employee or the investor in a small bank that is being resolved by the FDIC, against the backdrop of what we did, you know, in terms of forbearance to institutions, like Citigroup and Bank of America—how do we justify—how, in any respect, is that fair? And what do we say to the person who’s on the losing end of the unfairness? [No response.] Mr. SILVERS. I guess we say nothing. Is that really so? It’s kind of sad. [No response.] Mr. SILVERS. Well, perhaps it’s unfair to—— Dr. PARKINSON. I’ll just say two things. One, obviously the reason for the extraordinary interventions was a belief that, if the banks had failed in a disorderly manner, that the economy, the financial VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00095 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 90 system might have been much more worse off, including those small institutions that didn’t benefit directly from that assistance. I think also the too-big-too-fail problem is a very real problem. The Dodd-Frank Act has various provisions designed to address that. I think we’re still working through the implementation of those. So, ultimately, how effective they will be, the jury is still out, but we’re working very hard to ensure that, particularly, the socalled systemically important institutions are held to much tougher standards than other institutions. And, very importantly in terms of the market discipline side, with the new orderly resolution authority there’s no longer any authority to do open bank assistance, so there’s not going to be any benefit to the shareholders. I think all the agencies agree that any holder of a capital instrument should not benefit in any way from extraordinary assistance. And even the FDIC has proposed that holders of longer-term debt, that assistance payments for that class of creditors will be ruled out, in which case, I think all of those should do quite a bit to reinvigorate market discipline. Ms. THOMPSON. I think you’re right. What took place really helped everyone in the economy. And I think the Dodd-Frank Act did a lot to level the playing field between larger and smaller institutions. It took away some of the competitive inequities between the largest and the very smallest institutions. And, most importantly, it did remove ‘‘too big to fail.’’ So, I think that the steps that were taken were necessary. And the steps that we’re taking now, in terms of the orderly liquidation authority and implementation of other provisions of the Dodd-Frank Act, will go a long way toward having that conversation. Mr. SILVERS. Well, my time is long expired. Thank you. The CHAIRMAN. Dr. Troske. Dr. TROSKE. Thank you. I guess I want to—one comment I’ll make about my opening statement. I was hoping to get the point across, that I think regulators were far too much blamed for the financial crisis than was warranted. I think it was primarily a result of the managers and owners of firms. Dr. Parkinson, I wanted to start with you, because I wanted to ask a question sort of specific about the Fed. I was looking at the data yesterday, and I believe the levels of bank reserves at the Fed have grown back to $1.1 trillion, after dropping below 1.1 trillion for a while. We could discuss why that is. But, there seems to be— and most of that is excess reserves. So, banks seem to have a ample supply of capital sitting, certainly, at the Federal Reserve. Is that—does that give you some comfort, when thinking about the CRE situation? Do you have a sense of how much of this capital and excess reserves held at the Fed are held by these small- and medium-sized banks, thereby giving them a cushion if there are any additional problems in this market? Dr. PARKINSON. I don’t know the answer to that question. But, I would have approached it a different way, if the concern is about the availability of lendable funds to meet the needs of creditworthy borrowers. The fact that the banking system as a whole, is holding so much in excess reserves at the Fed that pays so very little, I VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00096 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 91 think they have ample motive to go out and find creditworthy borrowers that they can make loans to, to make much higher returns than they’re making on those excess reserves. And I think we are starting to see some signs that the tightening of credit conditions, that’s been going on since the crisis emerged, is coming to an end, and that they are looking very actively for creditworthy borrowers to put that money to work. Dr. TROSKE. And—— Dr. PARKINSON. But, I don’t know the answer to your specific question. I suspect that a disproportionate amount is at the large institutions, but I don’t know the facts. Dr. TROSKE. I suspect the same. And I did ask our staff to find out, yesterday, and they were unsuccessful, as well. So—I wasn’t surprised they were unsuccessful, since I suspected they weren’t going to be. I want to build on that last statement that you made, or the statements that you made, about just overall lending, and ask, I guess, the three of you. It is clear that lending is down by most banks. And there’s a question—and I’m not sure we’re going to resolve it today—about whether that reflects a lack of demand or a lack of supply. From your regulatory standpoint, can you give me a sense of whether you think—what it—it’s a lack of demand or supply? And we’ll start with you, Ms. Thompson. Ms. THOMPSON. I think it’s both. Actually, I think there’s three things. I think there’s a lack of demand. I believe that there are borrowers that lack confidence. I think that there’s a lack of supply. I think bank capital is concentrated. And, the biggest issue is the collateral values, because they’ve declined so precipitously. I think that there is plenty of capital in the system. People have to start showing confidence in the financial institutions, and that is a slow process. I think there’s a tentative rebuilding. We’re working our way towards whatever this new norm is. And when people get comfortable, they’ll go to institutions, apply for loans, and receive credit. But, I think there is a tentative nature out there right now. People are cautiously optimistic, because we’re not out of the woods yet. Dr. TROSKE. Okay. Dr. Parkinson. Dr. PARKINSON. Well, I think it is elements of both demand and supply. On the demand side when you talk to the banks, where they have binding lending commitments outstanding, the utilization rates of those lines is, sort of, at historic lows. And I think that’s a pretty good indicator, at least for those borrowers, they just don’t have the demand. On the supply side, I think there are signs that for stronger borrowers, there’s ample credit out there. But, obviously there’s been a real change since the crisis, in terms of the access to credit by weaker borrowers. Now, we don’t want to go back to the availability of credit that we had in 2006 and 2007. We want to go to some new normal, where there are more prudent underwriting standards. But, that does mean that lots of people that could get credit formerly probably are not going to be able to get it on the same terms today. And that must be constraining their spending. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00097 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 92 But, again, we have ask, ‘‘What’s the alternative?’’ Dr. TROSKE. Mr. Wilson, do you have anything to add? Mr. WILSON. I agree with that. I guess I would also point out, on both the demand and the supply side, the Federal Reserves’ quarterly survey shows that banks are saying that they’re not tightening standards beyond what they were. And also, they’re seeing loan demand starting to pick up. But, in our conversations with banks, they said, ‘‘Yeah, we don’t like the rate that the Federal Reserve pays on the reserves, and we would like to lend the money.’’ So, I think there is a willingness, on the part of our banks, to put those out—back into good quality loans. Dr. TROSKE. Thank you. The CHAIRMAN. Thank you. Superintendent Neiman. Mr. NEIMAN. Yeah. I’d like to follow up on the issues around supply and demand, and really focus on underwriting criteria. Ms. Thompson mentioned that underwriting criteria is so critical. The reference to the Federal Reserve senior loan officer survey does show that standards remain largely unchanged in the fourth quarter. Certainly, they are higher than the average level over the last decade. And the majority of respondents indicated that lending standards, would not expect to return to long-run norms until after 2012, and, as a result, will remain tighter, for the foreseeable future. Is this a good thing? Were underwriting standards too lax, or is this some evidence of an overreaction? Ms. Thompson. Ms. THOMPSON. Well, I think underwriting standards were lax. And, the return to the basic fundamentals of lending is critical: making sure the borrowers have the ability to repay, not focusing on collateral values as the primary source of repayment, and looking at other ways to generate income to repay the loans. I think that’s critical. Mr. NEIMAN. Where regulators are sometimes criticized for extending—going too far to one extreme, have banks, in tightening and correcting those lax standards, gone too far? Is there any evidence of that in your reviews? Ms. THOMPSON. Regulators are criticized, generally. In looking at the crisis, there were things that we could have done more quickly. And I do believe that there were some steps that we could have taken to help deal with this issue. I think that the lending and underwriting standards that we have worked collectively on through our guidance is good guidance, it’s prudent, and it certainly will be sustainable in good times as well as bad. Mr. NEIMAN. Dr. Parkinson, what are you seeing in your assessment of the underwriting standards being used by lenders? Dr. PARKINSON. Well, again, I think you had it right, that there was a long period of tightening. But, that proceeded from a base period, where standards were too lax. And now, we see some signs that that’s abating. But almost more important than the specific standards, when you’re assessing whether someone’s a creditworthy borrower, that VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00098 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 93 depends, in part, on your economic outlook, and how supportive you think the economic environment will be. And I think confidence, both by the borrowers and by the lenders, has been slow to recover. I guess there are hopeful signs that the economy, in the last couple of months, has been picking up steam. And I think, once people are convinced that that higher path of growth is sustainable and is the most likely path, you’ll get a rebound in confidence. And that’s probably the most important thing, both to work on increasing the demand and increasing the supply of credit. Mr. NEIMAN. Great. Mr. Wilson, you mentioned taking supply and demand into consideration has an impact on lending levels. And you indicated that it has a varying degree, depending on the size of the institution or the type of the asset. Can you elaborate so we can get a better sense of loan levels, whether they be from big or small banks or a variety of type of loans? Mr. WILSON. Well, I think that, for example, in the community banks that do have big concentrations of commercial real estate, what we’re going through right now, brought to bear the risks, and they’re more sensitive of those risks. So, they probably are tighter than they would have normally been if they didn’t have the concentration. Yeah, underwriting standards in almost any asset class in 2006, early 2007, were too liberal. The pendulum usually swings too far the other way as banks try to recover from problem loans. But, we’re seeing evidence that, you know, they’re coming back into balance pretty quickly, especially in certain markets, like leveraged loans. There are stories out there that the recap deals, number one, are very prevalent these days. Pricing is getting tighter. And, even in commercial real estate, pricing has tightened dramatically in the last couple of months. So, we do feel like those supply/demand factors are coming back into balance. Mr. NEIMAN. And taking into consideration, in addition to the tightening of underwriting standards, how much is preservation of capital playing into that same issue of supply? Mr. WILSON. And obviously that’s a big problem with community banks that are under stress. It’s, to some extent, an issue for all banks, because of the Basel 3 initiatives. But, Basel 3 was very sensitive to that. And that’s why the committee has a phase-in that goes out through 2018, to be sensitive to that issue, to not constrain lending because of capital requirements. Mr. NEIMAN. Thank you. The CHAIRMAN. Thank you, Superintendent Neiman. And thank the board. First, I want to thank you for being here today. But, even longer, I want to thank you for your public service. I continue to be incredibly impressed with the overall quality, intelligence, and competence of the people that serve in the Federal Government. And I think anyone here watching you today would be proud of the fact that you are representing all Americans near here, and doing a competent, thorough, and intelligent job at everything you do. So, I really want to thank you especially for that. Thank you. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00099 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 94 And if the second panel would come forward—the second panel, come forward. Mr. Silvers is going to have to leave. It’s nothing personal. [Laughter.] But, he has to be somewhere else. He’s necessarily absent. [Pause.] The CHAIRMAN. Welcome. Thank you for being here. Thank you for helping us work through these rather thorny complicated issues. I’m really pleased to welcome our panel: Matthew Anderson, managing director at Foresight Analytics, a division of Trepp; Richard Parkus, executive director at Morgan Stanley Research; and Jamie Woodwell, vice president, commercial real estate research at the Mortgage Bankers Association. And thank you for coming. Please keep your testimony to 5 minutes so we’ll have time for questions. Your complete written statement will be printed in the record. And we will begin with Mr. Anderson. srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF MATTHEW ANDERSON, MANAGING DIRECTOR, FORESIGHT ANALYTICS, A DIVISION OF TREPP Mr. ANDERSON. Chairman Kaufman and members of the Congressional Oversight Panel, thank you for the opportunity to discuss commercial real estate and bank stability. My testimony today will include a discussion of real estate value declines, the growth in the size of the debt market and resulting mortgage maturities, bank commercial real estate exposure and distress, and finally, some aspects of our outlook for the economy, real estate, and commercial real estate debt market, in particular. I should add, the views expressed today are my own and not necessarily those of my employer, Trepp LLC. One of the most important features of the current real estate cycle is the dramatic decline in property values. The most recent figures indicate that commercial property values have fallen by approximately 42 percent since speaking in late 2007. That’s larger than the decline in the earlier 1990s, when commercial real estate values fell by nearly one-third, and on par with our estimates of the decline during the Depression. A rise in volume of mortgage—maturing mortgages has put pressure on the commercial real estate debt market, and will continue to do so for several years. By our estimates, annual maturities reached $200 billion in 2006, and surpassed $300 billion in 2009. We further estimate that commercial real estate debt maturities will climb to approximately $350 billion per year between 2011 and 2013. The combination of lower property values and rising volumes of maturing mortgages has resulted in a large amount of maturing loans that are underwater. We estimate that as much as half of the loans maturing in 2011 to 2015 are currently underwater, and that $251 billion is underwater by 20 percent or more. Many banks entered the financial crisis with substantial exposures to commercial real estate. As of the first quarter of 2007, more than 2700 banks and thrifts, or 32 percent of the total bank count, had a commercial real estate, or CRE, concentration. The VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00100 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 95 greatest concentrations were among banks with $1 to $10 billion in assets and banks with $100 million to $1 billion in assets, where 56 percent and 43 percent of banks in those groups, respectively, had CRE concentrations. The number and proportion of banks with commercial real estate concentrations has fallen significantly since 2007. As of the third quarter of 2010, just under 1300 banks and thrifts had a CRE concentration, a decline of more than 1400 from the first quarter of 2007. Part of this reduction is the result of reduced amounts of debt outstanding. Approximately $300 billion of CRE loan exposure has been trimmed from banks’ balance sheets over the last 2 years. Banks that received CPP funds from TARP are more likely to have commercial real estate concentrations than non-CPP recipients. We’ve tabulated commercial real estate concentration figures for bank and thrift subsidiaries of firms that received CPP investments, including banks that have repaid the CPP funds, with the result that, as of the third quarter of 2010, 32 percent of the CPPrecipient subsidiaries had CRE concentrations, compared with 15 percent for non-CPP recipients. Delinquency rates for construction loans and commercial mortgages have been declining, but remain high relative to the pre-crisis levels. Our early estimates for the fourth quarter of 2010 indicate that construction delinquency rates stand at 18 percent and commercial mortgage delinquencies at 5.3 percent, compared with 1-percent delinquency rates prior to the onset of the downturn. We maintain a watch list of banks that appear to be at elevated risk of failure. This list has proven quite accurate, capturing 96 percent of failed banks since the beginning of the current cycle in 2007. Nonperforming commercial real estate loans have been the largest problem loan type for banks on this watch list. For more than 80 percent of the banks on our watch list, nonperforming commercial real estate loans are the main problem loan type. Economic and real estate market conditions are improving, albeit slowly. The job market is gradually turning around. And in the commercial real estate market, occupancy rates and rents are stabilizing, but net operating income has been reduced by 15 percent, or more, from pre-recession levels. Liquidity has also been returning to the commercial real estate market. This has been most notable in the CMBS segment, where $11.6 billion of new issuance occurred in 2010. Our parent company, Trepp LLC, expects this trend to continue, with $50 billion of new issuance during 2011. We believe the recovery will be a prolonged one, with slow improvement in the broader economy translating into gradually increasing demand for commercial real estate. Delinquency rates will improve, as well, as lenders continue to reduce nonperforming loan balances, but this process looks likely to last several more quarters. We remain concerned about the volume of underwater mortgages that will mature over the next several years, and the broader issue of mortgage maturities overall. Continued high demand for refinancing for loans originated during the commercial real estate debt boom of the 2000s will constrain real or inflation-adjusted growth in the commercial mortgage market over the next decade. We believe growth in the market will VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00101 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 96 srobinson on DSKHWCL6B1PROD with HEARING more closely resemble the 1990s, when annual growth was 0.8 percent in real terms, rather than 2000 to 2008, when annual real growth was 9.4 percent. Mr. CHAIRMAN, I thank you and the other members of the panel. This statement constitutes my formal testimony. And I look forward to any questions you might have. [The prepared statement of Mr. Anderson follows:] VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00102 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00103 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 155 65083A.059 srobinson on DSKHWCL6B1PROD with HEARING 97 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00104 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 156 65083A.060 srobinson on DSKHWCL6B1PROD with HEARING 98 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00105 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 157 65083A.061 srobinson on DSKHWCL6B1PROD with HEARING 99 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00106 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 158 65083A.062 srobinson on DSKHWCL6B1PROD with HEARING 100 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00107 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 159 65083A.063 srobinson on DSKHWCL6B1PROD with HEARING 101 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00108 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 160 65083A.064 srobinson on DSKHWCL6B1PROD with HEARING 102 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00109 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 161 65083A.065 srobinson on DSKHWCL6B1PROD with HEARING 103 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00110 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 162 65083A.066 srobinson on DSKHWCL6B1PROD with HEARING 104 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00111 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 163 65083A.067 srobinson on DSKHWCL6B1PROD with HEARING 105 106 The CHAIRMAN. Thank you very much. Mr. Parkus. srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF RICHARD PARKUS, EXECUTIVE DIRECTOR, MORGAN STANLEY RESEARCH Mr. PARKUS. Chairman Kaufman and members of the Congressional Oversight Panel, my name is Richard Parkus, and I’m head of commercial real estate debt research at Morgan Stanley, and chair of the research committee at the Commercial Real Estate Finance Council. I would like to thank the panel for taking—for giving me the opportunity to discuss the current state of commercial real estate financing markets and their potential impact on banks. I would like to emphasize that the opinions I share today are strictly my own and do not represent those of Morgan Stanley or the Commercial Real Estate Finance Council. The question of whether commercial real estate will be the next shoe to drop is often heard. In my view, this shoe dropped 2 years ago. Since late 2008, commercial real estate has gone through the most severe downturn since the early 1990s. In many respects, the downturn has been even more severe than the early 1990s. Vacancy rates have soared to greater heights. Rents have experienced larger declines. And the drop in property prices has been much larger than during the previous episode. With respect to commercial real estate loans, most analysts expect that the loss rates for CMBS loans, originated during the bubbled years of 2005 through 2008, will exceed the 9- to 10-percent losses experienced in the early 1990s, possibly by as much as 4 to 5 percent. The credit crisis had a particularly severe impact on commercial real estate financing markets. During the depths of the crisis, financing for large, high quality properties, so-called trophy properties, virtually disappeared. The availability of financing was severely impacted for small properties, as well, although it never completely dried up. Some regional and community banks continued to lend, albeit at reduced levels. As TARP brought calm to financial markets in mid 2009, the flow of capital began to return quickly to the trophy property segment. The trickle of new capital has since grown into a flood, and today financing markets for trophy assets has fully recovered. Financing is widely available, and at very favorable rates. Unfortunately, this story is not as positive in the financing markets for smaller properties. Here the market remains highly dislocated and has seen little improvement since the depth of the crisis. The vast amount of capital that has targeted the trophy property segment has not made its way into the market for smaller properties. In summary, there’s a growing bifurcation in the recovery of financing markets for trophy assets and smaller nontrophy assets, on the other hand. This is reflected in the large difference in property price appreciation between the two segments. Trophy property prices declined 39 percent between the 2007 market peak and the 2009 market trough, but have increased 17 percent since that trough. For the market as a whole, and smaller properties in par- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00112 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 107 ticular, prices were down 44 percent, peak to trough, and have been effectively unchanged since that time. Improving the availability of financing is a critical step in the price recovery process for smaller properties. One of the main sources of financing for this segment is banks, both regional and community, many of which continue to struggle with problem commercial real estate loan portfolios. Taking steps to improve the availability of financing for small properties would undoubtedly improve the ability of these banks to work through their problem loan books. To date, core commercial real estate loans and bank portfolios are exhibiting delinquency rates in the 5-and-a-half-percent range, significantly below the 9-plus-percent delinquency rates for loans in CMBS. At least part of the reason for this differential relates to the fact that a significant portion of bank loans are floating-rate. As short-term interest rates plunged from 5 and a half percent in 2007 to a quarter of a percent in 2009, required monthly mortgage payments on floating-rate loans declined by as much as 60 to 70 percent, or more. Without such enormous debt relief, we believe that delinquency rates on bank commercial real estate loans would be far higher, comparable at least to those of fixed-rate loans in CMBS, which did not receive the benefit of debt payment relief. However, this sword cuts both ways. If short-term interest rates rise significantly over the next several years, this could have a significantly negative impact on the performance of floating-rate loans and commercial real estate loans in bank portfolios. Not only would higher interest rates raise required mortgage payments, they could also lead to declining property prices, exacerbating the already significant maturity—maturing debt problem that lies ahead. Without question, the biggest uncertainty and potential problem facing commercial real estate debt markets today is the wall of near-term maturing debt. We estimate that approximately a trillion dollars of core commercial real estate debt will mature through the end of 2013, more than 600 billion of that coming from banks. Adding to this the $375 billion of construction loans in bank portfolios that mature over the same period brings the total to almost 1.4 trillion over the next 3 years. Many maturing CMBS loans are already receiving maturity extensions. And we speculate that the same is true in banks. Nevertheless, simply extending problem loans does not represent a comprehensive solution to the problem as a whole. While maturity extensions will undoubtedly help some borrowers, many loans are far too underwater—are too far underwater to be saved by this approach. A critical ingredient for managing smoothly through the mountain of commercial real estate debt maturities that lie ahead is a well-functioning financing market. This is particularly important for smaller properties, since they make up the bulk of the maturities. In my view, a reformed and revitalizes CMBS market, one that is quickly reemerging now, has the potential to play a key role in helping to improve the availability of financing, particularly to smaller properties; and thus, to reduce the degree of stress as we work our way though this massive deleveraging process. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00113 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 108 srobinson on DSKHWCL6B1PROD with HEARING I thank you for the opportunity to share my views on these important issues and would be happy to answer any questions you may have. [The prepared statement of Mr. Parkus follows:] VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00114 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00115 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 171 here 65083A.068 srobinson on DSKHWCL6B1PROD with HEARING 109 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00116 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 172 here 65083A.069 srobinson on DSKHWCL6B1PROD with HEARING 110 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00117 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 173 here 65083A.070 srobinson on DSKHWCL6B1PROD with HEARING 111 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00118 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 174 here 65083A.071 srobinson on DSKHWCL6B1PROD with HEARING 112 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 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folio 195 here 65083A.092 srobinson on DSKHWCL6B1PROD with HEARING 133 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00140 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 196 here 65083A.093 srobinson on DSKHWCL6B1PROD with HEARING 134 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00141 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert offset folio 197 here 65083A.094 srobinson on DSKHWCL6B1PROD with HEARING 135 136 The CHAIRMAN. Thank you very much. Mr. Woodwell. srobinson on DSKHWCL6B1PROD with HEARING STATEMENT OF JAMIE WOODWELL, VICE PRESIDENT OF COMMERCIAL REAL ESTATE RESEARCH, MORTGAGE BANKERS ASSOCIATION Mr. WOODWELL. Thank you for the opportunity to discuss the Mortgage Bankers Association’s research on conditions and trends in commercial real estate and commercial real estate finance. In my testimony, I’d like to cover three general areas. The first is to correct some myths that have taken hold in discussions about commercial real estate. The second is to highlight current conditions and trends in commercial real estate markets. And the third is to note some key factors that will affect commercial real estate markets, going forward. An important point of clarification is to ensure that we’re speaking of the same thing when we say ‘‘commercial real estate.’’ When industry professionals speak about commercial real estate and commercial mortgages, they’re speaking about office buildings, apartment buildings, shopping malls, warehouses, and other properties that lease out space in exchange for rental payments. This income-producing property market is generally distinct from two other markets that are sometimes folded into conversations, particularly in discussing bank lending: owner-occupied commercial real estate and construction loans. Neither owner-occupied commercial properties nor single-family construction lending are closely tied to the core commercial real estate markets. The many recent discussions and conclusions have grouped them. These distinctions are a key reason for some of the confusion about commercial real estate and how commercial mortgages have been forming in recent quarters. Before discussing the state of commercial real estate markets, I think it’s important to clear up a few myths that have taken hold in discussions about commercial real estate. The first is that banks are being excessively weighed down by their commercial mortgages or their mortgages on commercial and multifamily properties. The second is that there’s been a looming wave of loan maturities threatening the system. As of the third quarter, bank and thrift delinquency rates for commercial and multifamily mortgages remained lower than the average for their overall books of business. And commercial and multifamily mortgages continued to have the lowest chargeoff rates among any major loan type. To put these numbers in context: Since 2006, banks and thrifts have charged off $132 billion of single-family mortgages, $127 billion of credit card loans, $72 billion of commercial and industrial loans, $66 billion of construction loans, and $53 billion of other loans to individuals, but just $27 billion of commercial and multifamily mortgages. A second myth I’d like to address is that there’s been a looming wave of commercial and multifamily loan maturities weighing on the market. On Monday, MBA will release its third annual study detailing the scheduled loan maturities of $1.4 trillion of commercial and multifamily mortgages held by nonbank lenders. What VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00142 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 137 srobinson on DSKHWCL6B1PROD with HEARING these studies have shown is that, with a typical loan term of 10 years, most investor groups’ commercial and multifamily mortgage maturities are spread over a relatively long period. This is in direct contrast to other forms of credit, such as credit card debt, in which the entire outstanding balance rolls every month, and commercial paper, in which nearly the entire market matures every 80 days or less. Let me now turn briefly to current commercial real estate conditions and trends which continue to exhibit the influences of the broader economy. During the third quarter, the economy began to show modest growth, and the absorption of commercial space picked up in the face of little new space coming online. The impact has been marginal declines in vacancy rates and a firming of asking rents. Property sales and origination volumes have picked up, but have not been high enough to keep up with the mortgage debt that investors have seen paying off and paying down. Looking ahead, the most significant factor in the performance of commercial real estate markets will be the performance of the broader economy. Vacancy rates at commercial properties rose as jobs were lost, as consumers pulled back in spending, and as household growth contracted. Economic growth is needed to reverse this trend. Commercial real estate finance markets will be driven by property incomes, values, and interest rates, and where the markets are when loans come due, relative to where they were when loans were made. To the degree future incomes, values, and rates support refinancing existing debt, loans will mature and roll over. To the degree they do not, the existing equity, mezzanine debt, and, as a last resort, first-lien mortgages, will be resized to fit the future capital stack. The Great Recession has strained commercial real estate markets, as it’s strained nearly every part of the U.S. economy. The long-term nature of the market, in the form of relatively long leases and borrowing terms, however, has helped moderate the recession’s impact. Thank you for the opportunity to discuss these issues with you today. [The prepared statement of Mr. Woodwell follows:] VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00143 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00144 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 204 65083A.095 srobinson on DSKHWCL6B1PROD with HEARING 138 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00145 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 205 65083A.096 srobinson on DSKHWCL6B1PROD with HEARING 139 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00146 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 206 65083A.097 srobinson on DSKHWCL6B1PROD with HEARING 140 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00147 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 207 65083A.098 srobinson on DSKHWCL6B1PROD with HEARING 141 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00148 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 208 65083A.099 srobinson on DSKHWCL6B1PROD with HEARING 142 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00149 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 209 65083A.100 srobinson on DSKHWCL6B1PROD with HEARING 143 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00150 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 210 65083A.101 srobinson on DSKHWCL6B1PROD with HEARING 144 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00151 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 211 65083A.102 srobinson on DSKHWCL6B1PROD with HEARING 145 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00152 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 212 65083A.103 srobinson on DSKHWCL6B1PROD with HEARING 146 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00153 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 213 65083A.104 srobinson on DSKHWCL6B1PROD with HEARING 147 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00154 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 214 65083A.105 srobinson on DSKHWCL6B1PROD with HEARING 148 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00155 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 215 65083A.106 srobinson on DSKHWCL6B1PROD with HEARING 149 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00156 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 216 65083A.107 srobinson on DSKHWCL6B1PROD with HEARING 150 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00157 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 217 65083A.108 srobinson on DSKHWCL6B1PROD with HEARING 151 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00158 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 218 65083A.109 srobinson on DSKHWCL6B1PROD with HEARING 152 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00159 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 219 65083A.110 srobinson on DSKHWCL6B1PROD with HEARING 153 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00160 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 220 65083A.111 srobinson on DSKHWCL6B1PROD with HEARING 154 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00161 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 221 65083A.112 srobinson on DSKHWCL6B1PROD with HEARING 155 VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00162 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 Insert graphic folio 222 65083A.113 srobinson on DSKHWCL6B1PROD with HEARING 156 srobinson on DSKHWCL6B1PROD with HEARING 157 The CHAIRMAN. Can you—I’d like to start my first question to all three of you, starting with Mr. Anderson. Has the commercial real estate market, do you think, hit bottom? Mr. ANDERSON. From a value standpoint, yeah, I think so. I think the value indicators would—or price indicators would seem to indicate that we’ve hit bottom, we’ve bounced along bottom for roughly a year, for the broad market. As Mr. Parkus mentioned, for trophy properties, prices have picked up, and that’s gained a lot of attention. So, I think we have, more or less, hit bottom. But we also haven’t seen very much in the way of very strong price growth, at least for the broader market. The CHAIRMAN. Mr. Parkus. Mr. PARKUS. I also do believe that the commercial real estate market—in terms of fundamentals, we have to be careful about what we’re talking here about. In terms of the rents and vacancies, those dramatic declines that we’ve seen in the performance of actual properties, I believe is approaching a bottom. And we will probably be at a bottom sometime in 2011 or 2012 for most property sectors. So, yes, I do believe that that has—we are at a bottom. I think the bigger question is, ‘‘How long do we bump along the bottom?’’ as Mr. Anderson was saying. In terms of price improvements, we have seen dramatic improvements for a relatively small proportion of the commercial real estate universe which focuses really on trophy assets and higherquality institutional-quality assets, and relatively little improvement for smaller assets. The CHAIRMAN. Mr. Woodwell. Mr. WOODWELL. Echoing some comments that were made, I think there are many aspects to the commercial real estate markets. One can look at prices, one can look at the property performance, one can look at a whole range of different things. And they move in relation to one another, but not necessarily—— The CHAIRMAN. Right. Mr. WOODWELL [continuing]. In lockstep. Prices probably are the leading indicator. They were one of the leading indicators of the decline, and now they’re probably one of the leading indicators of a return. We have seen some greater strength there in the last quarter or so. I think it also is interesting to look at the different types of markets. So, a primary market, with more institutional investors, is probably more driven by investor yields and what competitive investor yields are. Whereas, the tertiary markets are probably more driven by the fundamental economics of what’s happening in that market, the job growth, and how those are supporting individual commercial properties. The CHAIRMAN. Great. And back to your question, Mr. Parkus. How long can we bump along the bottom? Mr. PARKUS. Well, you know, the—it’s a difficult question. But, our best estimate is that it will take several years for individual properties—the cashflow, the net operating income at individual properties to begin to improve substantially. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00163 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 158 We think that vacancy rates will begin to come down gradually, probably sometime in 2000—late 2011 or 2012. But, those improvements will tend to be offset by the sort of delay or lagged impact of declining rents. Declining rents don’t flow through into property revenues until space changes. And, as space changes, it will change those rents in the properties. Even as rents are rising—begin to rise, space will be rolling, in many cases, into lower and lower rents. So, that will drag the recovery out several years, we believe. So, property-level improvements are probably a late 2012 or maybe even 2013 phenomena. I should say, robust, very significant improvements, which we do believe will ultimately come. The CHAIRMAN. Mr. Anderson. Mr. ANDERSON. I would generally agree. I think you have to look sector by sector. And, really, in the multifamily sector there’s already some improvement. The lodging sector has shown some improvement, as well. Lodging tends to be very volatile and very correlated—highly correlated with the economy. So, with an improving economy, the lodging sector is one of the early beneficiaries. The office sector is probably one that we’re the most concerned about. Office jobs are off by almost 2 million jobs from the peak in 2007. And it’ll really take quite a while to build those jobs back up again. So, I think we’re looking at a multiyear impact in the office market. The CHAIRMAN. Mr. Woodwell. Mr. WOODWELL. Echoing that last point, I think by sector is very important. If you look at the different lease terms, of different types of commercial properties, you can think of a hotel having, essentially, a nightly lease; self-storage having a monthly lease; apartment buildings, generally, a year-long lease. The longer the lease term, the more muted the impact of the downturn in the recession, but also, then, the more muted the impact in the upturn. So, as a result, hotels and multifamily, which saw the impacts most immediately, are also seeing the positive impacts most immediately. The CHAIRMAN. Thank you. Mr. McWatters. Mr. MCWATTERS. Thank you, Senator. Following up on Senator Kaufman’s comments, it doesn’t sound like any of you see a double dip—a serious double dip in CRE within the next few years. Mr. Anderson. Mr. ANDERSON. No, that’s not a big feature of our outlook. It’s always possible. Mr. MCWATTERS. Okay. Mr. ANDERSON. And, you know, external events can drive the economy back into recession, as we’ve seen with the debt crisis in Europe. But, that’s not a major part of our outlook. Mr. MCWATTERS. Okay. Mr. Parkus. Mr. PARKUS. No, I don’t see anything like that. It would have to be driven, again, by some extraordinary surprise on the downside, which is economywide. Mr. MCWATTERS. Okay. Mr. Woodwell. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00164 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 159 Mr. WOODWELL. And, again, I think the market’s being driven very much, now, by the economy. Where the economy goes, so will the return of the commercial real estate markets. Mr. MCWATTERS. Okay. What about a spike in interest rates over the next year or so? How would that affect your outlook? Mr. ANDERSON. An outright spike would definitely have an impact on real estate, especially bank lending in real estate. There’s a large amount of floating-rate debt. On the construction side, it’s pretty much all floating-rate. So, the low interest rates have definitely benefited borrowers and lenders, from the standpoint of avoiding some of the distress that could crop up in that segment. And also, in the broader commercial mortgage market, I think. For banks, about half is floating-rate and half is fixed-rate; it depends on the bank. But, those are probably pretty good rough figures. So, a surge in interest rates could have a negative impact on borrowers’ ability to pay. Mr. MCWATTERS. Okay. Okay. Mr. Parkus. Mr. PARKUS. I agree with Mr. Anderson. I think that rising interest rates do pose a nontrivial threat to commercial real estate, especially if the rate increases are significant. I’d also say that it depends on what drives the interest-rate increase. As someone on the previous panel made the very good point, if rate increases largely reflect a buoyant economic condition, where the Fed is trying to sort of rein in, you know, surging economic activity, that would be one scenario. And I think the—that type of rising interest rate would be less problematic. On the other hand, today there’s a lot of concern about future inflation through commodity price inflation. And I think that fear can get embedded as—in interest rates, as well, as it—we—it appears to be in longterm interest rates, already. So, it really depends on whether the interest rates are—at the short end or the long end are rising, and what the source of the push upward is. Mr. MCWATTERS. Okay, fair enough. Mr. Woodwell. Mr. WOODWELL. One additional point is, it sort of is relative to the interest rates that are in place. So, if you think of the different cohorts of loans, loans that were made in the—2001/2002 that might be coming due now, they were made at points with relatively higher interest rates than we’re experiencing right now. So, they’ve got a bit of a cushion. As you get to 2004, say, the interest-rate environment there was much lower. So, loans that’ll be maturing— 10-year loans maturing from 2004, say, in 2014, they’ll have much less of a cushion for current interest rates, and, as a result, future higher rates would have more of an impact on them. Mr. MCWATTERS. Okay. So, it sounds like the three of you anticipate a slow recovery of the CRE market over the next few years. May I assume from that, that you do not see the basis, the need for a TARP–2, an RC—RTT—RTC-type structure or any other government source funds to bail out these financial institutions or CMBS holders? Mr. Anderson. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00165 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 160 Mr. ANDERSON. I don’t know about the outright need. It would certainly have an impact. If there were—if there was an RTC established all over again, it would help clear the market of troubled debt that much more rapidly. But, it would also have a cost and an impact. You know, part of the corollary would be a significant increase in the rate of bank closures; whereas, what we’ve been seeing is a high rate, but a—really a process of working through problem banks. And so, I—it would have an impact on the market. You’d have a sharp drop in prices, and it would come at a great cost. But, you would have—what we had in the early ’90s was a market that cleared and then, actually, rapid growth after that, in the later half of the 1990s. So, absent an RTC, our outlook is for pretty much more of the same as what we’ve been experiencing for the last couple of years, just really stretched out over quite a long period. Mr. MCWATTERS. Okay. My time’s up. I will continue with this next time. The CHAIRMAN. Thank you. Superintendent Neiman. Mr. NEIMAN. Thank you. During my opening remarks, I referenced the multifamily housing as a category of CRE; the impact that properties may deteriorate as rental income is diverted from maintenance to debt service, with the impact of renters possibly losing their homes. How do you all assess the impact of the CRE situation on multifamily housing? Mr. ANDERSON. Well, I’m—for us, we focus on bank loan performance very closely. And, probably simply put, the delinquency rates on bank multifamily loans have been highly correlated with the delinquencies on commercial mortgages. So, if the question is, ‘‘Do we see multifamily as a commercial real estate type?’’ I’d say, yes. The correlation is very high there. Mr. NEIMAN. Mr. Woodwell. Mr. WOODWELL. It’s interesting, if you look at what’s been happening with the homeownership rate, every percentage-point drop in the homeownership rate means, essentially, a 3-percent increase in demand for rental housing. So, with the drop in the homeownership rate, we’ve actually seen a large surge, essentially, in demand for rental housing. A lot of that is for single-family housing—rental housing, but also a fair amount going into the apartment sector, as well. So, notwithstanding the fact that the apartments do have those annual leases that turn, and turned over the course of the recession, the multifamily sector, the apartment sector, has been among the better-performing of the different commercial real estate sectors, in terms of fundamentals. And that has sort of rolled over to generally good performance in many of the different investor groups that lend money for multifamily mortgages. The one exception there is, in the CMBS market, the multifamily mortgages do have a delinquency rate that’s well above many of the other property types. Mr. NEIMAN. Well, as a result, and with increased demand for rentals due to the mortgage crisis, do we face a shortfall in available rental properties? VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00166 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 161 Mr. WOODWELL. A lot of folks have studied that. We’ve looked into some of those numbers, as well. It does appear that, with— the vacancy rates are still at relatively high levels. So, even with that demand, the vacancy rates remain high. We’ll see, as those start to get burned through, how much of a demand is there. Mr. NEIMAN. Are there ways that bankers and borrowers are working together, possibly with local or state housing finance authorities, to ensure that tenants and living conditions are not negatively impacted by the CRE crisis? Mr. WOODWELL. I guess I would just put out there that the servicer and the lender, themselves, often have some of the greatest stake in making sure that that property maintains its ongoing operations and value. So, they’re working very closely, in those situations, to keep those properties operating well. Mr. NEIMAN. Mr. Parkus, are there any unique issues that should be highlighted in distinguishing multifamily properties from other CRE? Mr. PARKUS. Well, I think there are. You know, our outlook for multifamily is dramatically better than for other sectors, in the near term. As some of my colleagues have mentioned here, the state—the restricted state of credit for the single-family housing sector has redirected much of the new family formation process to multifamily. And we’ve seen dramatic improvements in vacancy rents—vacancy rates, dramatic improvements in rents, over the last just 3 to 6 months. We think that that will continue, that the medium-term demographics look very good. In terms of the very stressed operating environment that we’ve just come through, and the impact on residents in these properties, I would also very much agree that the absolute most important objective of special servicers is to make sure the properties do not deteriorate, to the extent that they have any control over that. And they do, generally. Keeping enough cashflow to keep up maintenance and other property expenditures is very, very high; otherwise, the value of the property deteriorates. Mr. NEIMAN. So, your confidence in servicers of commercial property mortgages, as opposed to residential mortgages, you—— Mr. PARKUS. I’m not familiar—— Mr. NEIMAN [continuing]. Think—oh. But, you did indicate a level of confidence, with respect—— Mr. PARKUS. I do believe—— Mr. NEIMAN [continuing]. To the ability—— Mr. PARKUS [continuing]. That that is a very high priority, yeah. Mr. NEIMAN. Okay. Appreciate it. The CHAIRMAN. Thank you. Dr. Troske. Dr. TROSKE. Thank you. I guess I want to sort of look back and ask some—a somewhat more philosophical question about price movements and what occurred in the commercial real estate market over the early part of the decade. You know, it’s often been characterized that there was a bubble in the commercial real estate market. As many economists, I sort of struggle to know what that means, because—something that I can look back and name is not a particularly useful concept. I like to be able to know what it is before it occurs. VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00167 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 162 Recently, economist Casey Mulligan, in his New York Times column, has presented data suggesting that, relative to 2000, investing in commercial real estate actually fell, in real terms, which is not what you’d expect in a bubble, and then much of the price increase was being driven by sort of a competition for resources that were flowing into residential markets and driving up the price of land and the price of labor and the price of other inputs into—in the production. I’d like the three of you to comment. I mean, do you—would you characterize it as a bubble? Is it—was it—were changes in prices reflecting what was going on in the housing market? Or was there just some overly optimistic investors in commercial real estate that’s—that were driving all of this? And we’ll start with—actually, we’re going to start with Mr. Woodwell, since—you know, we’ll start at the other end—— [Laughter.] Dr. TROSKE [continuing]. Just to be fair. Mr. WOODWELL. It’s a great question. And trying to understand that, I think, is really important to trying to understand what the commercial real estate markets and other markets have been going through. If—one thing—the—we include in our written testimony is looking at commercial real estate prices, relative to the Dow-Jones industrial average. And the same type of increase. If you look, during that period, you saw increases in a whole variety of different investment forms and a variety of different commodities, et cetera, during that runup period. Absolutely, construction costs were high during that period, and rising. When one looks at the property performance, property performance was very strong. When one looks at the mortgage performance, the mortgage performance was very strong in that preceding period. So, I think that it did lead to a lot of optimism that folks probably wish that they could rewind a little bit right now. Dr. TROSKE. Mr. Parkus. Mr. PARKUS. I would say that there was a bubble. And I would say—you know, I can’t define a bubble, or I can’t do it here—but I would say that there was—you know, what we saw in the early part of this decade—and let’s not forget, commercial real estate went through a sort of mini downturn in 2001/2002, and really didn’t come out of that until sometime in 2000—late 2003 or 2004. And, because of that, we saw relatively little overbuilding in this time around. Now, overbuilding was beginning to show its sort of ugly face in 2006 and 2007, but was cut off very quickly in 2008. So, we owe the previous downturn, you know, a just drove of thanks to keeping the overbuilding away this time. However, what we did have, in coming out of the last downturn, was extraordinarily low interest rates, as we have right now. And extraordinary low interest rates drove many investors to demand into riskier and riskier products. We also had a tremendous increase in the size of the—of pools of so-called ‘‘hot money’’ in international financial markets, seeking yields wherever. All of that—and all of those conditions, I think, came together to create bubble-like conditions, not only in commercial real estate, but across the spectrum, in terms of leveraged loans, in terms of— VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00168 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 163 across all credit products, in terms of corporate bonds. We saw a loosening of lending standards, driven by a loosening—really driven by a loosening in what investors would accept. The demand for yield was dramatic and was driving—really drove the decline in lending standards. In normal conditions, investors don’t put up with that. But, in those in kinds of condition, with extraordinarily low interest rates, investors were amenable to almost anything. Dr. TROSKE. Mr. Anderson. Mr. ANDERSON. Yeah, that—although—quite a few comments. I think it was a bubble. In terms of a definition of a ‘‘bubble,’’ it’s probably—maybe one definition would be a rapid rise that’s really unsustainable. Now, whether you would know that it was unsustainable at the time, or not, may be something else. But, certainly one feature of the price increase that occurred during that period was that it was almost all based on pricing, as opposed to income. The way real estate is generally—real estate prices are generally thought of is—in terms of an income stream that’s capitalized. That has—and capitalization rates came way down during that period, and that drove almost all of the increase. So, really, net operating income grew a little bit, but not really that much. And it was almost all from declining capitalization rates, or cap rates. How did the cap rates come down? Well, a big part of it was the availability of financing. So, very liquid debt markets very much contributed to declining cap rates. If you had to pay all cash for a property, you’d have a very different standard for what sort of price you would pay. Whereas, if you can borrow ever greater amounts, which borrowers could heading into the boom, you know, you can pay ever higher prices and still hit a return, as long as you can add more debt. And, you know, one other feature factoring into the availability of debt was that—it was sort of self-perpetuating, but the great liquidity in the market and good cashflow performance helped keep delinquency rates very low. So, it appeared—from a lender standpoint, it appeared to be a very safe, you know, low-risk area to be lending in. And so, I think those factors really played together. One item I was going to add is, I remember vividly, in 2006, seeing an investor presentation, a very credible argument for why cap rates could be 5 percent, or even lower, and that that was very— that was sustainable. And I went in as a disbeliever, and came out not exactly being a believer, but having been impressed, anyhow, by the argument. So, in hindsight, certainly we know that it was a bubble. At the time, there were some very credible players that had good arguments as to why pricing could remain where it was at. Dr. TROSKE. Thank you. The CHAIRMAN. Thank you. I’d like each of you to comment on when you expect to see the majority of losses from defaults. Mr. Woodwell? In the commercial real estate market. Mr. WOODWELL. We don’t have any models that would predict that. I do think, based on the loan maturity survey that we’re—— The CHAIRMAN. Right, that’s what I was—— VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00169 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 164 Mr. WOODWELL [continuing]. Looking at there, as folks have discussed, there is, sort of, the income perspective on things, and then the maturity perspective, and which will be driving those. The different investor groups have very different maturity profiles so that, if there is a maturity issue facing mortgages, different investor groups will see them at different times. The multifamily investors, some of those loans—FHA, for instance, have a 40-year maturity. You work back, life insurance companies, 10-year, typically; CMBS, 5, 7, 10; and then, credit companies, banks would have a shorter term. So, to the degree one’s focused on maturity, one would look at those—— The CHAIRMAN. Right. Mr. WOODWELL [continuing]. Those schedules. To the degree one’s focused then on income-driven, then we’re probably back to the discussions of different property types having very different situations, where, for instance, hotel and multifamily—those are shorter-lease terms—have probably seen the bulk to the hit to their NOI and are starting to see a rebuilding of those. Whereas, the longer-lease-term properties weren’t as dramatically hit by the downturn, in terms of their bottom lines, but then, likewise, won’t see quite as quick of a rebound. The CHAIRMAN. Mr. Parkus. Mr. PARKUS. I think it depends on the location or the investor base. In CMBS, we are beginning to see losses ramp up very quickly now. It depends on the investor base, because it depends, really, on whether—the extent to which problem loans are pushed out, extended, and how long that process lasts. In CMBS, there will be a combination of loan extensions and foreclosure and liquidations. Losses are already ramping up very quickly now. We expect losses to remain high for this year and through next year. The difference is, is that the sources of losses in the nearer term are from term defaults—what we refer to as term defaults, where properties simply can’t make the mortgage payments and are foreclosed and liquidated. And sometime in 2012/2013, that will come more from maturity-related defaults. On the bank side, it really is a question about, I believe, when banks seriously begin to deal with the problem loan portfolios. It’s—— The CHAIRMAN. And, when—— Mr. PARKUS [continuing]. Hard to say. The CHAIRMAN [continuing]. Do you think that will be? Yes. I mean, no one knows. I’m—— Mr. PARKUS. I think, within a couple of years. I think that the regulators that we heard from today are right, that as soon as banks have the wherewithal—individual banks have the financial wherewithal to deal with these problems, they are being forced to deal with them. But, it will also be dragged out, because many banks do not have that wherewithal today. The CHAIRMAN. Mr. Anderson. Mr. ANDERSON. Actually, yeah, we do model it for banks. And we’ve done quite a few calculations, ourselves, to try to estimate what the ultimate losses will be for banks, and how far along they are through the charge-off process. By our estimates, banks, in ag- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00170 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 165 gregate, including large and small banks, are through 50 to 60 percent of the charge-offs on commercial real estate loans—on defaulted commercial real estate loans. So, you know, we’re past the halfway point, but there’s still quite a bit more to come, we think. The earlier panel noted that banks have been provisioning less over the last few quarters. You can kind of take that as a—two different ways. You could take it—the glass-half-full interpretation would be that banks see the light at the end of the tunnel and feel less of a need to add to loss allowances. The converse would be that—and I do think there is something to that—but, the converse would also be that, I think, there’s intense pressure in the— among—in the bank sector, to maintain capital. And so, the—to the extent that you can stretch your losses out, you certainly boost your capital in the near term. And I think that’s another feature of what’s going on. So, there’s certainly an incentive to work through the problems, but banks have been doing it for the last 2 or 3 years, and, you know, and given that they’re past the halfway point, I think, we’ll be at it for at least another couple of years, probably. The CHAIRMAN. Thank you very much. Mr. McWatters. Mr. MCWATTERS. Thank you. Let’s continue with the TARP-type structure, TARP–2. Mr. Parkus, do you think it would be critical that Congress provide more money to bail out financial institutions, due to their CRE loans? Mr. PARKUS. That gets to an area, really, outside of my domain. I guess I don’t feel that I have—you know, that I should be speaking to a question about—sort of really addressing how to deal with banks. My expertise is in commercial real estate. If I understand your question. Mr. MCWATTERS. Okay. Fair enough. Mr. Woodwell. Mr. WOODWELL. And, I apologize, I don’t think I have the adequate knowledge to address that adequately. Mr. MCWATTERS. Okay. Well, I mean, my question is, Can these banks work through CRE problems by themselves, or do they need assistance—the small banks and the large banks, both? It sounds like, when I heard the answer to your first questions, is that, you know, given a few years, things will turn out okay. It’s going to be rocky for a while, but it’s going to turn out okay. And that would lead me to believe, as the regulators said, there’s really not a need for an RTC, a TARP–2, or something along those lines. Mr. WOODWELL. I—— Mr. MCWATTERS. Does that help? Mr. WOODWELL. I guess I—I think I do understand what you’re getting at. I think that an RTC, traditionally, is for the liquidation of loans out of banks, in receivership. Mr. MCWATTERS. Yes. Mr. WOODWELL. Now, does it make sense for regulators, the FDIC, to consider an RTC solution for the large number of loans that they are taking in from failed banks? They should certainly consider it. It’s another form of securitization. And, quite frankly, VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00171 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 166 that is what gave rise to the CMBS market in the first place, in the early 1990s. On the other hand, you simply have to look at the cost-benefit analysis, according to how much they can get by liquidating loans in the way that they are currently doing. And, I—it’s difficult for me to know—to make that cost-benefit analysis. I would certainly think that it’s—it is a potential outlet. Whether or not it is more cost-effective than the current disposal methods, I don’t know. Mr. MCWATTERS. Okay. Okay. Help me understand, since you—all three of you think the market will turn around in the next few years, taking the approach of simply extending loans, today, at favorable rates—we have low interest rates, on a short-term basis—and rolling those, versus a fulltilt restructuring, refinancing, writedown, impairment of capital, recognition of tax cancellation indebtedness income, and the like. When is that appropriate to use one of those approaches, and when is it appropriate to use the other approach? Mr. Anderson. Mr. ANDERSON. Well, I—in one sense, I think you have to look at it loan by loan, borrower by borrower, property by property. You know, for the lender, the ultimate metric probably has to be what sort of loss they expect to take. So, whether it would be better to—if they need to take a loss now versus potentially taking a loss down the line. And, you know, if lenders are of the general view that the markets are gradually improving, then, at least in cases where they think that the borrower ultimately will get right-sideup again and be able to, ultimately—or keep current on payments and ultimately repay the loan, then that’s a sound strategy, as long as it works out. In cases where the bank doesn’t really think that that’s too likely, then it wouldn’t really be appropriate, and especially if they think that there’s, for whatever reason, the likelihood that the value recovered a year or 2 or 3 from now would be lower than it might be now, then certainly it makes more sense to put the pressure on now and try to deal with the loan—deal with that problem sooner. In terms of modifications and charge-offs, again, that has to do with whether or not the bank, after their analysis, deems that to be a better outcome than outright foreclosure or rolling the loan over. I should add also that, you know, per the guidance in 2009, banks can’t just roll over a loan if it’s not otherwise performing. So—— Mr. MCWATTERS. Right. Mr. ANDERSON [continuing]. So the borrower does have to be current in order to even quality for that. Mr. MCWATTERS. Right. And there could be some incentive to do that, not so much because that loan, in 2 or 3 years, is going to be in the money, but that the institution itself may be stronger in 2 or 3 years, and able to absorb a loss in 2 or 3 years. So, Mr. Parkus. Mr. PARKUS. Well, you know, I basically agree with that. I would add that, you know, if you have a borrower, with a loan that is, let’s say, an 85 LTV in the market—in order to refinance, the current market is a 70 or 75 LTV sort of maximum LTV—that cer- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00172 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 167 tainly makes sense, as long as you believe the borrower is—has good intentions, as long as the property is liked—likely to improve, as opposed to deteriorate. There are many cases where we think extensions make a lot of sense. But, there are many cases where we think that extensions clearly do not make a lot of sense. There are many loans out there that are not 85 LTV in today’s environment; they’re 120 or 130 LTV. These loans will not be viable in the future under any reasonable scenario. And there are many out there like that, many that were overlevered to that degree. When you—that’s what happens when you have a 40- or 50-percent price decline and the original LTV on the loan was not 70, but was 90 or 95, you get into those situations. So, in those cases, we think that that is not a good approach. Mr. MCWATTERS. Okay. That’s helpful. I’m way over my time. Sorry. The CHAIRMAN. Superintendent Neiman. Mr. NEIMAN. Thank you. I find interesting, and hopefully constructive, to make some comparisons between the CRE crisis, as well to the residential mortgage crisis. And when you hear about the factors that contributed to it—investors seeking higher yield, weak underwriting, low equity, over-leveraging, too much focus on collateral—lots of similarities, until you get down to the comparison, that on the residential side, a high evidence of borrowers who clearly did not understand the product they were getting into, less sophisticated in efforts by either brokers or lenders to take advantage of those borrowers. This, I don’t see on the commercial real estate side. We have some of the most sophisticated developers in the country. Can you speak to this issue and are there lessons to be learned in making comparisons or contrasting differences? Mr. PARKUS. Well, yeah. I would say that, for the most part, on the commercial real estate side, apart from really small loans—say, owner-occupied loans, in bank portfolios—certainly what we see in CMBS, we deal with borrowers, for the most part, that are fairly sophisticated. And the transparency. One of the huge differences, I think, between residential and commercial, is the—simply the degree of fraud that was out there. There was a lot of opacity in the residential side, and there was a lot of outright fraud. I would say, in CMBS, it was not a case of outright fraud, for the most part. There’s—you’ll always be able to find, you know, a small number of loans that had questionable this or that. But, we are not here because borrowers did not understand—or, I should say, investors did not understand the nature of the loans that were being made. I think we were all guilty, in the sense that very bad loans, clearly that should not have been made, were made. Mr. NEIMAN. So, is the same euphoria, that real estate prices, whether residential or commercial property, will always go up—— Mr. PARKUS. Yes. Yes, certainly that was that case. I think it had been so long since we had seen—I think the idea that rising prices just validates—rising price—the idea that prices will always rise just gets built into a mentality. And when you need—when you’re—when you have—as an investor, you need to reach certain debt hurdles, you’re willing to cut corners, you’re willing to believe VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00173 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 168 that, ‘‘Well, I—maybe this will perform, maybe this clearly inadequate loan’’—and then the next time, ‘‘Maybe this even worsequality loan will perform.’’ And it’s sort of a—you get swept away along those lines. Mr. NEIMAN. Mr. Woodwell, your organization sees this from both the commercial and the residential side. Mr. WOODWELL. I might draw a greater distinction between the motivations for purchasing a home and for investing in an incomeproducing property, that an investor, someone purchasing an office building, a shopping center, is looking for that—looking at that as an investment, as something that’s going to both throw off income and, essentially, get dividends through those income payments in the degree to which the income exceeds any mortgage payments; and then also is looking for a capital gain. And the degree to which an investor is driven more by a capital gain and, sort of, heightened expectations there, versus the income of the property, that can lead to those prices exceeding the growth of the incomes, which is probably something that we saw during the ’05, ’06, ’07 period. But, that being said, I do think that one needs to be careful that there are very different motivations between those who are purchasing homes and those who are purchasing commercial real estate. Mr. NEIMAN. Mr. Anderson—— Mr. ANDERSON. Yeah, I got a couple comments that—I’d agree, I don’t think there was a subprime element of—in the commercial real estate market. And, as you pointed out, they are generally sophisticated borrowers that understand, you know, the terms of what they’re agreeing to. Mr. NEIMAN. Are they so sophisticated that they took advantage of the system with little equity? Mr. ANDERSON. There might have been some of that going on, sure. You know, if you’re looking at it, thinking, ‘‘Gosh, I can squeeze some more dollars out of this by adding more leverage,’’ you can understand how people might get into that. The irony is that, with ever higher prices, the sense of risk was diminished. So, the pricing of risk went way down, and yet, actually, that was when risk was the highest. So, the higher the prices went, the greater the real risk, but the lower risk pricing actually went. Mr. NEIMAN. Well, thank you. The CHAIRMAN. Dr. Troske. Dr. TROSKE. Thank you. A number of you have made a distinction between sectors of the commercial real estate market, in a number of your comments. And I guess I wanted to explore that a little more. I’ll start with you, Mr. Parkus. You made a big distinction between financing trophy properties and other smaller properties, or the difference in performance of financing, going back into commercial properties. And, I guess, what are some of the—you know, what are the differences that are producing this—in these two types of markets, that are producing these different performances? Mr. PARKUS. Well, I think the big difference is in the price performance. We’re seeing trophy properties and institutional-quality properties appreciate at a much more significant rate than smaller properties. And I think that that is, you know, largely the result VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00174 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 srobinson on DSKHWCL6B1PROD with HEARING 169 of, you know, institutional investors. When institutional investors come in and look for higher-quality properties. There’s been a tremendous interest, from institutional investors all over the world, in the U.S.—high-quality U.S. commercial real estate properties. Smaller properties are typically outside of their purview. They don’t invest in small multifamily—for the most part, small multifamily properties, in Dallas, say. They invest in large office properties in gateway cities. So, there is—what my point was, is that there is a very significant bifurcation going on between the haves, the very best, and, kind of, the have-nots, which is more the—a very large portion of the commercial real estate sector is. Dr. TROSKE. And listening to your comment, it does seem like you indicated that the difference was reflecting the fact that these trophy properties were seeing a greater appreciation in price. So, there should—a reason for why they have an easier time getting financing, not just some dream of owning a office building in Manhattan. Mr. PARKUS. They have an easier time getting financing, because there is, intrinsically, greater demand for those types of assets, from large, well-capitalized investors. If there is—if you have an asset for which there is a lot of interest, lenders will be very interested, as well. Dr. TROSKE. Mr. Anderson, you’ve sort of commented on that, as well. Mr. ANDERSON. Yeah. Well, I’d pick up on the demand-for-trophy-properties argument. I think that’s true. What you tend to see in a market downturn with lower rents is occupants—occupiers of space being able to move up the quality of space at roughly the same rent that they were paying. So, they may move from what’s called B space in the—B-quality space in the office sector, up to A space, with little or no increase in rent. So, they take advantage of those price declines—or rent declines. The way that works—and so, how that benefits the trophy properties is that they tend to remain full; whereas, the B properties and then C properties experience even greater vacancies as people move out of those spaces and into higher-quality properties. Dr. TROSKE. Mr. Woodwell—and you focused primarily on the difference between, sort of like, commercial properties and development—construction. And so, give me a little—I mean, and that seems to be much of the difference between your point—your view of the market and some of the other views we’ve heard. And so, can you, sort of, maybe, expand on that a little? Mr. WOODWELL. Sure. And I think the—first, it sounds like everyone is peeling off the construction activity, particularly that that had to do with single-family construction activity that’s driving a lot of the numbers that we’ve seen, in terms of chargeoff rates, delinquencies, in that broader CRE category. In terms of, then, the distinction between, sort of, primary, secondary, tertiary market, I think what you have there sort of makes sense. If you think about it as primary markets, you’ll have hundred-million-dollar investments; tertiary markets, you’ll have $500,000 investments. And that the large institutional investors who are drawn to those hundred—hundred-million-dollar invest- VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00175 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083 170 srobinson on DSKHWCL6B1PROD with HEARING ments, it would take a whole lot of tertiary market investments to get to one of those major market investments. So, that there—there is a natural break, with more local investors playing in those smaller primary—or secondary and tertiary markets; more of the large international institutional players playing in those primary markets. I think also, if you think about the course of the credit crunch in the recession, the credit crunch probably had more of an impact—which came first—probably had more of an impact on those large international institutional investors. And then the recession probably had much more of an impact on those local. So, slightly different impact, slightly different forces at play amongst those different players. Dr. TROSKE. You wanted to—— Mr. PARKUS. There’s one additional factor, I think, that we could mention here. And that is the—sort of, emphasize the demand from lenders. The ultimate lenders, in many cases, are not the banks, but investors in CMBS. And investors in CMBS have a strong preference for high-quality assets, when you can get them. So, that tends to drive—you ask, ‘‘Why would lending focus on trophy assets versus smaller assets?’’ I think that that is—and large banks, as well. Dr. TROSKE. Thank you. The CHAIRMAN. Well, that concludes our meeting. I want to thank you for your—for being here today and for your excellent testimony and dealing with our questions. Also want to take a moment to thank a member of our professional staff. We’ve had 27 hearings, and every one of them has been organized by Patrick McGreevy, including nine field hearings. Patrick, we appreciate all your terrific work, on behalf of the panel. And I want to thank you, for the panel, for your good work. We’ll leave that hearing record open for 1 week, in case there are any questions. This is not our last hearing. So, until the next time, which will be our last hearing, this hearing is adjourned. [Whereupon, at 12:40 p.m., the hearing was adjourned.] VerDate Mar 15 2010 21:17 Mar 29, 2011 Jkt 065083 PO 00000 Frm 00176 Fmt 6633 Sfmt 6602 E:\HR\OC\A083.XXX A083
@FedFRASER