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Remarks
By
Donna Tanoue
Chairman
Federal Deposit Insurance Corporation
Before
RMA's Annual Conference of Lending and Credit Risk Management Nashville,
Tennessee
November 14, 2000

Effective risk management is the bank manager's most important bulwark against credit
loss and bank failure. This is true not only in bad times, but in the best of times.
A century ago, Nashville was triumphantly riding the crest of a strong economic
expansion, whose remnants can still be seen and enjoyed today just 13 miles from
here: Centennial Park - the Parthenon - and the magnificent Union Station.
That boom ended - just like they all do.
Today, the United States is triumphantly riding the wave of the longest economic boom
in our history. As of November 2000, we entered our 115th straight month of expansion.
With this expansion has come the most profitable period in banking history. Record
commercial bank profits have been reported each year since 1992. These record profits
have been accompanied by an equally impressive decline in non-performing bank
assets - from 3.02 percent of total assets in January 1992 to .066 percent as of June 30,
2000.
Real estate markets have become particularly robust in the past decade. Office
Vvacancy rates nationally stood at 8.1 percent through the first half of 2000.
This growth in real estate markets is reflected on bank balance sheets. Commercial real
estate loans grew from $258 billion at the end of 1992 to $447 billion through June of
this year. Construction and development loans have more than doubled to $150 billion
from their low point of $62.6 billion at mid-year 1994.
Much of this growth has occurred over the past two and a half years. In 1998,
construction and development loans grew 21 percent. In 1999, construction and
development loans grew 27 percent. Through June 2000, they grew at a 23.5 percent
annualized rate.
And that brings one to wonder: Can there be too much of a good thing?
I'm not the only one asking questions like that.

Your president and CEO Al Sanborn recently wrote to you about rising risk levels. He
pointed out the increased level of problem loans identified in the Shared National Credit
Review exam, the increased corporate leverage, and increases in default rates.
We agree that these are worrisome trends. In addition to these trends, we believe that
some banks have developed certain portfolio characteristics that leave them vulnerable
to potential softening in local real estate markets.
The FDIC has been acting recently as a kind of economic weatherman. We've pointed
out that a number of cities nationwide are at risk for overbuilding commercial real estate.
This does not necessarily mean that these cities are headed inevitably for the kind of
real estate crisis we experienced in the late 1980s and early 1990s. A tornado watch
does not mean severe weather is inevitable. It does, however, mean that conditions
exist for the development of a tornado and that one needs to keep up to date on the
latest weather information.
In the same way, FDIC's recently-released list of cities at risk for overbuilding
commercial real estate"at-risk" list means that bankers in those markets need to keep a
weather eye out, because conditions are favorable for damage to occur in the event of
an economic downturn.
Problems in commercial real estate markets were integral to the 1980's banking crisis in
the United States and were at the heart of the banking crisis in Asia in 1997-1998.
Therefore, the FDIC is especially watchful of steadily increasing volumes of construction
and development loans and commercial real estate loans in the banking industry in
general, particularly when these loans are concentrated in certain markets.
That's why the FDIC two years ago began developing an offsite model for identifying
banks that may be susceptible to a downturn in the local commercial real estate market.
In order to develop a method for identifying these banks, we needed to analyze a
previous real estate crisis.
We chose the New England experience of the early 1990s because the history of the
crisis was very clear., and the crisis occurred well after the Tax Reform Act of 1986 You
may remember that the New England economy had grown rapidly following the 1981-82
recession. Five years later, New England was enjoying a booming commercial and
residential real estate market, and, by the beginning of 1988, the unemployment rate
had fallen to 3 percent.
But the stock market crash in October 1987, combined with other factors such as the
decline in defense spending as the Cold War ended, resulted in a sharp decline in New
England's economy and a collapse in the real estate markets.
With this well-defined economic scenario as a basis, o Our model asks one pointed
question: What would happen to banks today if they encountered a real estate crisis
similar to that of the New England Crisis? At the core of the model is a comparison of

the condition of New England banks that were CAMEL rated 1 or 2 in 1987 to the
condition of those same banks in 1990.
In 1987, with the local economy booming, the banks in New England were apparently
very healthy, but by 1990, many of these banks had evident problems. Using Ccall
Rreport information we were able to identify risk profiles in 1987 that resulted in severe
financial distress or failure in 1990. We refer to the model as the Real Estate Stress
Test or REST.
After we developed this model, we needed to test it in order to gain some confidence in
the model's ability to identify a risky real estate portfolio. We looked at the Southern
California real estate downturn in the early 1990s. We concentrated on banks and thrifts
that had CAMEL ratings of 1 or 2 in 1988, well before troubles had developed, and tried
to identify banks that would be rated CAMEL 4 or 5 or had failed between 1991 and
1995.
Our model tested true. Approximately 75 percent of banks and thrifts that the model
identified as potential problems became a CAMEL 4 or 5 or failed.
Certain asset and liability categories drive the results of the REST model. The primary
risk factor is the ratio of construction and development loans to total assets. Banks with
high volumes of construction and development loans seem to be the most vulnerable
when a real estate crisis hits. Secondary risk factors are the percentage of commercial
real estate loans, percentage of multifamily loans, and percentage of commercial and
industrial loans. Additional risk factors include high non-core funding and rapid asset
growth. A bank with a high concentration in construction and development loans,
coupled with rapid asset growth, would appear to be riskier than a bank with similar
concentrations but low asset growth.
We have calculated REST scores for the banking industry as a whole from 1987 to the
present and have seen a significant deterioration in the scores since 1995. Between
1987 and 1995, a period that included the New England and Southern California crises,
the percentage of very vulnerable institutions per the REST model never exceeded 5
percent of the industry.
But by December 1999, that percentage had increased to 8 percent of the industry. It
now exceeds 9 percent of the industry.
On top of this, an additional 16 percent of the industry is identified as somewhat
vulnerable to a downturn. Combine the two figures, and one fourth of the industry is
potentially affected.
However, it is important to understand that, like other models, REST has its limitations.
It only identifies banks with exposures that may be vulnerable to a downturn. REST is a
"worst-case" scenario based on patterns from the severe New England Crisis of the
early 1990s, the depths of which may never be seen again. The model does not take

into account federally mandated changes in underwriting standards since the early
1990s. Nor can the model reflect a particular bank's underwriting standards or the terms
and conditions of its loans. Also, the model is based on Call Report data, which is
limited, and, for instance, cannot tell us whether construction loans are centered in
residential or commercial real estate, which have very different risk characteristics.
Because of these limitations, REST, like other offsite tools, provides clues for examiners
to further explore. Onsite examination or other follow-up action would be necessary to
determine the reasons behind REST results.
Despite the above caveats, wWe do have concerns about the trends in real estate
concentrations.find this a disconcerting trend.
Conditions are indeed favorable for damage in the event of an economic downturn. The
rising level of risk is accompanied by a geographic concentration of much of the risk. In
14 metropolitan areas, over 40 percent of the banks are identified as "very vulnerable."
In Atlanta, almost 70 percent of the banks have high-risk profiles. In Portland, Oregon,
55 percent are deemed "very vulnerable."
The FDIC is not alone in its concern. A recent newsletter by Tucker Anthony Capital
Markets listed 50 publicly traded commercial banks that they felt "have developed heavy
exposure in the higher-risk and commercial real estate loan areas." The rising level of
risk is accompanied by a geographic concentration of much of the risk. In 14
metropolitan areas, over 40 percent of the banks are identified as "very vulnerable." In
Atlanta, almost 70 percent of the banks have high-risk profiles. In Portland, Oregon 55
percent are deemed "very vulnerable."
It should be pointed out here that the REST model only identifies banks that may be
vulnerable to a real estate downturn. It does not reflect the banks' underwriting
standards or the term and conditions of their loans. The model also does not predict a
decline in the real estate sector; it only shows what may happen if a downturn occurs. In
other words, the REST model is analogous to a tornado watch. Conditions, it says, are
favorable for damage to occur in the event of an economic downturn.
The FDIC not only looks at portfolio risks in banks, but also at the risks within local
economies. We recently published an analysis of commercial real estate markets in the
latest edition of our Regional Outlook. As risk managers you are acutely aware that
commercial real estate markets are prone to periodic bouts of overbuilding caused by
the business cycle, which decreases demand for new space as business activity slows.
But another, perhaps more important factor, is the lag time in the development process
as new construction moves from inception to completion. High demand and growing
demand that may exist when projects are started can sometimes turn into little demand
and no growth by the time projects are completed. This can cause large decreases in
the value of properties and subsequent loan defaults and loan losses for the project's
lender.

The FDIC has identified commercial real estate markets potentially at risk for
overbuilding on the basis of comparative rankings in the rates of growth in commercial
space. We rank U.S. metropolitan areas based on new construction activity as a
percentage of existing stock for five main property types: office, industrial, retail,
multifamily, and hotel. We identify an area as "at risk" for overbuilding if it ranks in the
top ten metropolitan areas in two of the five categories. Based on this criterion, the cities
considered at risk are: Atlanta, Charlotte, Dallas, Denver, Fort Worth, Jacksonville, Las
Vegas, Orlando, Phoenix, Portland (OR), Salt Lake City, and Seattle.
When the list of cities "at risk" for overbuilding commercial real estate are is compared
to the 14 cities REST identifies as concentrations of high-risk banks, six are found on
both lists. These cities are: Atlanta, Las Vegas, Phoenix, Portland (OR), Salt Lake City,
and Seattle.
The FDIC has been making the best possible use of this information. Examiners are
tuned in to their local markets and which banks are exposed to concentrations through
the supervisory process. As part of this process, REST information is made available
every quarter to FDIC staff. This information is one of several the many offsite models
that are available for supervisory staff to review during the examination planning stage.
Exposures identified by the model can be used to focus examiners on risk areas to
review during the onsite examination help identify staffing needs and expertise when
forming an examination team. Our examiners use REST can be used as an opportunity
to view a "worst-case" stress scenario based on the risk exposures from the last Ccall
Rreport. The on-site examination includes a review of the many factors that are not
observable solely from financial data. This allows the examiner an opportunity to review
the institution's risk management practices. REST information is also shared with the
other federal banking agencies and with state regulators who have expressed an
interest.
The FDIC believes that the supervisory process, supplemented with the long forecasting
horizon of the model, allows examiners to discuss the identified issues with
management while time still exists for corrective action to take effect.
Some banks have responded to the data warnings by slowing their real estate lending
growth. Others have tightened underwriting standards, but continued adding credits.
Still others believe that their markets are healthy and see no reason to change their
business strategy.
I, too, hope that the economic expansion will continue unabated and that local real
estate markets remain healthy and stable. However, as you know, hope is not a risk
mitigation technique.
(Pause)

On April 16, 1998, a tornado passed directly through the heart of Nashville during the
evening rush hour. This tornado was one of a line of storms that claimed more than 100
lives in the region.
For the people who live in Nashville, the 1998 tornado laid to rest forever the myth that
tornadoes never strike big cities. Along with the usual damage to businesses and
homes, it damaged the Hermitage - the beautiful home of Andrew Jackson - and
uprooted most of the 100-year-old trees in Centennial Park. It even bent the recentlyrestored winged statue of Mercury on the clock tower of Union Station so that it was
parallel to the ground.
If you have the opportunity to visit some of the sights of Nashville during your stay here,
you will see that the damage from that tornado has been largely repaired. In a parallel
way, the sustained economic boom we are still enjoying has given the banking industry
the opportunity to recover economically from the disastrous events of the late 1980s
and early 1990s.
But I am willing to bet that the citizens of Nashville will forever go on the alert when they
know a tornado watch has been issued. Because this will mean that conditions are
favorable for the development of a damaging event.
In the same way, all of us - regulators, risk managers, and developers - need to remain
alert when signs begin to indicate the industry might be vulnerable.
Working together, we can weather any future turbulence.
Thank you.
Last Updated 12/7/2011