Though it is now generally assumed that the worst of our recent economic woes are behind us, we probably still have not seen the end of the banking industry's troubled-loan scenario.

The primary reason for this is that banks' problem loans are a lagging indicator. Positive economic conditions not only spawn marginal loans but also allow problematic loans to behave in a performing manner. It is only when economic times turn harder that a loan portfolio's true weakness becomes apparent. Or as Warren Buffett famously said, "Only when the tide goes out do we see who is swimming naked."

Though much of the media focus has been on residential real estate loans, many of the banking industry's current problems involve commercial real estate. Though these loans have not drawn nearly the public attention that residential real estate loans command, they have long concerned bank regulators.

The regulatory concern stems in significant part from the concentration of commercial real estate loans on bank balance sheets. At the turn of the last century (1999) commercial real estate loans accounted for just over 23% of all loans at banks with less than $5 billion of assets. By December 2005 their share had grown to 31%, and by the end of last year the proportion was more than 35%. Such increases in loan concentrations often portend weakness, and for commercial real estate this concern has been proven real.

Commercial real estate loan losses have risen substantially, and the amount of real estate that has gone through foreclosure and is now on bank books as "other real estate owned" has gone from 0.10% in 2005 to 0.84% at the end of last year.

Though many banks have struggled with these problems for some time, we can see a common thread — the banks are, to some extent, still in denial about these loans' real status. Denial — in this case meaning a lack of objectivity in evaluating loan quality — is not a new issue, nor is it hard to understand. When a bank commits itself to a loan arrangement with a borrower, the expectation is that it will perform as agreed and the loan will be a mutually advantageous arrangement. Most loan contracts, in fact, do perform as agreed on. When the opposite turns out to be true, it is both unexpected and unwelcome. The banking relationship at that point changes from a sort of partnership to something adversarial. All in all, not a pleasant transition.

Banks can make several organizational moves to minimize the denial barrier and deal with troubled CRE loans. First, when a loan moves from performing to nonperforming status, it is almost always wise to move the collection responsibility from the loan relationship person to a workout specialist. This is often easier said than done.

Many banks — particularly community banks — distinguish themselves by building relationships with customers, and these relationships encourage customer loyalty during good and bad times. The reassignment of a troubled loan can breach this relationship. Yet the argument for making this change is compelling.

The originating loan officer acts with confidence that the loan will be repaid, so when initial signs of trouble emerge, both sides tend to make adjustments, with an expectation that the trouble can be corrected. As the loan continues to deteriorate, the loan officer and borrower keep trying to make corrections.

But their focus is on how the loan will be repaid, not on whether it will be repaid. A loan workout specialist is not burdened by that history and can be far more objective in evaluating a loan's current status. One important benefit to the bank is that adjusting the loan's risk rating or reserving for the possibility of loss (to the extent those functions are not interrelated) may well have to be done.

A workout specialist will typically have the benefit of knowing the current risk ratings of similarly troubled loans in the institution and can recommend an adjustment consistent with others.

Second, a bank should examine its compensation policies to ensure that they do not unwittingly encourage loan management behavior that rewards denial. Compensation policy that rewards loan volume rather than loan quality often leads to problems. Though a compensation system should encourage quality lending, once a loan turns sour it should not implicitly reward denial or postponement of addressing the underlying problems.

Maintaining objectivity in evaluating loan quality is always a challenge for bankers, but it is particularly difficult during an economic down cycle. This is why it makes good sense to segregate loan administration functions from loan origination functions.

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