The danger looming over commercial real estate is as apparent as an empty Circuit City. While banks brace for CRE storms, new stress testing software can soften the blow, or at least provide a more detailed diagnosis.

To prepare for regulatory exams, Pacific Commerce Bank is deploying stress testing software from Banker's Toolbox to locate weaknesses in its CRE portfolio. Cliff Nielsen, vp and CTO of Pacific Commerce Bank, says the $180 million asset bank's CRE portfolio has not been earmarked as having a high concentration of CRE loans, a distinction usually reserved for banks with outstanding CRE loan value of more than 300 percent of Tier 1 capital. But the institution is concerned about how economic weakness will impact the retail sector, and how that impact will be felt downstream in the bank's CRE portfolio. "It's always in our best interest to be doing [stress testing] to make sure we're in good working order and not in a problematic situation," says Nielsen, noting that the bank's CRE footprint is mostly in California and Arizona.

The Banker's Toolbox software, called Crest, analyzes future changes in criteria such as vacancy, capitalization rates, interest rates and potential gross income. Reports on LTV, debt service coverage ratios (DSC) and net operating income are produced, allowing the bank to determine hypothetical net collateral shortfall, note hazardous concentration areas or forecast complications with borrowers facing refinancing.

Crest, which has attracted about 15 banks in its first year (Banker's Toolbox has more than 450 total customers), also allows specific asset classes such as apartment loans, retail or businesses to be analyzed. "You can paint multiple pictures and look at your portfolio from different angles," Nielsen says.

Banker's Toolbox's competitors in the CRE stress testing space include Fimac, whose solution includes tests for changes in interest, vacancy, cap rates, operating expense and collateral value. The firm also produces stress ratings based on LTV and DSC ratios. Other providers include Reis, PPR and Capgemini, which has developed a stress testing tool in conjunction with SAS.

Harland also offers a CRE stress testing product called Portfolio Manager, available as part of its CreditQuest commercial credit risk management suite or as a standalone product. "It's critical to have a dependable mechanism to quickly and accurately monitor our portfolio," says Julie Jennette Barnes, evp and chief credit officer of American Bank of Texas, a $1.5 billion asset bank which recently deployed Harland's solution to test for concentrations of different types of CRE loans, such as land and commercial development loans, as well as diagnostics to take interest rate shocks, occupancy levels and appraisal values into account.

Samir Kamat, a senior manager at Capgemini, says advances in stress testing and broader data sourcing allow assessments to graduate from loan level stress testing to diagnostics of an entire geographic region or type of loan. "The traditional [loan level] stress testing approach still exposes you to systemic threats," he says.

An additional business case that tech vendors make for automated CRE stress testing is that banks, particularly community banks, are so busy working out residential loans, they don't have time or staff to run hypothetical numbers on outstanding CRE loans, or manually track indirect drags.

"We have big box retailers, such as Circuit City and Linens N' Things, that have filed for Chapter 11. The smaller businesses that surround those stores suffer because there's less traffic. That affects the vacancy rate, which affects a CRE portfolio," says Michelle Lucci, a risk management consultant for Banker's Toolbox, which charges for its service per CRE asset. Lucci says many banks are still using capitalization rates - which rise inversely with loan values - that are too low for the economic climate, and can be easily recalculated with automated stress testing.

Marketwide risks also argue for strong stress testing. The Real Estate Roundtable says about $400 billion in commercial mortgages will come due through the end of 2009. And Foresight Analytics says total recession-related commercial mortgage losses could rise as high as $250 billion. "There's a huge de-leveraging that has to occur," says Tino Korologos, managing director of distressed debt for Deloitte Corporate Finance LLC.

Community and mid-sized banks are particularly vulnerable given their lack of portfolio diversity. "These banks don't have a market outside of their own area, so they can get blindsided by a downturn," says Joel Pruis, director of advisory services for Experian Decision Analytics.

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