The government's annual review of large commercial loans reveals a spike in problem credits that regulators are attributing to risky underwriting.
According to an interagency look at commercial loans that are larger than $20 million and shared by at least three banks -- the Shared National Credit Review -- the dollar volume of classified and special-mention credits soared 70%.
Bankers last year had rated more than half the loans reviewed as "pass," Office of the Comptroller of the Currency Chief Counsel Julie L. Williams said Tuesday. Regulators said they would not release more details on the loan review until later this month.
Ms. Williams used the data to supplement criticism of bank lending practices in a speech delivered to 500 bankers at a Robert Morris Associates conference on lending and credit risk management in New Orleans.
"It's a sobering message," said Kevin M. Blakely, executive vice president for risk management at KeyCorp and chairman of Robert Morris. "We all know this has been going on because we've been in the market. We have to know when to let go when things get too crazy."
Saving particular criticism for leveraged loans based on the "enterprise value" of the borrower, Ms. Williams told bankers that allowing risk management to languish while focusing on increasing revenues is "akin to ignoring termites in the foundation of your house while you're busy adding a sunroom to the second floor."
The Shared National Credit Review is conducted jointly by the Comptroller's Office, the Federal Reserve Board, and the Federal Deposit Insurance Corp. The review also found that 14% of problem loans had been made to new borrowers. "In other words," Ms. Williams said, "banks are booking new loans that are weak at their inception."
In her speech, a copy of which was released here, Ms. Williams acknowledged that her agency's recently completed Survey of Credit Underwriting Practices found a tightening of loan requirements for the first time in five years. But she said this is no cause for complacency.
"Beneath the statistics of the survey, there are some troubling trends that require bankers' attention," she said.
Ms. Williams expressed the agency's particular concern about the continuing decline in banks' loan-loss reserve accounts. The average ratio of reserves to loans at all national banks fell to 1.82% at the end of the second quarter, the lowest level since 1986.
It would be more appropriate for banks to increase their reserves than decrease them, she said.
Recent work by bank examiners, she said, has uncovered an increased willingness on the part of lenders to use a borrower's enterprise value to make up for a lack of collateral in leveraged loans.
Enterprise value is a formula that uses a borrower's projected earnings as the basis for determining how much the business could be sold or refinanced for in the event of default.
The Comptroller's Office defines leveraged loans as those that meet one of the following criteria: the borrower's debt-to-equity ratio is significantly above the industry average, the borrower is in an industry that typically uses significant leverage, or the loan is structured with lenient repayment requirements that rely heavily on the presumption of future success.
Ms. Williams pointed out that the value of a business, calculated at the time the loan is made, may be significantly lower if the business defaults on a loan and must be sold. So treating enterprise value as collateral may leave a lender facing large losses if the loan goes bad.
" 'Enterprise value' is a volatile, disappearing intangible, inherently prone to vanish when it is most needed," she said.
The Comptroller's Office is also concerned by the "increasing equity-like appearance" of some leveraged loans. Loans are being structured in a way that forfeits many of the protections against loss that banks have historically built into agreements, making the lender reliant on the success of the borrower's business for repayment.
One OCC official said, "We are seeing lenders taking an equity risk for a lender's return."
David Weidner contributed to this story from New Orleans.