It seems that periodically banks get clobbered by the real-estate market. If it isn’t one thing, it’s another. Sometimes it is due to external forces beyond banks’ control.

Back in the 1970’s, banks’ real-estate-loan portfolios consisted of fixed-rate loans, and competition from a new financial product offered by nonbanks—the money-market fund—resulted in significant disintermediation. This led to some relief from the federal law that prohibited banks from paying interest on demand deposits, which is still in effect. The relief came in the form of authority to offer money-market deposit accounts and negotiable order of withdrawal, or NOW, accounts. The former is a type of savings account with a limited transaction capability and the latter is the functional equivalent of a demand-deposit account that pays interest, although it may only be offered to individuals and non-profits. While this was good news for depositors, it made the process of asset/liability management more daunting. Until their fixed-rate loans ran off, banks had to fund them with floating-rate liabilities, a prescription for disaster. Now, rates on both liabilities and assets can float, and the latter has made a lot of borrowers seasick.

The subprime-mortgage-lending crisis has had many causes. A threshold question is: What is a subprime loan? In a statement on subprime-mortgage lending by federal banking regulators last July, they pointed out that the term is not consistently defined in the marketplace or among individual institutions. In response to the statement, a number of commentators had requested that regulators define the term. However, they declined to do so. They did, however, allay the concerns of some commentators who feared that the proposed statement implied that subprime lending is, per se, “predatory.” Addressing this concern, regulators noted that their statement “clarifies that subprime lending is not synonymous with predatory lending, and that there is no presumption that the loans to which the statement applies are predatory.”

While it is nice that subprime loans are not considered to be predatory, per se, they have caused a lot of pain for bankers and borrowers alike. A lot of these loans weren’t originated by banks and their originators aren’t subject to the same constraints as banks. Nonbank mortgage lenders are typically licensed by the states, which provide some oversight, but not to the same degree as they oversee banks. At the federal level, they are subject to the jurisdiction of the Federal Trade Commission; however that agency does not have a statutory mandate to regulate mortgage lending. Mortgage brokers also are typically required to be licensed by the states.

Federal bank regulators have been offering guidance on real-estate lending for quite some time, issuing interagency guidelines in 1992. Since then, the agencies have released a number of issuances addressing various concerns about real-estate lending. The guidelines required banks to “adopt and maintain written policies that establish appropriate limits and standards for extensions of credit that are secured by liens on or interests in real estate, or that are made for the purpose of financing permanent improvements to real estate.” These policies must be reviewed and approved by a bank’s board of directors at least annually.

The interagency guidelines are very comprehensive. Bank senior management, loan officers and credit-administration officers involved in real-estate lending should become thoroughly familiar with them. The annual review and approval of the bank’s real-estate lending policies should not be merely perfunctory. Board members should be furnished with an executive summary of the guidelines so they can ask appropriate questions. Too often, regulatory items on a board’s agenda are rubber-stamped, with little or no discussion. Given the periodic problems in real-estate lending, directors should inquire about a bank’s real-estate loans not only at the time of the required annual review, but throughout the year. Having a real-estate professional on the board would be helpful.

The excuse often given for board members’ inattention to regulatory items is that they take away valuable time better spent on business discussions. However the interagency guidelines do invite discussion about an important segment of the bank’s business. (c) 2008 U.S. Banker and SourceMedia, Inc. All Rights Reserved.

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