Faulty Appraisals Kill Banks
If you read through enough material loss reviews prepared by the FDIC's Inspector General — essentially autopsies on failed banks — certain common themes emerge. One of the recurring themes is that many closed banks overconcentrated in commercial real estate and development loans. The rapid decline in property values, reflected by appraisals, then rendered the bank undercapitalized.
Banks often tell the story of a downward spiral in the carrying value of their property loan portfolios as examiners require updated appraisals followed by a series of re-appraisals. In most cases, these dwindling values involve GAAP accounting and valuation definitions (market value versus fair or liquidation value) and appraisal assumptions.
Regulators fostered this confusion by not regularly updating interagency appraisal guidance. Between 1994 and December 2010, the respective regulators failed to update interagency appraisal guidance once.
Why is this point so pivotal to banks? Each downward revision and additional loan loss provision tightens the noose as loan value markdowns whittle away the bank's capital position.
Although it is difficult to reconstruct precisely, in all probability, these re-appraisal cycles have contributed to most of the four hundred plus bank failures since 2008. Are appraisals accurate enough to impose death sentences on banks when there is such confusion in value terminology, assumptions and interagency appraisal guidance?
Recent evidence from the commercial mortgage-backed security market suggests not.
Until recently, the ability to review rigorously the accuracy of appraisals did not exist. Boom-and-bust real estate lending cycles extend back at least as far as the Banking Panic of 1837, but reliable standardized data on appraisals and their relationship to liquidation values was unavailable. This absence of hard data on bank commercial real estate valuations contributed to this financial crisis. The regulatory failing persists today, even as yearend 2011 bank stress tests are underway and due in early 2012. There is scant consistency in data on valuations, appraisals or key metrics among banks or their regulators.
In 2009, regulators undertook a first-of-its-kind effort to collect 40 key data metrics on CRE and values. The CMBS industry collected this data in 1996.
Among all major sources of commercial real estate financing — banks, life insurance companies and CMBS — only the latter industry collects and disseminates sufficient, standardized data to explore the relationship between appraised values and liquidation proceeds. With the downturn in CRE markets, required appraisals and subsequent liquidations have skyrocketed.
Based on data provided by Trepp, through September 2011, the CMBS industry had liquidated 5,258 loans (mostly REO disposition, but some note sales) with an unpaid principal balance totaling $33.3 billion, most recent appraised values of $42.7 billion (78% loan-to-value) generating gross proceeds of $20.8 billion and incurring total realized losses (including collection costs and brokerage fees) of $13.8 billion, for a loss severity of 41% of unpaid principal balance.
Applying more restrictive filters to the data still produces more than 2,000 liquidations that aggregate liquidation proceeds of $7.6 billion against appraised values of $8.4 billion. The research, as described at length in the upcoming January issue of Commercial Real Estate Finance World, employs the ratio of appraised value to gross proceeds. An AV/GP of 1.0 shows a perfect appraisal prediction of gross proceeds to be realized; an AV/GP ratio of 1.50 implies an appraised value of, say, $15 million, that generates proceeds of $10 million.
In aggregate, the AV/GP of all 2,076 liquidations produces a ratio of 1.10. So far, so good. A deeper investigation reveals that the gaps between appraised values and gross proceeds — some too high, some too low — offset each other.
Against an average appraised value of $4 million, the average absolute gap against liquidation proceeds exceeds $1 million. Even more alarmingly, the standard deviation of the gaps equals $4 million. Statistically, this means that 68% of the time, the value of a $4 million appraised property will generate gross proceeds between $0 and $8 million — not particularly helpful in determining whether a real estate lender is insolvent.
On the chart showing the AV/GP distribution the right and left-hand tails are noteworthy: in 121 instances, the appraised value is more than double gross proceeds realized; on the other extreme, 132 appraisals were less than 70% of actual proceeds.
For a smaller community bank with a collateral dependent loan that appraises for only $7 million, but which will eventually liquidate for $10 million, this measurement error can be crippling and unnecessary.
By some measures, banking is healthier than it's been for years. The industry's average leverage ratio is a robust 9.2% as of third quarter 2011. But that's still an 11:1 leverage. Small changes in the carrying value of loans materially impact a bank's capital adequacy. Some banks can be one unfortunate appraisal away from a consent order. Given the scattered distribution of results shown above, this seems like a poor foundation for placing a bank on the conveyor belt to a receivership. Legislators are getting the message and responding by calls for questioning the process and impact of bank closures (HR 2056) and tightening up requirements for new appraisals as well as institutionalizing exam appeals without fear of retaliation (HR 3461). More work is needed as appraisal oversight is delegated to the states and inconsistency among regulators persists.
The data analyzed involve income-producing commercial real estate properties. As demonstrated, appraisals on these properties can vary in dramatic and, depending on the materiality to the originating bank, sometimes life-threatening ways. But many classified bank loans are backed by development land loans with no operational cash flows. As difficult to value as income-producing properties may be, land loans are even more likely to be wide of any useful mark.
What can be done?
The Financial Institutions Examination Fairness and Reform Act (HR 3461) makes good points and should be enacted. And the regulators' own "Policy Statement on Prudent Commercial Real Estate Loan Workouts," from October 2009, should be enforced. The statement, when followed, does not automatically write-down the value of a secured property loan when other repayment sources have been identified.
Most importantly, both examiners and bank risk managers should recognize the limitations on appraisals, particularly in a disorderly market. As one private equity investor recently remarked, "appraisals are another data point." Life and death decisions should be left to higher authorities. Let's not pronounce the patient dead because of one erratic measurement if the other vital organs are still healthy.
Brian Olasov is managing director at McKenna Long & Aldridge LLP. KC Conway is executive managing director at Colliers International. The views expressed are their own.