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| TO: |
CHIEF EXECUTIVE OFFICER |
| SUBJECT: |
Internal and Regulatory
Guidelines for Managing Risks Associated with Acquisition, Development,
and Construction Lending |
The U.S. has benefited from strong
economic growth and generally favorable real estate markets since the early
1990s. As a result, financial institutions in many metropolitan areas are
active in residential and commercial real estate acquisition, development,
and construction (ADC) lending. ADC lending has had a positive impact on
financial institutions and the overall economy. However, information obtained
by the FDIC through the examination process and from other sources indicates
that several areas of the country are experiencing very high levels of construction
activity and an extremely competitive lending environment. The combination
of these factors often leads to thin profit margins on ADC loans and looser
underwriting standards. This letter is intended to make institutions aware
of this situation and to remind them of existing regulatory guidance for
real estate lending activities.
Recent studies undertaken by the FDIC's
Division of Insurance find early indicators of potential imbalances in a
number of real estate markets. These studies, which are supported by the
opinions and research of credible industry experts, caution that the rapid
pace of development within various markets may lead to an oversupply of
developed property during the next several years. Many of the most rapidly
expanding metropolitan areas are located in the Southeast and Southwest
portions of the country. While the studies do not predict an imminent downturn
in these markets, they do raise concerns about the substantial growth in
real estate development and the related increase in financial institution
ADC loan concentrations within some markets. Additional information about
these studies can be found on the FDIC's World Wide Web site at /bank/analytical/bank/fil998.html.
The majority of financial institutions
have operated their ADC lending programs prudently for most of this decade.
However, ADC lending is a highly specialized field with inherent risks that
must be managed and controlled to ensure that this activity remains profitable.
Management's ability to identify, measure, monitor, and control portfolio
risk through effective underwriting policies, systems, and internal controls
is crucial to a sound ADC lending program.
Part 365 of the FDIC Rules and Regulations
requires FDIC-supervised institutions to adopt and maintain written policies
that establish appropriate limits and standards for all real estate loans,
including ADC loans. The institution's board of Directors
is responsible for establishing appropriate risk limits, monitoring exposure,
and evaluating the effectiveness of the institution's efforts to manage
and control risk. The level and complexity of risk-monitoring techniques
for ADC lending should be commensurate with the level of real estate activity
and the nature and complexity of the institution's market. When crafting
internal guidelines for ADC and other real estate lending programs, the
board should carefully consider the Interagency Guidelines for Real Estate
Lending Policies, which can be found under Appendix A to Part 365. In particular,
the following items within the Interagency Guidelines should be noted.
* Underwriting Standards - Underwriting
standards for construction and development loans should address the following
items, commensurate with the size and complexity of the project:
- Feasibility studies and sensitivity analyses;
- Minimum initial investment and hard equity maintenance requirements;
- Minimum standards for net worth, cash flow, and debt service coverage
of the borrower or the underlying property;
- Standards for the acceptability of, or limits on, non-amortizing loans
and interest reserves;
- Pre-leasing and pre-sale requirements;
- Limits on partial recourse or non-recourse loans and requirements
for guarantor support;
- Requirements for take-out commitments; and
- Minimum covenants for loan agreements.
* Supervisory Loan-to-Value Limits
- Institutions should establish their own loan-to-value (LTV) limits for
real estate loans; however, these internal limits generally should not exceed
the LTV limits suggested within the interagency guidelines. While the interagency
LTV limits can be exceeded under certain conditions for individual credits,
loans exceeding the interagency guidelines should be noted as such on the
bank's records. In addition, the aggregate amount of loans exceeding the
interagency LTV guidelines should be reported to the board at least quarterly
and the total amount of those loans should not exceed 100 percent of the
bank's total capital. Moreover, within the 100 percent of capital limitation,
the total amount of non-1-4 family residential real estate loans exceeding
the LTV limits should not exceed 30 percent of total capital.
* Exceptions to Policy - The board
of Directors is responsible for establishing
standards for reviewing and approving exceptions to loan policy. The approval
of any loan that is an exception to policy should be supported by a written
justification that clearly sets forth all of the relevant credit factors
supporting the underwriting decision. Exception loans of a significant size
should be individually reported to the institution's board of Directors.
The institution should monitor compliance with its internal policies and
maintain reports of all exceptions to policy. Such reports will be reviewed
by examiners during the course of regular examinations to determine whether
the institution's exceptions are adequately documented and are appropriate
in view of all the relevant credit considerations.
The above list represents a partial
summary of the interagency guidelines and is not intended to be comprehensive
nor all-inclusive. Institutions are encouraged to refer to Part 365 and
Appendix A to Part 365 for additional guidance. If you have any questions,
please contact your Division of Supervision Regional Office for further
assistance.
| Arthur
Murton |
Nicholas J. Ketcha
Jr. |
| Director, Division
of Insurance |
Director, Division
of Supervision |
Distribution: FDIC-Supervised Banks
(Commercial and Savings)
NOTE: Paper copies of FDIC financial
institution letters may be obtained through the FDIC's Public Information
Center, 801 17th Street, NW, Room 100, Washington, DC 20434 (800-276-6003
or (703) 562-2200).
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