A new round of land valuations force banks to adjust assets values in their construction portfolios.
Source: BIG BUILDER Magazine
Publication date: July 15, 2008
For months, land has been seen as the residential real estate industry’s four-letter word. But as a new army of bank regulators work to recognize current appraisals–those that reflect the aggressive price reductions that builders and landowners are making in a desperate attempt to lighten their balance sheet load–it’s becoming increasingly obvious that a more appropriate four-letter utterance might be debt.
“I was taught a long time ago, it’s not the land that kills you, it’s the debt on the land that kills you,” says John Landon of Landon Development Co. “It’s not the weight of the assets; it’s the amount of debt you have on the assets. If you have none, they may be worth less, but that just means they are worth less on paper. You don’t have to pay anyone to carry them.”
The fact that builders and landowners have been making price reductions in an attempt to get rid of land and lot inventory is certainly not news. But what’s creating an increasingly deafening buzz is the loss of value that is expected to be reflected in the new appraisals–and the anticipated ramifications are sending the banking industry into a tailspin.
Banks are encountering an increasing supply of land and lots, and they are trying to figure out what they have, what to do with it, and what is still to come.
What’s unclear is if the banks will actually be able to take the hit to their asset portfolios and, scars in place, move on–or whether we might be heading toward an RTC (Resolution Trust Corp.)-like environment once again.
During the last serious downturn, a sharp decline in markets meant appraisals on the actual value of land and lots collateralizing construction and acqusition and development (A&D) loans became outdated. Because bankers were reluctant to make adjustments that reflected the new conditions, examiners unilaterally–and, in the opinion of many sources, overzealously–made them on the bankers’ behalf.
In 1989, a piece of government legislation called the Federal Institutions Reform Recovery and Enforcement Act (FIRREA) was passed, which forced the S&Ls to exit the equity investment business. As a result, roughly 1,000–or 25 percent of all lending institutions–simply failed. The industry collapsed, and the RTC was formed to take in assets and liquidate them.
Back to the Future
Today, much like the previous downturn, a sharp decline in markets means appraisals have become outdated. But the Office of the Comptroller of the Currency (OCC), which charters, regulates, and supervises all the national banks, seems to be less inclined to take a heavy hand in the situation–at this stage, anyway.
The OCC’s chief officer John Dugan noted in remarks to the Senate in early June that the agency had implemented some “controversial practices” in the late 1980s. But he also said that there is training and discussion with examiners today on expectations, as well as how to consistently measure performance with regard to project performance for construction and development loans.
It’s the OCC’s nationwide staff of examiners that conducts on-site reviews of national banks and supervises bank operations. Examiners analyze a bank’s loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk, and compliance with consumer banking laws, including the Community Reinvestment Act. They also evaluate bank management’s ability to identify and control risk.
According to Christopher Mutascio, a banking analyst with Stifel, Nicolaus and Co., as well as a former examiner with the OCC, the evaluations are done on what is termed a C.A.M.E.L. scale. Ratings of one to five are assigned to banks, with one being the best, based on the following criteria: capital, asset quality, management, earnings, and liquidity.
One concern regarding the examiners is that most are relatively young and have only experienced an environment where real estate has continued to climb in value. It’s for this reason that additional training is being implemented and many retired examiners with experience from the RTC days are being wooed back into service.
But it’s this very activity that has many industry veterans fearing that examiners’ short-term thinking will create a knee-jerk reaction that ultimately compounds problems for the sector.
According to sources in the industry that went through the previous downturn, there was no mercy from examiners. And Mutascio confirms the behavior. “During that time, we were beating people over the head,” he says. “The appraisal guideline 12CFR34*, we would cite that as a violation in every single exam–numerous times if every ‘i’ wasn’t dotted.”
Still, fear and cynicism remain regarding anyone’s ability to accurately value the assets in real estate. And considering that banks are entering the next phase of this economic environment with thin loan-loss reserves, it’s hardly a stretch to imagine they won’t be persuaded to build up their reserves significantly.
Dugan’s office wouldn’t comment specifically for this article on strategies currently being given to examiners, other than to point to this statement that was also made to the Senate in June: “This time around, we have stressed to bankers and reiterated to examiners that our objective is to minimize the need for such action. We emphasized that examiners should give bankers reasonable time frames for obtaining updated appraisals and making their assessments.”
Says Mutascio, “I think what he is saying is that we have issues. We know we have issues. And the way to address these issues isn’t going to be the same as last time.”
Bigger Is Better
Today, banks seem to fall into two categories: too big to fail (KeyBank, Wells Fargo, and IndyMac, to name a few) or too small to save (insert the name of any small or mid-cap bank with a high concentration of construction loans here).
An issuance in December 2006 stated guidelines for a bank’s “concentration risk,” and when the test is applied, it’s clear where the concern lies related to construction loans.
“A lot has been made about the big banks like Bank of America and Wells Fargo and the fact that there is $30 billion dollars out there in construction loans,” says Stifel, Nicolaus and Co. banking analyst Christopher Mutascio. “People say it’s a disaster waiting to happen. But you can’t look at the dollar amount.” Instead, he points to the balance sheets of large cap banks. “Thirty billion dollars against B of A’s $1.5 trillion balance sheet is a drop in the bucket. The large caps only have 4 percent to 5 percent of the portfolio in these loans.”
What’s more at risk are the small and mid-cap institutions that have upwards of 30 percent of their loan books in such products as a result of funding many large and medium home builders with construction and A&D loans.
Despite all the doom-and-gloom talk about banks at risk, there are only approximately 75 banks on the FDIC watch list today. Since the beginning of the year, only three banks have failed, although Dugan noted in his remarks that two of those were attributed to a heavy concentration of commercial real estate loans.
Although builders have been writing down land values since the end of 2006, many banks are just getting started. “They are a year behind the curve,” says Mutascio. “The regulators are going to be on these portfolios like white on rice. We already know there are issues because they aren’t cash-flowing. The next step is that we need to know the value of the property. Therein lies the debate.”
Then and Now
There is no denying that parallels between the RTC days and today are beginning to emerge. A simple comparison shows that loose lending in both scenarios created a boatload of investments that made no sense when the market corrected. Although there are some eerie similarities between the current environment and that of the late 1980s to early 1990s, there are also some clear distinctions. Here are some insights on those differences from industry veterans:
“In the 1990s, the lending problems and overbuilding were mostly on the commercial side of the real estate business. Then the influenza spread into residential. This time, it’s a purely residential illness.” –Derek Thomas, vice chairman and CIO, Newland Communities
“What happened in the late 1980s is that the S&Ls saw this coming and tried to lend their way out of their problems. They made riskier and riskier loans trying to make up for their losses already on their balance sheet; they compounded the problem. This time around, the regulators are saying they are more educated and they want to get out ahead of this. When they see bad loans, there aren’t one or two; there are lots because the bank made bad credit decisions. So banks are trying to get ahead of that process [by unloading defaulted or impaired projects] and beat the regulators who are going to require greater capital allocations.” –Chris Mahowald, managing partner, RSF Partners
“Most loans and equity were whole loans. If a bank made a loan, they owned it. If it went bad, they fixed it. It was a buy-and-hold versus a buy-and-distribute model for loans.” –Jeffrey Gault, CEO, LandCap Partners
“Institutions are creating their own portfolios to resolve their land holdings. Many of them have enough assets to do this in a systematic and orderly way. Today, the private equity folks have enough money to come out and buy whole pools if they make sense. Many of the large private equity players likely have their start in the RTC days. The pools and transactions were smaller, but plentiful. They were able to show particular success, and, with that track record, they can now raise huge amounts of money and participate again.” –Albert Praw, CEO, Landstone
CORRECTION: In Big Builder’s June 8 issue article titled “Fallen Empire,” it was reported that some assets were “transferred” from Jim Previti’s Empire Cos. to son Jimmy Previti’s Frontier Homes. It should have stated that Frontier Homes managed the assets on behalf of Empire.
The Dirt
Cleaning House
On June 11, Pulte Homes, KB Home, Centex Homes, and Richmond American Homes agreed to pay the U.S. Environmental Protection Agency a combined $4.3 million in penalties to resolve Clean Water Act stormwater violations at hundreds of construction sites nationwide. The companies also agreed to implement a program that should prevent an estimated 1.2 billion pounds of sediment from re-entering the nation’s water each year.
According to the EPA, the four separate settlements resolve alleged violations of stormwater run-off regulations at construction sites in 34 states and the District of Columbia. Centex will pay a penalty of $1.5 million; KB Home, $1.2 million; Pulte, $877,000; and Richmond American, $795,000. The settlements require the companies to develop improved pollution prevention plans for each site, increase site inspections, and correct any problems that are detected. They are required to have trained staff present at each construction site, implement a management and internal reporting system to improve oversight of on-the-ground operations, and submit annual reports to the EPA.
Trend’s Transfusion
On June 5, private investment firm Najafi Cos. completed its purchase of Gilbert, Ariz.-based Trend Homes following the builder’s emergence from bankruptcy proceedings.
The Phoenix-based Najafi Cos. bought “a substantial portion of the assets of Trend Homes Inc. and several of its affiliates for $86.5 million,” according to the company. The price was significantly higher than the estimated $65 million Najafi said it planned to pay when it announced the pending sale in January.
The transaction was subject to approval by the U.S. Bankruptcy Court for the District of Arizona under the conditions of Trend’s petition for debt relief under Chapter 11 of the federal bankruptcy code.
The restructured company expects no immediate changes in operations and no layoffs are planned, according to Trend CEO Reed Porter.
