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 ARNOLD  PORTER LLP

 C L I E N T A DV I S O R Y




COMMERCIAL REAL ESTATE CONCENTRATIONS                                                       JULY 2008
PREPARINg FOR THE HEIgHTENED REgULATORY SCRUTINY OF
COMMERCIAL REAL ESTATE LOAN PORTFOLIOS                                                      Washington, DC
                                                                                            +1 202.942.5000
While the meltdown in the subprime mortgage and securitization markets continues
                                                                                            New York
to receive considerable media attention, an increasing supervisory concern of the           +1 212.715.1000
federal banking regulators is not subprime mortgage lending. Instead, the banking
                                                                                            London
agencies are most concerned about, and are increasingly directing their attention           +44 (0)20 7786 6100
to, the large concentrations of commercial real estate (CRE) loans held by both
                                                                                            Brussels
domestic and international banking institutions.                                            +32 (0)2 517 6600

For the past several months, the federal banking agencies have been preparing for           Los Angeles
the after-effects of the economic slowdown, and have now begun to implement a               +1 213.243.4000
strategy to scrutinize more closely the CRE lending exposures to banks across the
                                                                                            San Francisco
country. The banking agencies are particularly concerned about banks that have a            +1 415.356.3000
large percentage of their loan portfolios secured by commercial real estate, especially
                                                                                            Northern Virginia
loans for acquisition, development, and construction of real estate projects (ADC).         +1 703.720.7000
As the market for residential real estate continues to soften, banks that have made a
                                                                                            Denver
heavy commitment to ADC lending, or have a significant concentration of total CRE           +1 303.863.1000
loans, may be feeling greater stress in their loan portfolios. Based on our intelligence,
these banks should expect to receive heightened scrutiny from the banking regulators
for the foreseeable future.

The banking agencies have been forecasting a downturn in asset quality since
earlier this year. They expect the deterioration in asset quality to be particularly
acute in areas of the country where the real estate market was, until recently, the
most robust, such as the Southeast and Southwest, or where the overall economy
has been in decline, such as the Upper Midwest. Their concerns about excessive
concentrations and the need for enhanced risk management have been expressed
in agency issuances and guidance documents, in testimony before Congress, and
in recent speeches to banking groups. The agencies’ message has been consistent
and clear. Banks should take the initiative now to redouble their efforts at effective
                                                                                            This summar y is intended to be a
risk management, and act decisively to increase loan loss reserves and shore up             general summary of the law and does
capital bases to weather the impending storm facing the industry.                           not constitute legal advice. You should
                                                                                            consult with competent counsel to
In recent testimony before the Senate Banking Committee, Comptroller of the                 determine applicable legal requirements
Currency John Dugan described the steps that the OCC is taking to identify the              in a specific fact situation.
scope of the problem among national banks and to prioritize its supervisory efforts.        arnoldporter.com
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ARNOLD  PORTER LLP


First, Mr. Dugan testified that the OCC is focusing its greatest            WHAT CAN BANKS DO TO gET PREPARED?
attention on national banks that have concentrations of CRE                 The need by the agencies to prioritize examiner resources
that exceed one or both of the following thresholds:                        provides an opportunity for banks to minimize the regulatory
                                                                            scrutiny they may otherwise receive if steps are taken now
ƒƒ acquisition, construction, and development loans
  total
                                                                            to evaluate and strengthen risk management practices.
    in excess of 100% of capital; and/or
                                                                            The key is the agency’s confidence in senior management
ƒƒ CRE of all types of loans in excess of 300%.
  total                                                           1
                                                                            to recognize the issues and undertake action to proactively
For banks in either of these categories, the agency’s                       address those issues. Banks with high concentrations
examination staff is preparing analyses that identify the                   should take affirmative steps to ensure that they do not
banks with the highest exposures in order to quickly evaluate               exhibit any of the red-flag characteristics that will attract
the capability of bank management to manage the bank’s                      attention from their regulator. Some steps that banks can
exposures in the current environment. From these reports,                   take include the following:
the OCC has identified the banks reflecting the greatest
potential risk. Comptroller Dugan has committed the OCC                     ƒƒ that the full board of directors or a designated
                                                                              Ensure
                                                                                committee thereof takes a more active role in
to conducting asset quality reviews of all of the highest-risk
                                                                                establishing CRE lending policies, setting acceptable
banks by the end of this year. Although the Federal Reserve
                                                                                levels of risk in the portfolio, monitoring bank
Board, OTS, and FDIC have not described their actions as
                                                                                management’s implementation of the policies, and
publicly as has the OCC, we understand that those agencies
                                                                                receiving regular reports from management on portfolio
are taking similar approaches with respect to the institutions
                                                                                performance;
they supervise.

Even if not on a regulator’s priority list, all banks with
                                                                            ƒƒ that the bank has classified its CRE portfolio
                                                                              Ensure
                                                                                into segments that have common risk characteristics,
concentrations in CRE can expect heightened scrutiny
                                                                                in order to track performance of each segment of the
by examiners in the coming months. Such banks should
                                                                                portfolio;
expect examiners to be more forceful about requiring loans
to be downgraded where there are identified weaknesses                      ƒƒEstablish a formalized process for regularly stress-
                                                                                testing CRE loans on a portfolio-level basis;
in borrowers’ ability to repay, and in pressing banks to
increase the allowance for loan and lease losses to address                 ƒƒEstablish a risk rating process that is transparent,
CRE exposures. In addition, the banking agencies will be                        granular, and independent;
more likely to opt for the imposition of enforcement actions                ƒƒEstablish and implement a bank policy to ensure that all
earlier than they have been during the relatively benign                        exceptions to the lending policies are properly approved,
environment that has existed over the past several years.                       documented, and monitored;
Conversely, banks that are taking seriously the need to
bolster loan loss reserves and capital levels and that
                                                                            ƒƒ that the bank has contingency plans to reduce
                                                                              Ensure
                                                                                or mitigate concentrations, or diversify into other
demonstrate robust risk management practices are more                           markets or lines of business, as CRE market conditions
likely to be able to avoid the closer regulatory scrutiny that                  deteriorate; and
other banks are presently experiencing.
1   these thresholds were identified in interagency guidance on effective
                                                                            ƒƒ that the bank has developed well-reasoned and
                                                                              Ensure
    risk management of CRa concentrations, published in December
                                                                                achievable plans to enhance capital levels.
    2006. Concentrations in Commercial Real Estate Lending, Sound
    Risk Management Practices, oCC, Federal Reserve and FDiC, 71
    Fed. Reg. 74580 (December 12, 2006).




                                                                            COMMERCIAL REAL ESTATE CONCENTRATIONS                       2
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ARNOLD  PORTER LLP


ALTERNATIVES TO FORMAL SUPERVISORY                                 confidence level the agency has in bank management and
ACTION                                                             its ability to implement the corrective measures mandated
It is a certainty that, in the current environment, the banking    by alternative informal actions.
agencies will be pressing banks to agree to enforcement
actions in greater numbers than has been typical in
recent years. In fact, the agencies have indicated they
                                                                   We hope that you find this brief summary helpful. If you would like
will not hesitate to impose formal enforcement actions on          more information on the issues raised in this client advisory, please
banks whose risk management practices they conclude                feel free to contact:
are not sufficient to mitigate the risks presented by CRE
                                                                   Richard Alexander
concentrations and exposures.                                      +1 202.942.5728
                                                                   Richard.Alexander@aporter.com
If confronted with the threat of an enforcement action, the
options available to the bank may be limited. The first and        Brian C. McCormally
                                                                   +1 202.942.5141
most obvious option is to propose that the agency allow            Brian.McCormally@aporter.com
the bank to enter into an informal action, such as a board
resolution or memorandum of understanding. Because a
violation of an informal action can not be enforced directly,
agencies are often reluctant to opt for them in lieu of formal
actions, such as written agreements or cease and desist
orders, which can be enforced directly by the agency.

Other approaches that the banking agencies may consider
involve alternative forms of informal supervisory actions
that offer the agency a greater degree of enforceability if
violated, and thus, can potentially be more attractive to
the agency. In particular, safety and soundness plans and
individual minimum capital requirements offer alternatives
to formal enforcement action while providing the agencies a
greater degree of enforceability, if violated. These alternative
approaches may also be more attractive to a bank or its
holding company because they provide an objectively
verifiable mechanism for achieving regulatory satisfaction,
but are not public and may be less intrusive.

In our experience, however, these alternative forms of
supervisory action have rarely been used because the
agencies do not typically offer them and bank counsel
many times are unaware of their availability. Accordingly,
bank counsel will need to take the lead in proposing such
alternative actions to the agency. The agency’s willingness
to agree to such an action will depend, in large part, on the




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