OCC Head Dugan Prepares to Exacerbate a Bad Situation

by: Tom Brown

As night follows day, so it is that the Office of the Comptroller of the Currency inevitably makes a bad situation worse whenever the banking industry enters a down cycle, by changing regulations and conducting overly aggressive examinations. Here we go again.

It’s frustrating to watch it happen, since the havoc the OCC is about to foster does no good at all and is entirely preventable. Still, the earnings of some banks will be excessively punished, investor fear will push their stock prices into free fall, and good bank executives will lose their jobs. It’s a shame.

On Thursday, John Dugan, the Comptroller of the Currency, gave a speech to the Florida Bankers Association. I read it after I listened to the conference call Moody’s (NYSE:MCO) held to explain why it’s changing, yet again, its stress-case losses for mortgage-backed securities. The rating agencies have gone crazy in their overreaction to the problems afflicting subprime mortgage and home equity credit markets. The overreaction has made the whole mess worse by creating such fear and confusion among investors that the whole credit-intermediation process has been slowed to a crawl.

It’s almost as if Comptroller Dugan is so jealous of the rating agencies’ ham-handedness and wants to show off some of his own. Lord knows we’ve seen such an overbearing regulatory attitude before, back in the late 1980s and early 1990s, when OCC examiners overreacted to real commercial real estate credit deterioration with “cures” that made the pain even worse. Dugan, and his man in charge of examinations, the excitable Tim Long, appear all set to hit the replay button.

Dugan told the bankers in Florida he’s worried about the concentration of commercial real estate loans at many banks, particularly “community banks,” and noted that “. . . the ratio of commercial real estate loans to capital has nearly doubled in the past six years, to 285%” at community banks. More concerning to our head bank regulator, “over a third of the nation’s community banks have commercial real estate concentrations exceeding 300% of their capital, and almost 30% have construction and development loans exceeding 100% of capital.”

Call me crazy, but I think if those figures count as excessive concentration (and I have no view, by the way) then why did Dugan and his minions let them get that high in the first place? It is utterly bizarre that the first worries we hear about CRE loan concentration from the OCC didn’t come until late 2006, more than ten years into the cycle and long after most of the loans were written.

So Dugan is suddenly worried about loan concentration. Fine. But that’s not all. He’s also worried that “. . . during the past year national community banks have experienced a significant increase in nonperforming C&D loans.” While he acknowledges that the commercial lending business is cyclical and that the level of problem loans has until lately been hovering at cyclical lows, he says he’s concerned anyway because nonperforming construction and development (C&D) loans have jumped 100% in a single year and up “eight-fold” among Florida banks!

Wow! Call me crazy again, but if you recognize commercial real estate is a cyclical business, and that we’re in the down part of the cycle, wouldn’t you expect non-performing loans to rise from their low levels? I would.

So the Comptroller is concerned about concentrations and cyclical deterioration in the portfolio--but that’s not all. He’s also concerned about banks’ underwriting and credit management practices such as in inadequate “stress testing of income-producing properties beyond interest rate to other business variables that affect risk, such as vacancy rates, lease rates, and expense scenarios.” In addition, Dugan told the bankers “we have seen an increasing number of instances in which appraisals on file have become outdated.”

Well keep on calling me crazy, but I would have expected the Comptroller’s office to spot poor underwriting and credit management practices years ago, in the examinations they’ve conducted every year over the past decade, when the concentration of commercial real estate loans that now has the Comptroller so worried first started to rise dramatically!

So what is the suddenly oh-so-worried Comptroller going to do about this? You don’t want to know. He’s going to pull out the play book from the early 1990s, bring in the leading bonecrusher from that era, Tim Long, as National Bank Examiner, and preside over a regulatory crackdown that will make the commercial real estate problems worse. You’re going to see excessive write downs, overly aggressive reserve building, capital raises at distressed level, and serious employment loss. (It really does sound like the credit rating agencies’ game plan, doesn’t it?)

He told the bankers, “There will be more criticized assets; increases to loan loss reserve; and more problem banks. And yes, there will be an increase in bank failures.” That’s code for “the OCC is going to make you classify good loans as bad and build excessive reserves, and if you don’t have enough capital, you will fail. We, the OCC, will make the problems worse so we can appear to congress and the world as if we are doing our job.”

Call me crazy for the last time, but where has the OCC been for the last decade? Perhaps if it had done its job then, the agency wouldn’t have to step in now, overreact, and make existing problems worse. I’ve seen this movie before, and I can’t understand why I have to watch it again.