Bankers and Regulators Clash Over Surge in Real-Estate Loans

By Bernard Wysocki Jr.
From The Wall Street Journal Online

Federal regulators are trying to hit the brakes on commercial real-estate lending. That annoys Bradley Rock, the chief executive officer of Smithtown Bancorp Inc.

Wheeling his black Lexus sedan toward the clubhouse of the Fox Hill Golf & Country Club, Mr. Rock gazed at the lush fairways of the 175-acre property, appraised at more than $15 million. The owners of the club owe $2.7 million to his bank. "You could sell the property for massively more than the debt," Mr. Rock said. "It’s impossible for the bank to lose money."

Like thousands of community banks across the U.S., Smithtown, of Hauppauge, Long Island, has feasted on commercial real-estate loans. About 80% of Smithtown’s $800 million loan portfolio is concentrated in that category, which Mr. Rock calls "the last safe, profitable niche" for community bankers trying to compete against giant banks. The banks consider these loans — the $1 million to $10 million loan to a home builder or strip-mall owner — to be their sweet spot.

To bank regulators, the rapid growth in commercial real-estate loans — up 16% in 2005 alone to $1.3 trillion — is alarming. In January, four regulatory agencies, including the Federal Reserve, proposed a clampdown. In a draft of new "guidance," they said banks exceeding certain levels of lending in construction and commercial real estate should step up risk monitoring or add capital, or both.

The proposed guidance wasn’t a hard rule and didn’t impose limits on lending, but the bankers went bonkers. The Independent Community Bankers of America, the American Bankers Association and more than 1,000 banks wrote protest letters. The community bankers, citing the government’s own reports, said commercial real-estate loan performance is healthy and growth is driven by employment and population growth. Bankers argued that their lending practices had become far more sophisticated since the last real-estate bust in the early 1990s, while the regulatory guidance had all the finesse of a meat cleaver.

A hearing on the issue before a House subcommittee is set for Thursday. Regulators probably will issue final guidelines sometime after that, and the implications could be significant. If regulators are too lax, there could be a raft of bad loans. If they are too tough, they could prompt a credit crunch, with small business owners unable to get loans. That could cast a chill on the entire U.S. economy.

Commercial real-estate loans "can be the sweet spot — or the tar pit" for banks, says Susan Bies, a governor of the Federal Reserve. It supervises bank holding companies and about 900 state banks, including the Bank of Smithtown, a wholly owned subsidiary of Smithtown Bancorp.

The regulators conjure up memories of the late 1980s and early 1990s, when aggressive lending led to overbuilding, vacant properties, price collapses and huge losses for taxpayers. From 1987 through 1994, more than 1,100 banks and nearly 1,000 savings-and-loan institutions failed or required financial assistance, according to the Federal Deposit Insurance Corp.

"It is hard to overstate the impact of that crisis on our economy," John Dugan, the comptroller of the currency, said in a speech to New York bankers in April. Mr. Dugan’s agency, part of the U.S. Treasury, supervises more than 2,500 nationally chartered banks.

Cracking Down

Though the guidance isn’t finalized yet — and, even when completed, won’t include hard-and-fast lending caps — examiners already are cracking down, say bankers. TransAtlantic Bank, of Miami, has cut back commercial real-estate loans in reaction to the regulators’ proposals, while expanding unsecured loans to doctors, lawyers and other business customers. Chief Executive Miriam Lopez says the unsecured loans are actually riskier; the bank has more than doubled its credit department to handle the change in strategy.

"Talk about unintended consequences," says Mr. Rock, who as vice chairman of the American Bankers Association is helping lead the charge against regulators.

The 54-year-old banker grew up in Hauppauge, 50 miles east of Manhattan, where he was a high-school football star. He worked as a lawyer before becoming chief executive at Smithtown in 1990.

He has produced strong results: soaring loan and deposit growth, rising profits and minimal bad loans. The bank says investors who bought its Nasdaq-listed stock in 1995 have enjoyed a more than 20-fold return on their investment.

The Smithtown formula involves gathering deposits, currently about $835 million, at 13 branches on Long Island. The bank then lends out the money at interest rates that are more than four percentage points higher, on average, than what it pays on deposits. Demand is robust in Long Island’s mostly white-collar economy, which has enjoyed strong job growth in health care and education, according to Moody’s Economy.com Inc., although it says high costs could crimp that growth.

The bank mostly steers clear of consumer lending, such as auto loans and credit cards. Residential real estate is just 14% of the loan portfolio. Mr. Rock says Smithtown can’t compete with the big banks that blanket the greater New York market.

"Citibank, Chase, Bank of America, they spend enormous amounts of money on the mass market," Mr. Rock says. "You need to be on television every night" with advertising, he says. "There’s no way we can afford to do that."

Instead, Smithtown has a small lending team of five people who specialize in making real-estate loans to businesses. One banker focuses on loans to homebuilders. Mr. Rock’s 24-year-old son recently joined the bank and is cutting his teeth on mortgages for small commercial buildings. The bank also lends to owners of multitenant office buildings and family restaurants.

In recent years, Mr. Rock has moved into the five boroughs of New York City, lending to smaller developers who might, for example, need a $5 million loan to convert an industrial building in Brooklyn’s trendy Williamsburg section into condominiums or rental apartments.

He has an army of loyal borrowers, such as Vincent Di Canio, a Smithtown developer who has received dozens of real-estate loans from the Smithtown bank over the past 25 years. Mr. Di Canio says he goes to the big banks only when he needs more than $10 million. He is worried the regulators’ guidance will cause Bank of Smithtown to cut back lending. "It would be detrimental to me and all midsized entrepreneurs," he says.

Mr. Rock acknowledges that real-estate busts occur and can be devastating. In his first years as CEO, in the early 1990s, his own bank had several loans go sour. Often, the bank hadn’t paid attention to the income stream on the borrower’s property, he says.

He slows his car to an intersection in Melville, just off the Long Island Expressway, and gestures at rows of 250,000-square-foot office buildings that were built in the 1980s, sometimes with financing from big banks. By the early 1990s, a number of the Melville buildings lay vacant and were sold at a loss.

"Here’s your 1980s real-estate bust," Mr. Rock proclaims. "The biggest amounts came from the biggest banks putting mortgages on the biggest buildings."

Mr. Rock believes most smaller banks such as his aren’t engaging in the sort of indiscriminate lending that caused trouble 15 years ago. Nowadays, he says, he ensures that a developer’s income from property is enough to pay down the mortgage, and he leaves an ample margin of safety in his loan portfolio in case real-estate prices turn south.

Mr. Dugan, who took over as comptroller in August 2005, is less sanguine. A former Washington lawyer with many financial institutions as clients, Mr. Dugan was heavily involved in the savings-and-loan cleanup as a U.S. Treasury official from 1989 to 1993. He declined to be interviewed, but his speeches leave no question about his concerns.

At a conference last October of credit experts from the Office of the Comptroller of the Currency in Atlanta, Mr. Dugan noted that about a third of national banks had commercial real-estate loans amounting to 300% or more of their bank capital. In its simplest definition, capital is equal to a bank’s assets minus liabilities. Under U.S. regulations, banks are required to hold a certain amount of capital, measured in various ways, as a financial cushion. Mr. Dugan urged his credit staffers to continue "carefully monitoring banks where these concentrations could become, or already are, significant."

Warning Letters

Within weeks, the office’s regulators in the field were sending out letters to banks, warning about concentrations.

Community bankers say the letters made them shudder. "I was very upset," says Everett Crawford, chief executive of First National Bank of Artesia, N.M. If he has to cut back such lending, "it will diminish the franchise," says Mr. Crawford, who worries the 103-year-old institution may have no choice but to sell itself.

By all accounts, banks have a much better handle on their loan portfolios these days than two decades ago. Nonetheless, regulators fear standards still aren’t strict enough sometimes.

The letter Mr. Crawford received was from Kay Kowitt, a deputy comptroller of the currency. She didn’t single out his bank but dwelt on several emerging problems among the 400 banks supervised by the western district of the agency. Noting that "competition in virtually all markets is intense," the letter fretted about "liberal terms for speculative land loans" and said some borrowers had only a thin margin between the cash flow from their property and their loan repayments. It also questioned whether some banks are getting fully independent property appraisals.

Regulators also believe new forces in the market are pushing up real-estate prices. One new factor: Unlike small banks, the biggest banks often are selling their commercial loans to be packaged into securities and sold to global investors. That market is making it easier for banks to come up with money for loans, which in turn boosts demand for commercial property.

In April, Mr. Dugan sounded the alarm bells again, this time before the New York Bankers Association. In the late 1980s and 1990s, he said, failed banks had three times the real-estate concentrations of banks that survived. With Mr. Rock looking on, Mr. Dugan also defended the guidance proposed by his agency and three others. It would single out for scrutiny banks that have lent more than 100% of their capital in construction or more than 300% of their capital in commercial real estate generally.

Smithtown’s portfolio is way over the guidelines because its commercial real-estate loans amount to 750% of, or 7.5 times, its capital. Mr. Rock believes it is simplistic to lump all commercial real estate into "a single bucket." His portfolio, he argues, should instead be viewed as "75 buckets" of diverse loans with different maturities and risks. Mr. Rock says he welcomes examinations, but he thinks examiners should dig down and assess the risks of individual loans and various types of loans.

In a June 20 meeting that Mr. Rock and officials from the American Bankers Association held with regulators, Mr. Rock complained that field examiners are using the measures in the guidelines to "beat up" banks with heavy concentrations of commercial real-estate loans. "Susan, here’s the essence of the disconnect," he says he told Gov. Bies of the Fed. "You call it guidance, but examiners are in my bank, criticizing me for having too many commercial real-estate loans."

Gov. Bies, in an interview, says she hasn’t received concrete evidence of overzealous activity by bank examiners, but she says the Fed will start a training program for its staff once the guidance becomes final. Regulators say their metrics are a valuable screening device to flag potential problems. Bankers say the definition of a commercial real-estate loan is too broad.

On a recent afternoon, Mr. Rock drove around Suffolk County, his prime lending area, and stopped outside a medical office building. He has extended a $350,000 line of credit to the doctors backed by the property, which he said is valued at two to three times that amount. He drove past one of Mr. Di Canio’s housing developments, with 34 single-family units under construction, and said his lenders minimize risk by doling out money little by little as the work progresses.

Then Mr. Rock drove a few miles out to the Fox Hill golf club. If the property ever got developed into houses on half-acre lots, he said, it could be worth $40 million or more. "This is just my idea of an absolutely great loan," Mr. Rock said. "But the regulators are saying I have a ‘concentration.’ So if another one comes along like this, I’m supposed to turn it down."

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