Below are the top banking risks involving credit as determined by the Chicago Fed's Risk Committee in March 2011. Since banking conditions rarely change dramatically from quarter to quarter, the list of top risks tends to change only gradually over time.
|Allowance for Loan and Lease Losses (ALLL)||Inadequate ALLL balances and releasing of reserves at some banks are a concern. Although there are signs of stable to improved credit conditions, the prolonged economic recovery suggests continued vigil over ALLL adequacy and coverage of expected losses. ALLL methodologies need to reflect appropriate consideration for economic environmental factors and migration analysis.||Inadequate funding of ALLLs and a reserve model that does not properly consider economic environmental factors may significantly impact future earnings and capital if acceptable levels of reserves aren’t maintained. Firms may incur substantial and unexpected increases in credit provisions due to continued high volumes of problem assets.|
|Commercial Real Estate (CRE) Valuations||Some firms continue to delay obtaining updated appraisals and evaluations on troubled CRE, and/or fail to properly analyze and review new or existing appraisals. Banks are sometimes improperly using BPOs and tax assessments as substitutes for evaluations. Some evaluations do not meet the regulatory standards or are prepared by unqualified personnel.||Lack of timely and quality appraisals and evaluations lead to improperly funded ALLLs (inadequate ASC 310 impairment allocations), and inaccurate loan grades. With some projections for continued CRE loss rates through 2011, impairment allocations may not be sufficient to absorb these anticipated losses.|
|CRE Workout and Refinance Risk||Completed CRE projects are entering long stabilization periods with many banks defaulting to inappropriately long interest only terms. Refinance risk with inadequate cash flow (either through unit sales or rents) to amortize principal is a significant issue. Many District banks with CRE concentrations will have significant rollover risk of CRE portfolios in 2011, 2012 and 2013.||There is likely to be a significant increase in TDRs and net credit losses on CRE in 2011 and beyond as banks must address eventual refinancing with principal amortization included. With insufficient collateral margins and lack of adequate cash flow to amortize the debt, guarantors will have to service principal or banks will have to face A/B note restructures or foreclosure. Cash flow for many loans is only sufficient to service interest only payments at these historically low interest rates.|
|Mortgage Foreclosure Documentation, Notarization and Securitization||Recently, large mortgage firms and GSEs admitted thousands of foreclosure documents were not thoroughly reviewed. In some cases, this sparked firms to delay foreclosure proceedings. The notarization process is also being brought in question. Concern extends to the securitization process, where in some cases trusts may have not legally perfected their interest in the mortgages serving as collateral for issued securities.||The lack of appropriately reviewing mortgage foreclosure documentation could delay mortgage foreclosure proceedings and push back mortgages to originators. Many originators are no longer in operation. Investments backed by such mortgages may incur losses. Foreclosure proceedings again could be hindered from issues with perfecting the interest.|
|Second Mortgage and Home Equity Line of Credit Portfolio Management||Delinquency rates on junior mortgages are increasing, but may not entirely capture the risk within these credits as borrowers tend to default on first mortgages before the junior positions. Home values have fallen and eroded equity positions may render the second mortgage underwater or simply unsecured. Write-downs on second mortgages may accelerate.||Some banks’ failure to properly monitor junior mortgage borrowers may see unexpectedly high net losses in the future on these loans, as foreclosures by the first lien holder become final. Firms may also be inadequately funding their reserves for the inherent risk of these loans.|