Regulators Give Greater Weight to Loan Quality in U.S. Tests

Regulators conducting the stress tests on the 19 largest U.S. banks are increasingly focusing on the quality of loans the companies made after finding wide variations in underwriting standards, a regulatory official said.

Supervisors concluded that banks’ lending practices would need to be given as much weight as macroeconomic scenarios after finding a wide variation in standards for mortgages and other loans as about 200 examiners pored through the portfolios, the official said.

The expanded criteria for the assessments will allow regulators to identify how much of each bank’s vulnerabilities stem from the economy’s deterioration, and how much comes from management decisions. Treasury Secretary Timothy Geithner has said he’s prepared to make management changes in any firms requiring “exceptional” amounts of fresh taxpayer funding.

“There was a heavy assumption” that soaring loan defaults in recent months were caused by the recession, said Kevin Petrasic, who served at the Office of Thrift Supervision from 1989 to 2008 and is now an attorney at law firm Paul Hastings in Washington. “If they find out that these were business decisions, that, in an odd way, is probably a good sign because you can fix this. There are very hard lessons to be learned.”

The official’s remarks provide insight into the release April 24 on the regulator’s methodology for the tests. Supervisors are addressing an error made two years ago when basing foreclosure projections on economic assumptions and concluding that poorly written loans may default regardless of the economy’s performance.

Capital Assessments

The person also said the tests don’t amount to solvency judgments, noting that estimates of each bank’s losses over the coming two years won’t necessarily equal the amount of new capital it needs to raise.

The goal of the reviews is to keep the major financial institutions lending over the next two years, and to determine how much capital they might need should the economic downturn worsen. Assumptions about capital will be forward-looking, the official said.

Supervisors will take into account how much capital each company now has, the ability to retain earnings over the next few years, access to private capital in the future and how aggressively they have already written down some assets.

Federal Reserve officials are coordinating the exams, dedicating a staff of about 140 people to the effort. All told about 200 regulatory officials are involved, with information percolating up from front-line bank examiners.

Bank Regulators

While the tests are a central element of the Obama administration’s financial rescue plan, the Treasury charged the Fed, Office of the Comptroller of the Currency, Federal Deposit Insurance Corp., and Office of Thrift Supervision to conduct them.

Some of the findings on how portfolio quality varied will be revealed April 24 when supervisors release the white paper on the methodology. Final results of the tests will be released May 4. No decision has been made yet on how to publish the results, with some regulators concerned about a lack of uniformity in the releases if each firm discloses its own results, the official said.

The methodology paper will discuss what supervisors describe as a propensity for loss among loan portfolios. Some categories of lending, such as credit cards, are highly correlated with macroeconomic data such as rising unemployment.

Repayment Ability

More variance might be expected in other kinds of assets, such as commercial real estate or mortgages, where assumptions about clients’ ability to repay played a larger role. There, default rates have soared on some products because they were originated with little regard for a borrowers’ underlying payment ability.

U.S. supervisors failed to prevent the plunging credit standards that surrounded the home-lending boom earlier this decade. They also underestimated how the housing shock would reverberate through the financial system, tightening credit, and worsening overall economic conditions.

In a review of the crisis, Phillip Swagel, former assistant Treasury secretary of economic policy, said Treasury and Fed officials in May 2007 predicted that “the foreclosure problem would subside after a peak in 2008.”

Swagel wrote in a March 30 Brookings Institution paper that supervisors realized they “missed” the fact that “problems were baked into the mortgage at origination” and that the quality of the underwriting was another issue on top of how credits respond to changes in the broader economy.

Delinquency Rate

Foreclosure rates on subprime mortgages soared to 13.7 percent in the fourth quarter of 2008, up from 8.65 percent the same quarter a year earlier, according to the Mortgage Bankers Association. Mortgage delinquencies increased to 7.9 percent of all loans in the final three months of last year, the highest level in records going back to 1972.

Geithner announced the stress tests in February, including two economic scenarios. Under the assessments’ “more adverse” scenario, the unemployment rate is seen rising to 10.3 percent in 2010 from 8.5 percent currently.

Bank of America Corp., the largest U.S. lender by assets, fell the most in almost two months of New York trading April 20 after putting aside $6.4 billion to cover a growing pool of uncollectible loans. Kenneth D. Lewis, chief executive officer of the Charlotte, North Carolina-based bank said unpaid loans are rising because of the weak economy and higher unemployment.

Bank of America is one of the 19 firms, along with Citigroup Inc., Capital One Financial Corp., GMAC LLC and regional lenders including Keycorp and Regions Financial Corp.

Goldman Sachs Group Inc. and JPMorgan Chase & Co. have said they plan to return the taxpayer funds they’ve received under the Treasury’s $700 billion Troubled Asset Relief Program.

Geithner said in an interview with the Wall Street Journal published April 20 “we want to make sure that the financial system is not just stable, but also not inducing a deeper contraction in economic activity. We want to have enough capital that it’s going to be able to support a recovery.”