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Report on Underwriting Practices
APRIL THROUGH SEPTEMBER 2001
At the end of each FDIC-supervised bank examination, the examiner in charge responds to a questionnaire on the bank’s underwriting practices. This Report on Underwriting Practices covers the responses submitted during the six months beginning April 1, 2001, and ending September 30, 2001. The number of responses received during this six months was 1,221—which represents approximately 22 percent of the number and 28 percent of the assets of all FDIC-supervised banks. The results reported here refer to weighted responses and are estimates of the underwriting practices of all FDIC-supervised banks. An explanation of the use of weights appears in “Purpose and Design of the Report.” All weighted responses appear in the table at the end of this Report. Throughout the Report, the response rates have been rounded to the nearest 1 percent for ease of exposition.
GENERAL UNDERWRITING TRENDS
During the six months ending September 30, 2001, risk
in banks' loan portfolios and in loan administration
increased compared with the six months ending March 31,
2001. The proportion of banks with
Among examiners' concerns in banks with high risk in their loan portfolios were consistently inadequate underwriting standards, lack of enforcement of underwriting standards, inadequate management, and incomplete documentation. Concerns in banks with medium and high risk in loan administration were lack of loan monitoring and incomplete loan documentation and financial statements.
The occurrences of two general risky underwriting practices also increased. The proportion of banks that either "frequently enough to warrant notice" (hereinafter, "frequently") or "commonly or as standard procedure" (hereinafter, "commonly") made loans in amounts that resulted in—or contributed to—concentrations of credit to one borrower or to one industry increased from 21 percent to 23 percent. And the proportion of banks that either "frequently" or "commonly" failed to require a material principal reduction before renewing term loans increased from 22 percent to 24 percent.
Other differences for FDIC-supervised banks during the six months ending September 30, 2001, compared with the six months ending March 31, 2001, included changes in the proportions of banks in the following categories:
During the six months ending September 30, 2001, examiners indicated that 11 percent of FDIC-supervised banks showed a material change in underwriting practices since the previous examination—6 percent tightened their underwriting practices and 5 percent loosened them. During the previous six months, the proportions were 5 percent and 6 percent, respectively.
The main reasons for the loosening of underwriting practices (according to examiners) were competition and/or growth goals; the main reasons for the tightening were a need to respond to regulatory observations and/or a change in management.
Of the 1,221 banks examined, 199 (20 percent) used a credit scoring model for credit decisions; the model was used most frequently (113 banks) for consumer installment lending. During the six months ending March 31, 2001, 19 percent had used a credit scoring model.
During the six months ending September 30, 2001, of the 1,221 banks examined, 1,062 were active in business lending, 952 in consumer lending (excluding credit cards), and 904 in commercial (nonresidential) real estate lending. Eleven banks were not active in any of the major loan categories covered. The accompanying chart shows the number of banks for each major loan category.
Examiners are also asked to report activity in any loan category that is not listed in the chart.1 Only 231 banks examined had activity in additional loan categories, with the largest number of banks (118) having dealer paper loans.
During the six months ending September 30, 2001, the frequency of risky underwriting practices decreased slightly for most major loan categories. For business and consumer lending, however, slight increases were seen in a few risky underwriting practices. For agricultural lending, the increases were larger.
For banks active in agricultural lending, the frequency of three risky underwriting practices increased during the six months ending September 30, 2001, compared with the previous six-month period. The proportion of agricultural lenders that either "frequently" or "commonly" made agricultural loans on the basis of land values that cannot be supported by farm operations increased from 10 percent to 15 percent. In addition, fifteen percent (up from 11 percent) of banks made agricultural loans on the basis of unrealistic cash flow projections, and 23 percent (up from 21 percent) showed a "moderate" or a "sharp" increase in the bank's level of carryover debt. Forty-four percent (unchanged) either "frequently" or "commonly" had portfolios tied to crops affected by the Federal Agricultural Improvement and Reform Act of 1996.2
The main concerns among examiners in banks that lend on the basis of land values that cannot be supported by farm operations are inadequate cash flow analysis, collateral-based lending, and lack of financial statements.
The frequency of risky underwriting practices in business lending increased slightly during the six months ending September 30, 2001, compared with the six months ending March 31, 2001. The proportion that either "frequently" or "commonly" made business loans without a clear and reasonably predictable repayment source increased from 14 percent to 16 percent, and the proportion that either "frequently" or "commonly" failed to monitor the collateral pledged on asset-based loans (a subset of business lending) rose from 20 percent to 23 percent.
The proportion of FDIC-supervised banks that either "frequently" or "commonly" made business loans to borrowers who lacked documented financial strength to support such lending remained the same: 22 percent.
For FDIC-supervised banks active in consumer lending (excluding credit card loans), the increases in the proportions of banks that "commonly" made loans with two risky underwriting practices edged up. The proportions doing so "frequently," however, decreased an equal amount. The proportion of banks that "commonly" made loans to borrowers who lacked demonstrable ability to repay increased from 2 percent to 3 percent during the six months ending September 30, 2001, but the proportion "frequently" doing so decreased from 18 percent to 17 percent.
And the proportion of banks that "commonly" made "secured" consumer loans without adequate collateral protection increased from 2 percent to 3 percent, but the proportion that did so "frequently" edged down from 13 percent to 12 percent.
For commercial (nonresidential) real estate lending, occurrences of specific risky underwriting practices were essentially unchanged compared with the previous six months. Of the FDIC-supervised banks actively making such loans, 14 percent either "frequently" or "commonly" made short-term commercial real estate loans with minimal amortization terms and large "balloon" payments at maturity, down from 15 percent previously.
Ten percent (unchanged from previously) either "frequently" or "commonly" made commercial real estate loans without consideration of repayment sources other than the project being funded; 9 percent (also unchanged) either "frequently" or "commonly" made loans without using realistic appraisal values relative to the current economic environment and/or to the performance observed on similar credits; and 7 percent (up slightly from 6 percent) either "frequently" or "commonly" made interest-only, extended-amortization, or negative-amortization permanent commercial real estate loans.
For banks active in making construction loans, the frequency of risky underwriting practices was about the same during the six months ending September 30, 2001, compared with the previous six-month period, except for two practices. The proportion of banks that either "frequently" or "commonly" funded, or deferred, interest payments during the terms of their commercial construction loans fell from 17 percent to 15 percent. And the proportion of banks that made speculative construction loans (that is, projects without meaningful pre-sale, pre-lease, or take-out commitments) dipped from 29 percent to 28 percent.
In contrast, for banks that actively made construction loans, the proportion of banks that either "frequently" or "commonly" engaged in the following risky underwriting practices remained the same: (1) making construction loans without consideration of repayment sources other than the project being funded—13 percent during both periods; (2) failing to take appropriate steps to verify the quality of alternative repayment sources when such sources are required—also 13 percent during both periods; and (3) failing to use realistic appraisal values relative to the current economic environment and/or to the performance observed on similar credits—12 percent during both periods.
Of the FDIC-supervised banks that were active in home equity lending, a slightly larger proportion were making home equity loans that pushed mortgage indebtedness above 90 percent of collateral value. Specifically, 11 percent either "frequently" or "commonly" made such loans compared with 10 percent previously.
Two percent of banks (up from 1 percent) "frequently" qualified borrowers for home equity credit on the basis of initially discounted (teaser) loan rates. None did so "commonly."
Credit Card Loans
Few FDIC-supervised banks were making new credit card loans. Of the banks active in new credit card lending, 1 percent (unchanged) had "high" risk in current underwriting practices for new credit card loans. One percent (down from 3 percent) had "high" risk associated with the bank's credit card portfolio. Examiners were concerned about the level of subprime credit card lending in those banks with either "high" risk in current underwriting practices for new credit card loans or in banks with "high" risk in their credit card portfolios.
Purpose and Design of the Report
In early 1995, the FDIC began to require that a supplementary examination questionnaire on current underwriting practices at FDIC-supervised banks be filled out at the end of each FDIC-supervised bank examination. The questionnaire focuses on three topics: material changes in underwriting practices for new loans, the overall degree of risk in underwriting practices for new loans, and the frequency of specific risks in underwriting practices within major categories of loans (business, consumer, commercial [nonresidential] real estate, agricultural, construction, home equity, and credit card loans). Examiners are also asked to report whether the institution is active in additional loan categories (unguaranteed portions of Small Business Administration [SBA] loans, subprime loans [automobiles, mortgages], dealer paper loans, low- /no-document business loans, high loan-to-value ratio home equity loans [up to 125%], or any category of loan not mentioned). The systematic collection and analysis of questionnaire responses provides an early-warning mechanism for identifying potential lending problems.
Examiners evaluate underwriting practices in terms of FDIC supervisory practices. Until October 1, 1998, examiners were asked to rate the risk associated with a bank's underwriting practices in relative terms: "above average," "average," or "below average." Beginning October 1, 1998, examiners began rating the risk associated with a bank's underwriting practices in absolute terms: "low," "medium," or "high."3 New questions about underwritingpractices were also added to the questionnaire. Examiners continue to classify the frequency of specific risky underwriting practices as "never or infrequently," "frequently enough to warrant notice," or, if the risky practice is used more often, "commonly or as standard procedure."4
The questionnaire is completed at the end of each bank examination the FDIC conducts. Which banks are included during a reporting period, therefore, depends on how the FDIC schedules bank examinations. Examination schedules are heavily influenced by the financial condition of a bank, with the examinations generally becoming more frequent the poorer a bank's financial condition. In addition, the FDIC shares examination authority of state-chartered nonmember banks (those that are not members of the Federal Reserve System) with state bank regulators. To avoid excessive regulatory burden, the FDIC generally alternates examinations with state regulators, and the latter do not fill out questionnaires. Finally, examination schedules are affected by the availability of examination staff. For these reasons the group of banks included in any given report is not randomly selected and therefore may not be representative of the population of FDIC-supervised banks.
To address the potential bias that examination scheduling might introduce into the report's results, we statistically weight the responses. The weights are designed to make questionnaire responses in the aggregate more reflective of the population of FDIC-supervised banks. Simply put, when we compute aggregate questionnaire responses, we give greater weight to FDIC-supervised banks that are "underrepresented" in the questionnaire (when compared with the population of FDIC-supervised banks) and less weight to "overrepresented" groups.5 Although these weightings cannot remove all potential bias, they do allow for more meaningful comparisons of results over time. Nevertheless, we advise readers to interpret trends cautiously, for two reasons: (1) the lack of random selection of banks for examination, as noted above, and (2) the small number of responses for some loan categories.
Throughout this report, the proportions presented refer to these weighted responses and are estimates of the underwriting practices of all FDIC-supervised banks in the nation. In addition, the data used to weight responses in this report are subject to slight revisions, so some of the weighted proportions might be revised in subsequent reports. We expect no substantive changes, however.
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