For months, land has been seen as the residential real estate industry's four-letter word. But as a new army of bank regulators work to recognize current appraisals–those that reflect the aggressive price reductions that builders and landowners are making in a desperate attempt to lighten their balance sheet load–it's becoming increasingly obvious that a more appropriate four-letter utterance might be debt.

The OCC's chief officer John Dugan noted in remarks to the Senate in early June that the agency had implemented some "controversial practices" in the late '80s. Photo: Getty "I was taught a long time ago, it's not the land that kills you, it's the debt on the land that kills you," says John Landon of Landon Development Co. "It's not the weight of the assets; it's the amount of debt you have on the assets. If you have none, they may be worth less, but that just means they are worth less on paper. You don't have to pay anyone to carry them."

The fact that builders and landowners have been making price reductions in an attempt to get rid of land and lot inventory is certainly not news. But what's creating an increasingly deafening buzz is the loss of value that is expected to be reflected in the new appraisals–and the anticipated ramifications are sending the banking industry into a tailspin.

Banks are encountering an increasing supply of land and lots, and they are trying to figure out what they have, what to do with it, and what is still to come.

What's unclear is if the banks will actually be able to take the hit to their asset portfolios and, scars in place, move on–or whether we might be heading toward an RTC (Resolution Trust Corp.)-like environment once again.

During the last serious downturn, a sharp decline in markets meant appraisals on the actual value of land and lots collateralizing construction and acqusition and development (A&D) loans became outdated. Because bankers were reluctant to make adjustments that reflected the new conditions, examiners unilaterally–and, in the opinion of many sources, overzealously–made them on the bankers' behalf.

In 1989, a piece of government legislation called the Federal Institutions Reform Recovery and Enforcement Act (FIRREA) was passed, which forced the S&Ls to exit the equity investment business. As a result, roughly 1,000–or 25 percent of all lending institutions–simply failed. The industry collapsed, and the RTC was formed to take in assets and liquidate them.

Back to the Future

Today, much like the previous downturn, a sharp decline in markets means appraisals have become outdated. But the Office of the Comptroller of the Currency (OCC), which charters, regulates, and supervises all the national banks, seems to be less inclined to take a heavy hand in the situation–at this stage, anyway.

The OCC's chief officer John Dugan noted in remarks to the Senate in early June that the agency had implemented some "controversial practices" in the late 1980s. But he also said that there is training and discussion with examiners today on expectations, as well as how to consistently measure performance with regard to project performance for construction and development loans.

It's the OCC's nationwide staff of examiners that conducts on-site reviews of national banks and supervises bank operations. Examiners analyze a bank's loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk, and compliance with consumer banking laws, including the Community Reinvestment Act. They also evaluate bank management's ability to identify and control risk.

According to Christopher Mutascio, a banking analyst with Stifel, Nicolaus and Co., as well as a former examiner with the OCC, the evaluations are done on what is termed a C.A.M.E.L. scale. Ratings of one to five are assigned to banks, with one being the best, based on the following criteria: capital, asset quality, management, earnings, and liquidity.

One concern regarding the examiners is that most are relatively young and have only experienced an environment where real estate has continued to climb in value. It's for this reason that additional training is being implemented and many retired examiners with experience from the RTC days are being wooed back into service.

But it's this very activity that has many industry veterans fearing that examiners' short-term thinking will create a knee-jerk reaction that ultimately compounds problems for the sector.

According to sources in the industry that went through the previous downturn, there was no mercy from examiners. And Mutascio confirms the behavior. "During that time, we were beating people over the head," he says. "The appraisal guideline 12CFR34*, we would cite that as a violation in every single exam–numerous times if every 'i' wasn't dotted."

Still, fear and cynicism remain regarding anyone's ability to accurately value the assets in real estate. And considering that banks are entering the next phase of this economic environment with thin loan-loss reserves, it's hardly a stretch to imagine they won't be persuaded to build up their reserves significantly.

Dugan's office wouldn't comment specifically for this article on strategies currently being given to examiners, other than to point to this statement that was also made to the Senate in June: "This time around, we have stressed to bankers and reiterated to examiners that our objective is to minimize the need for such action. We emphasized that examiners should give bankers reasonable time frames for obtaining updated appraisals and making their assessments."

Says Mutascio, "I think what he is saying is that we have issues. We know we have issues. And the way to address these issues isn't going to be the same as last time."

–Lisa Marquis Jackson