Publications by Type: Survey of Credit Underwriting Practices, October 2006

October 2006

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Introduction

The Office of the Comptroller of the Currency (OCC) conducted its twelfth annual survey of credit underwriting practices during the first quarter of 2006. The survey identified trends in lending standards and credit risk for the most common types of commercial and retail credit products offered by national banks.

The 2006 survey included results from the 73 largest national banks and covered the 12-month period ending March 31, 2006. Although mergers and acquisitions have altered the survey population, the survey has covered substantially the same group of banks for the past 10 years. All companies in the 2006 survey have assets of $2 billion or greater, and their aggregate loan portfolio was approximately $3 trillion as of year-end 2005, which represented over 90 percent of all outstanding loans in the national banking system.

The OCC examiners-in-charge of the surveyed banks were asked a series of questions concerning overall credit trends for 18 types of commercial and retail credit products. For purposes of this survey, the OCC groups commercial credit into 11 categories of loans: agricultural, asset-based, commercial construction, residential construction, other commercial real estate, commercial leasing, international, large corporate, leveraged, middle market, and small business. Retail credit consists of 7 categories of loans: affordable housing, credit card, indirect consumer paper (loans originated by others, such as car dealers), conventional home equity, high loan-to-value (HLTV) home equity, other direct consumer, and residential real estate mortgages.

The term "underwriting standards," as used in this report, refers to items such as collateral requirements, loan maturities, facility pricing, and covenants that banks establish when originating and structuring loans. Conclusions about "easing" or "tightening" of underwriting standards are drawn from the OCC examiners' judgment about observations since the 2005 survey. A conclusion that the underwriting standards for a particular loan category have eased or tightened does not indicate that all the standards for that particular category have been adjusted, or that all banks have eased standards. It indicates that the adjustments that did occur had the net effect of easing or tightening underwriting criteria.

Part I of this report summarizes the overall results of the survey. Part II depicts the survey results in graphs and tables.

Part I - Overall Results

Primary Findings

• Competitive pressures have led to a third consecutive year of eased credit underwriting standards. Examiners report that national banks have eased underwriting standards for both commercial and retail credit products.
• Demand for bank loans from nonbank investors has influenced underwriting terms for leveraged loans and pushed credit spreads lower. The easing of standards for leveraged loans has extended more broadly to other types of commercial credit.
• While current loan performance and overall loan quality remain sound, credit risk is increasing due to the continued weakening of underwriting standards.

Commentary on Credit Risk

The OCC's twelfth annual survey of credit underwriting practices indicates a third consecutive year of easing underwriting standards, as banks continue to stretch for volume and yield. While the current performance of commercial and retail portfolios remains sound, examiners note that credit risk has increased and is expected to continue to increase over the next 12 months.

While most of the easing has been noted in pricing concessions, there has also been easing in loan structure, such as tenor and guarantor requirements. Many OCC examiners commented on the liberalization of repayment terms and covenants. Of particular note is the increasing volume of term loans with nominal amortization required during the initial years of the exposure. The loosening of underwriting standards has been most dramatic in large corporate (syndicated credits) and leveraged loans, but spillover effects are also being seen in middle market lending as well. In commercial real estate, underwriting standards continue to loosen while concentrations continue to grow. Examiners noted that even when the applicable lending policy has not changed, the volume of exceptions to policy has increased.

Strong corporate earnings, a sustained economic expansion, abundant liquidity, and a global search for yield by institutional investors have led to significant investor appetite for bank-originated loans and lower credit spreads. A number of banks in the survey have increased their loan volumes through commercial syndications. Banks that purchase syndicated credits originated by other banks should recognize that the underwriting of these exposures often reflects the demand from nonbank institutional investors, many of whom have different investment horizons and greater risk tolerance than commercial banks. Such investors tend to prefer bond-like structures, with limited amortization requirements and fewer covenants. Originating banks may underwrite to these investor preferences and hold little of the originated exposure on their own balance sheet. The OCC reminds national banks of the need to follow the credit principles contained in Banking Circular 181 (REV), "Purchases of Loans in Whole or In Part - Participations," when purchasing loans. To make a prudent credit decision on a purchased loan, a national bank should conduct an independent credit analysis to satisfy itself that the credit exposure is one that it would assume directly. National banks that originate syndicated credits, on the other hand, should recognize that the quality of their originations may have reputation and liquidity risk implications.

Although asset quality performance of retail portfolios remains satisfactory, both delinquency levels and losses are beginning to show slight increases. Underwriting standards for retail credit continue to ease as banks aggressively seek market share. Reduced documentation requirements and more relaxed underwriting criteria are increasingly layered atop new products that can magnify risk levels, especially for unseasoned retail portfolios. Many borrowers have not yet been asked to perform under new, higher interest rates, or a principal-amortizing repayment structure.

A number of national bank chief credit officers have expressed concern to the OCC that competitive conditions, often from nonbank investors, have led to widespread weakening of underwriting standards and thin loan pricing. The OCC cautions national banks to evaluate and monitor the terms and conditions under which they extend credit. More specifically, the OCC encourages national banks to monitor and evaluate the volume of underwriting policy exceptions to determine the impact of loosening underwriting standards on credit quality. National banks should also ensure that weakening underwriting standards have not unduly compromised their tolerance for credit risk and that strong risk management systems exist to appropriately measure, monitor, and control the risks in their credit portfolios. National banks should review the risk management expectations set forth in the following OCC guidance:

• OCC Bulletin 2005-22, May 16, 2005, "Home Equity Lending - Credit Risk Management Guidance;"
• OCC Bulletin 2005-3, February 2, 2005, "Standards for National Banks' Residential Mortgage Lending Practices: OCC Guidelines;"
• OCC Bulletin 2003-1, January 8, 2003, "Credit Card Lending: Account Management and Loss Allowance Guidance;"
• OCC Bulletin 2001-18, April 9, 2001, "Leveraged Finance: Sound Risk Management Practice;" and
• Banking Circular 181 (REV), August 2, 1984, "Purchases of Loans in Whole or In Part - Participations."

Commercial Underwriting Standards

In 2006, the trend toward easing commercial credit standards continued, with significantly more banks easing than tightening standards. Examiners reported that 31 percent of banks eased overall commercial underwriting standards, compared to 34 percent in 2005. In 2006, only 6 percent tightened standards compared to 12 percent in 2005. The remaining 63 percent made no change to commercial underwriting standards. Notably, 43 percent of the banks eased standards in at least one of the past two years, with 18 percent of the banks easing standards in both years. The tightening of standards that prevailed during 1999-2003 began to turn in 2004 when examiners reported that 13 percent of banks eased and 12 percent tightened underwriting standards.

Underwriting trends at the product level confirm the broad easing trend in commercial loan products. Easing is most prevalent in large corporate/syndicated loans and leveraged lending. Sixty-two percent of the banks offering leveraged lending reported easing standards, nearly double the 2005 level. More than 30 percent of banks reported significant easing for commercial real estate and middle market loans. Since most banks offer these two products, the potential impact on credit quality and credit costs could be significant, supporting examiners' assessments of increasing credit risk. Examiners also noted that this is the third year of net easing for leveraged finance, asset-based lending, and middle market products.

Examiners again cited competition as the primary reason for easing commercial credit standards, and also pointed to significant liquidity in the marketplace, particularly from nonbank participants. As in prior years, the most common methods of easing standards were reduced pricing, increased advances, and lengthening tenors. For those banks that tightened standards, the primary reasons were a change in risk appetite and product performance. When tightening standards, banks relied on adjustments to covenants rather than collateral requirements as noted in last year's report.

Examiners reported that the level of credit risk in commercial portfolios has increased and is expected to continue increasing during the next 12 months. Examiners noted increased commercial credit risk in almost 30 percent of the sampled banks, with only 13 percent showing decreased risk. The greatest increase in risk was centered in commercial real estate products, leveraged lending, and large corporate loans.

Retail Underwriting Standards

For the second consecutive year, examiners noted easing of retail credit standards in more than a quarter of the banks surveyed. At the product level, easing was most notable in home equity lending and indirect consumer lending. Easing standards for home equity lending, both conventional and high loan-to-value, include longer interest-only periods, the offering of "piggy back" loans to avoid mortgage insurance requirements, lower scorecard cutoffs, and higher allowable debt-to-income and loan-to-value ratios.

Overall, "remaining competitive" is cited as the main reason for the easing of underwriting standards. The standards for home equity lending eased considerably further than indirect consumer lending, with the "easing" of indirect lending standards centered primarily in product changes, mainly longer terms. Examiners reported that 26 percent of the surveyed banks eased underwriting standards for residential mortgage lending, with an increased presence of nontraditional products such as interest-only loans and payment-option ARMs.

For the 7 percent of banks that tightened retail underwriting standards in 2006, a change in risk appetite was the primary rationale. Second was product performance, followed closely by regulatory guidance. The tightening was effected mainly through changes to scorecards, tighter debt service requirements, and more conservative minimum payment expectations. Credit card lending was cited most often as tightening standards (25 percent), attributed primarily to the implementation of higher minimum payments consistent with the account management guidance detailed in OCC Bulletin 2003-1, "Credit Card Lending: Account Management and Loss Allowance Guidance."

Examiners reported the level of retail credit risk increased in 25 percent of the banks since the prior survey, and they expect risk to increase in nearly a third of the banks over the next 12 months. Home equity lending led the retail products exhibiting higher risk levels. For conventional home equity products, examiners estimated increased risk in 31 percent of the reporting banks over the past year, and are forecasting increased risk in 49 percent of the banks over the next 12 months. For the 26 percent of surveyed banks reporting high loan-to-value home equity lending, examiners estimated increased risk in 37 percent of the banks over the past year, and are forecasting increased risk in 47 percent of the banks over the next 12 months. In general, examiners cite rising interest rates, concerns over a potential downturn in property values, and general portfolio seasoning for the increased risk levels. None of the banks exhibited decreasing risk for home equity products in the past year.

Part II — Graphs (PDF)
Tables: Commercial Lending Porfolios (PDF)
Tables: Retail Lending Porfolios (PDF)