Bank Underwriting Eases, Risk Rises

Those were amongst the findings in OCC’s 13th annual Survey of Credit Underwriting Practices for the year ending March 31, 2007. The survey was based on the responses of the 78 largest national banks on trends in lending standards and credit risk for the most common types of commercial and retail credit offered.

In commercial lending, large banks continued to ease standards, especially for leveraged and large corporate products, mid-size banks eased standards modestly and community banks tightened standards, the OCC reported.

Commercial credit performance, including the level of nonperforming and adversely risk-rated loans, remains very healthy, though examiners have seen slight deterioration in recent months as weakening loan structures continue to be reported for large corporate and leveraged loans. Minimal amortization and lack of meaningful financial maintenance covenants to monitor borrower performance in these loans’ structure increase credit risk, thereby may be masking performance deterioration.

For the first time, the OCC’s survey assessed national bank credit exposures to hedge funds. The examiners found the principal source of credit exposure from hedge funds is counterparty credit risk from derivatives transactions, as hedge funds are not a material source of direct lending exposure. The report noted that hedge funds continue to press banks for softer initial margins, a source of collateral beyond that securing current credit exposures and that protects a derivatives dealer against future changes in the value of derivatives contracts.

The OCC said it expects commercial credit risk will continue to increase in the current annual survey period. However, it is anticipated originators and investors will refocus on fundamental credit principles, mostly on capacity to repay, and national banks will underwrite credit exposures with “a more balanced perspective on risk and return over the full range of liquidity conditions.” Leveraged, commercial real estate, large corporate, and middle market loans were particular types of lending cited in the report for increased credit risk.

Primarily due to competition in the year’s period, more banks eased underwriting standards for retail credit than tightened, but fewer respondents eased standards than in the prior two years. Easing was most prevalent in the large bank group, where 65 percent of the banks did so, and tightening was noted mostly in community banks, or at one-fifth of them.

Overall, retail underwriting standards are now predominately moderate for large banks, conservative at mid-size banks, and evenly divided between the two levels for community banks, according to the report. That was also the conclusion when specifically analyzing residential real estate and home equity conventional loans, the dominant retail products and where easing occurred most. The OCC noted such product trends relate primarily to prime loans because few of the surveyed banks offer subprime residential and home equity lines or loans.

Retail credit risk increased in 29 percent of the banks over the past year — which is the highest percentage in the past five surveys. And even as changes in market conditions since the latest survey have led to tightened underwriting for various residential loan programs, retail credit risk is expected to increase in 36 percent of the banks for the next survey, the OCC reported.

The surveyed banks’ aggregate total loan portfolio as of yearend 2006 was approximately $3.2 trillion, or over 85 percent of all outstanding loans in the national banking system, according to the report.