Without a net: LTV ratios offer little regulatory leverage against risky real estate lending

RMA Journal, The, June, 2004 by Michael I. Frachioni

Amid a myriad of changes in real estate lending, fundamentals of the discipline remain intact. This article sets the historical stage for the risks inherent in current loan-to-value practices. Its author, a lawyer, has had firsthand experience in seeing what can happen in risky real estate lending and offers sage and practical advice to lenders today.

National banks have had the power to make real estate loans since the Federal Reserve Act of 1913. However, that Act only permitted such loans on unencumbered farmland within its Federal Reserve district, for a term of no more than live years. Most significantly, for purposes of this article, was the inclusion of the first loan-to-value (LTV) limitation: "No such loan shall be made ... for an amount exceeding 50 per centum of the actual value of the property offered as security." Over the ensuing decades, the maximum LTV ratio steadily rose--to 60% in 1935, 66% in 1955, 80% in 1964, 90% in 1970, and 100% in 1989. Meanwhile, geographic and other restrictions fell away, and numerous exemptions from the ratios, such as loans under the National Housing Act, the Small Business Act, HUD, and the Community Development Act, were granted.

Fast-forward to 2004: Borrowers now are demanding ever-greater amounts and offering less as collateral. This may be due in part to the notion held by borrowers and lenders that real estate is an ever-appreciating asset. George Washington, the great American surveyor (among other roles), once observed that "land is the most permanent estate, and the most likely to increase in value." As security for a loan, however, it has traditionally been viewed much more conservatively. It is inherently illiquid, for example. Further, real estate loans are generally long term and thus can be affected by numerous unforeseeable factors. Finally; the checkered history of real estate lending in America, from the mass of foreclosures undertaken by the Second Bank of the United States in the 1810s, through the banking and S&L debacle of the 1980s, has periodically tempered the view of this collateral.

In 1993, the four federal banking regulators--the Federal Reserve, FDIC, OCC, and OTS--promulgated new LTV ratio guidelines for lending secured by various classes of real estate. As we shall see, these serve as little more than weak lines drawn in the shifting sands of real estate lending and regulation.

Six years later, the regulators felt it necessary to issue additional guidance on what they termed "high-LTV residential real estate lending." This guidance may be seen, in a way, as the regulators simply taking a step backward and drawing another weak line in the sand.

We are now a full business cycle beyond the FDIC Improvement Act and FIRREA. In the years leading up to this cycle, and throughout its duration, both borrowers and lenders evidenced changing philosophies regarding secured transactions, interest rate, credit and reputation risks, the use of debt, and the role of financial institutions generally. Further, these changes evolved during a period noted for the rise of e-commerce and the freeing of financial institutions to engage in a myriad of previously prohibited activities.

While we marvel at our new technological capabilities and attempt to increase profits from new opportunities, we must remain aware of history and the prudent fundamentals that underlay economic growth and success. This is particularly true with respect to real estate lending, in no small part because of the market's size. Residential mortgages alone, for example, totaled almost $6 trillion by 2003. In the past year, numerous commentators have voiced concerns over the strength and stability of both residential and commercial real estate loans. The regulators, too, are voicing concern. If we expect LTV ratios to be an effective tool in measuring and managing risk inherent in real estate lending, a review and revision of the LTV guidelines are called for.

Review of Recent History

Over the past 10 to 15 years, financial institutions have undergone fundamental changes in their structure, products, and business methods. At the same time, consumers evidenced a similar change in their views on such fundamentals as home ownership and consumer debt. Meanwhile, the business cycle continued apace, bringing its pressures to bear on both these groups, particularly as it weakened toward the end of this period.

Financial institutions. Historically, insured depository institutions have avoided originating residential real estate loans with an LTV of greater than 80% unless the excess was secured by mortgage insurance, government guarantees, or other support. However, this trend has changed. From approximately 1994 through 2000, about one-fourth of all residential mortgages were originated with a high LTV; a high-residential real estate loan is defined as one that equals or exceeds 90% of the real estate's appraised value unless additional credit support such as mortgage insurance or other collateral reduces the ratio below 90%. At the same time, the delinquency rates (at least one month behind in payments) on, for example, loans insured through the Federal Housing Association, rose to over 10%.