ByGary S. Corner , Daigo Gubo
OREO (other real estate owned) at community banks increased sharply during the 2007-2009 recession because of high loan default levels—the result of a deterioration in economic conditions and what appears to be a relaxation of underwriting standards before the financial crisis. Increases in OREO on bank balance sheets, however, continued well beyond the official end of the recession, peaking between 2010 and 2011. Consistent with a legacy concentration of real estate loans, community banks have experienced the highest ratios of OREO-to-assets on their books. Today many banks are still working on reducing their elevated levels of OREO. Liquidating properties, however, is proving to be a significant challenge to community bankers given the current soft real estate market conditions.
As illustrated in Figure 1 below, community banks nationally and across the District experienced a peak in their OREO holdings in the second quarter of 2010. OREO holdings then appeared to plateau until the middle of 2011. Since the third quarter of 2011, OREO levels have declined. Despite these recent declines in OREO, the current volume of these properties is much higher than what it was before the start of the financial crisis. As of the third quarter of 2012, community banks headquartered in the District had 1.06 percent of their assets in OREO. Nationwide, community banks had only 0.85 percent of their assets in OREO.
Loans initially collateralized by construction and land development (CLD) properties represent the highest share of OREO properties on bank balance sheets, followed by nonfarm nonresidential properties. This is understandable given that CLD and nonfarm nonresidential properties make up most of the commercial real estate held on community bank balance sheets. Figures 2 and 3 below show OREO composition at community banks nationwide and at community banks headquartered in the District. The general composition of OREO at both groups of banks is very similar. The key difference is that District institutions remain burdened by a higher ratio of OREO as a percentage of their total assets.
As illustrated on the map below, community banks headquartered in states in the Eighth District have, on average, fairly moderate ratios of OREO to assets. Community banks in Indiana and Kentucky have ratios of less than 1 percent. The remaining five states—Arkansas, Illinois, Missouri, Mississippi and Tennessee—each have average OREO-to-assets ratios of 1 percent to 1.49 percent. On a state level, Georgia has the highest average ratio of OREO to assets on its community banks’ balance sheets. This is not surprising, as it also is the state with the largest number of bank failures. As would be expected, lower OREO ratios are correlated with lower problem asset ratios. Problem asset ratios at community banks headquartered in Indiana and Kentucky are the lowest among District states at 3.18 percent and 3.69 percent, respectively.
With the rise in foreclosures, the cost of maintaining and disposing of OREO property can become a significant drag on a bank’s performance. Through the third quarter of 2012, community banks across the nation incurred $1.38 billion in annualized OREO expenses, which effectively trims 6 basis points off their return on average assets. District community banks fared slightly worse, losing $0.35 billion on an annualized basis on OREO, which trims 7 basis points off their return on average assets. The impact of OREO on asset quality and earnings highlights how important it is that banks appropriately market their OREO holdings to prospective investors.
On April 5, 2012, the Federal Reserve issued a Policy Statement on Rental of Residential OREO Properties (SR 12-5/CA 12-3) to clarify that banking organizations are permitted to rent OREO properties as part of an orderly disposition strategy. The move was aimed at providing more flexibility in OREO marketing and improving the sales value of properties. On June 28, 2012, the Federal Reserve issued Questions and Answers for Federal Reserve-Regulated Institutions Related to the Management of OREO (SR 12-10/CA 12-9) to help address questions regarding the management of OREO by institutions regulated by the Federal Reserve. Generally speaking, the Federal Reserve permits bank holding companies to hold an OREO asset for up to five years, with an additional five-year extension available under certain circumstances. However, the policy statement emphasizes that bank management must have sound strategies and processes in place for the management and disposal of OREO properties.
Foreclosed properties spiked significantly during the financial crisis. As a result, many community banks now have significant holdings of foreclosed-upon construction and land development properties on their balance sheets. Since CLD loans proved to be one of the riskiest asset classes for community banks, naturally it holds that effectively disposing of such properties from OREO inventories is challenging. Despite the recent clarification from the Federal Reserve regarding the rental of OREO as part of an orderly disposition strategy, the stubbornly elevated levels of OREO on bank balance sheets suggest that community banks still have a long way to go before these levels return to where they were prior to the financial crisis.