Remarks by

Julie L. Williams

# First Senior Deputy Comptroller and Chief Counsel

Office of the Comptroller of the Currency

Before the

Robert Morris Associates

Lending and Credit Risk Management Conference

# New Orleans, Louisiana

# October 5, 1999

It is a real honor and genuine pleasure to again have the opportunity to
address an RMA conference, and to talk again about credit risk
developments in the banking industry.

As you probably are aware, the OCC has just released its latest annual
credit underwriting survey. The 1999 survey results show some positive
trends from previous years' survey findings, as underwriting standards
for commercial loans appear to have strengthened in several significant
categories. I am happy to be able to report these improvements, but they
are not cause for complacency.

The aggregate data from our underwriting survey does not tell the whole
story. Beneath the statistics of the survey, there are some troubling
trends that require bankers' attention. Easing continues in some
important loan markets. And today's improvements cannot mitigate the
overhang of credit risk created by weaker standards used in previous
years. To illustrate this concern, I'll be talking about the findings of
our credit-focused exam work, including our "Ugly Loan" review. This
work provides important perspectives and depth to understanding the
credit underwriting picture we see today.

Finally, I want to talk about what you, as bankers, can and should do to
manage and mitigate your institutions' credit risk.

First, the results of the OCC's 1999 credit underwriting survey reflect
some positive developments. For the first time in five years, the survey
indicates that underwriting standards for commercial loans have
strengthened, with examiners reporting that 25 percent of the surveyed
banks tightened standards, compared to just 4 percent in 1998. Examiners
also reported that only 13 percent of surveyed banks eased standards,
compared to 44 percent in 1998. Overall, firming up was evident in
syndicated/national and international lending, areas that appear to be
most affected by the credit events in the fall of 1998, and in
agricultural lending, which reflects low commodity prices and weakened
export demand.

While we\'re encouraged to see strengthened underwriting standards in
these areas, easing of standards persisted for some commercial products
\-- commercial real estate and middle market lending. This is of concern
because these two categories represent a large portion of bank loan
portfolios. Further, a large percentage of banks reported either a
mixture of easing and tightening, or no change from last year. While
this indicates standards did not deteriorate, we must keep in mind that
"no change" also means no improvement.

Increased pricing was the most prevalent method used to tighten
standards (56 percent), followed by adjusting maximum credit
availability (33 percent), increasing collateral requirements (31
percent), and strengthening loan covenants (28 percent). For those banks
strengthening standards, examiners reported economic outlook and a
change in risk appetite as the primary reasons.

The story has parallels on the retail side. Strengthening continued for
the third successive year with slightly more banks tightening standards
at 27 percent, than easing (22 percent). Products where tightening was
most pronounced included consumer leasing, indirect consumer loans,
credit cards, and other direct consumer loans. This seems appropriate as
these products have been particularly vulnerable to rising consumer
delinquency and charge-off rates in recent years.

But, among the retail products, the trend toward *easing* standards for
home equity loans continued for the third successive year. By
definition, a high LTV home equity product represents an easing of
underwriting standards, and poses greater risk of default and risk of
loss in the event of default.

Those banks that strengthened underwriting standards for retail products
most commonly used scorecards or pricing and, for real estate-related
products, enhanced collateral requirements. Most banks tightening
standards did so because of a change in risk appetite or market
strategy.

Perhaps the most worrisome finding in the 1999 survey is the continued
increase in credit *risk* reported for *all* commercial and retail
products. For the fourth successive year, examiners report increased
*inherent portfolio risk*, and they expect risk to continue to increase
over the next twelve months.

Overall, the modest changes in risk tolerance and the additional
emphasis on risk-based returns for commercial credit highlighted by this
year's survey are certainly trends that we would all like to see
continue. But, we all recognize that competitive pressures of the
marketplace will continue to exert pressure, and that continued
strengthening of underwriting standards in this economic environment is
very challenging.

Moreover, positive news this year about underwriting standards does not
erase the increased risks embedded in bank portfolios caused by four
successive years of easing commercial loan underwriting standards. Nor,
in the face of this year's results, can we ignore that banks shoulder
increased portfolio credit risk not only as a legacy of weaker
underwriting standards employed in recent years, but also as a result of
the more limited credit risk selection options available to them. As the
better quality loans continue to migrate to the capital markets, bankers
are left to compete with other lenders for less desirable, riskier
paper, which increases the risk of default.

In response to all these developments, the OCC has been implementing a
series of modulated supervisory responses. These actions commenced with
early warnings and advisories. Last year, when I spoke at the RMA
conference in Chicago, I announced a series of calibrated actions
designed to further focus examiner and banker attention on signs of
deteriorating credit standards, and to highlight the need for bankers to
implement risk evaluation and management systems commensurate with the
increasing credit risks they held.

We instructed our examiners to identify loans with specific types of
structural weaknesses in reports of examination and factor those
weaknesses into their judgments about the quality of individual credits,
portfolios, and the quality of portfolio risk management. Our subsequent
findings give rise to concerns. Particularly at our largest banks, we
found significant numbers of loans containing various structural
weaknesses. The most frequently cited weaknesses include:

-   Non-existent, weak or waived covenants;

-   Indefinite or overly liberal payment terms;

-   Inadequate financial analysis;

-   Insufficient collateral support;

-   Elevated leverage ratios; and

-   Repayment dependent on highly optimistic or undemonstrated cash
    flows.

Loans with such structural weaknesses were listed in the reports of
examination or other supervisory communications with management and/or
boards of directors, to ensure that they understood the nature and
extent of the weaknesses disclosed and their impact on our judgments on
portfolio quality and management.

Simultaneously, we formed a team of our best credit experts and
instructed them to review loans across the population of our larger
banks in order to better identify examples of the types of structural
weaknesses that we were seeing. Unfortunately, the team had no trouble
finding example after example. Based on this review \-- which came to be
nicknamed the "Ugly Loan Project" \-- we developed and delivered a
focused training program designed to advance the credit risk evaluation
and classification skills of our examiners and clarify our expectations
about how structural weaknesses should be incorporated in their
judgments of credit risk in individual loans and portfolios. We also
communicated these efforts to the CEOs of our largest banks.

These efforts coincided with the interagency Shared National Credit
Review, which recently concluded. As you all probably know, the Shared
National Credit Review is jointly conducted by the OCC, FRB and FDIC
each Spring. That review covers all commercial loans that are shared
among three or more banks and exceed \$20 million. This year's program
covered approximately 30 percent of all commercial loans in the U.S.
banking system.

The results of this year's SNC review have shown a marked increase in
classified and special mention credits compared to 1998 \-- an increase
of roughly 70 percent in the dollar value of adversely rated loans.
Fifty-nine percent of the adversely rated loans had been rated "pass"
last year. Of particular concern, 14 percent of the adversely rated
loans were to *new borrowers*. In other words, banks are booking *new
loans* that are weak at their inception. These results reflect the
increasing portfolio risk building up in the system as a result of
weakened underwriting and risk selection standards.

Thus, while our most recent credit underwriting survey indicates that
banks are firming up their underwriting standards, our exam work also
tells us that banks have heightened embedded credit risk as a result of
previous years' underwriting practices.

What should bankers be doing about this?

Let me offer some suggestions and cautions.

We all know that risk-taking is inherent in the business of banking and
that exceptions are an expected component of the underwriting process.
We expect that you will underwrite a certain number, hopefully not too
large, of loans with exceptions, but we also expect that you will have
good controls over and intelligence on changes in the underwriting
standards applied in your banks. This requires a system that routinely
identifies the aggregate level of loans that do not meet your own
underwriting criteria, segmented by portfolio and type of exception.
Over the years, many bankers have resisted the need to identify and
track exceptions to their risk selection and underwriting policies;
however, recent studies indicate that those that do routinely track
exceptions and analyze their implications for portfolio risk are among
the better performing banks.

The need for such information is precisely why OCC initiated examination
procedures to identify loans with structural weaknesses last year.
Indeed, a number of the banks we supervise were appreciative of the
detailed work performed by our examiners to identify "ugly" loans.
Because examiners identified, reported and discussed the *specific*
underwriting weaknesses they found as well as their risk implications,
bank management and boards were better informed and could more readily
determine whether weaknesses represented isolated events or common
occurrences. Bankers found examiner's feedback regarding specific
underwriting weaknesses to be much more valuable than general
expressions of concern about deteriorating underwriting standards. As a
result, we will continue to perform these procedures in every safety and
soundness examination, and we will continue to urge bankers to adopt the
exception reporting processes.

Another critical component of sound portfolio risk management hinges on
the integrity of banks' own internal risk ratings. Many banks are making
substantial progress, setting higher internal standards for accuracy and
using credit models to back-test and cross-check the integrity of their
internal ratings. We applaud these advances, but our recent examination
activity, including the 1999 SNC review, has made clear that most banks
have room to improve the accuracy and timeliness of their problem loan
identification. Even the most sophisticated banks can improve the level
of precision and reliability of distinctions among various risk levels
of "pass" rated credits. This becomes particularly imperative for the
additional reason that today consideration is being given to using those
internal risk ratings to set components of banks' *capital*
requirements.

Unfortunately, in too many banks today, risk management advancements and
MIS to provide timely risk analysis information to senior management and
the board of directors are not being pursued with the same vigor as new
business and revenue generation opportunities are being pursued. In
practical terms, this is akin to ignoring termites in the foundation of
your house while you're busy adding a sunroom to the second floor.

We also are concerned with the continuing relative decline in the ALLL.
The average ratio of the ALLL to loans for all national banks is at its
lowest level since 1986. That ratio, which was maintained *above 2
percent* for all years between 1987 and 1995, *dropped to 1.82 percent*
at the end of the second quarter. That is why the OCC and the other bank
regulatory agencies were extremely concerned earlier this year that
certain actions and pronouncements by the Securities and Exchange
Commission last year and earlier this year would have the unintended
effect of prompting unwarranted reductions in banks' reserve levels. We
applaud SEC Chairman Levitt's statements clarifying the SEC's positions
in this area, and we continue to strongly believe that given the higher
risk inherent in bank portfolios today, it would be more appropriate for
banks to be *increasing* their reserve coverage, rather than decreasing
it.

One particular credit issue that caught our attention during our efforts
of the past year has been the evolution of leveraged finance. Earlier
this year, the OCC issued guidance to bankers advising them of the risks
in leveraged lending activities and the need for more intensive risk
management of these types of credits. This guidance was in keeping with
our measured responses to loans with structural weaknesses, but also
reflected our growing concerns with the developing trend toward higher
leverage in the lending markets overall.

In that guidance, we expressed a number of concerns about the risk
characteristics involved with today's leveraged lending activity. As a
result of our more recent exam work, however, our concerns have
particularly escalated about the increasing reliance on so-called
"enterprise values" to justify collateral shortfalls common to many
leveraged financing packages. The premise behind banks' reliance on
"enterprise values" as a secondary source for repayment of a loan is
that the borrower's business can be sold or refinanced at an amount that
can be estimated based on a projected earnings capacity. But, the
interagency Shared National Credit Review revealed that too often
documentation and analytical support for enterprise values are
inadequate.

Let me give you some examples of enterprise value lending situations
that concern us:

The first example is a loan made to finance an acquisition. The loan was
"collateralized" by all assets of the company; however, the bank group
did not value the assets, but instead relied on the estimated enterprise
value. Optimistic earnings and cash flow projections never materialized.
Market prices for the company's product declined and now the company is
closing plants and attempting, thus far unsuccessfully, to sell assets.
The acquisition price now appears inflated as does the \"enterprise
value\" used to underwrite the loan. The potential for substantial loss
to the bank group is considered very high.

Lending against valuations based on multiples of stabilized cash flow
valuations can be dangerous. In another example, the borrower is a
highly specialized manufacturer who sought funds for working capital and
growth. Accounts receivable, inventory and fixed assets only covered 60
percent of total bank debt. The balance of the loan was supported by a
stabilized cash flow enterprise valuation that provided a modest 10
percent cushion. The borrower's product has met reduced demand and
increased competition. Cash flow has been severely reduced \-- it was
inadequate to service debt in 1998 and is negative YTD 1999.

A final example is a consumer goods manufacturer that required
re-capitalization. Although the bank group took a lien on fixed assets,
their value was considered minimal. To justify the loan, the bank group
relied on an enterprise value based on anticipated refinance or sale of
the borrower. Unfortunately, product demand has weakened, the borrower
has lost a number of key customers, and operating margins have shrunk,.
Cash flow is no longer adequate to service debt. The likelihood of a
refinancing or sale of the company that will rescue the banks from the
loan is bleak. Thus, the risk of loss is very high.

Stepping back from these particulars, this type of transaction raises
several fundamental concerns:

Our first concern arises from the interdependence between the primary
and secondary sources of repayment when "enterprise value" is the
secondary repayment source. Enterprise value is often a calculated
multiple of the borrower's historical or projected cash flow. As long as
cash flow is sufficient to meet the repayment terms of the loan, there's
no problem; but if cash flow does not materialize as projected, both the
primary and secondary sources of repayment of the loan are at risk. The
same events that endanger the first source of repayment \-- cash flow
\-- also will endanger the second source of repayment \-- the enterprise
or going concern value of the business.

Our second concern lies with loan officers' and loan review officers'
apparent level of comfort with "enterprise value" as a substitute for
real collateral. *"Enterprise value" is a volatile, disappearing
intangible, inherently prone to vanish when it is most needed.* It is
not the equivalent of hard assets and equity, properly assigned and
hypothecated, valued under normal and stressed conditions, with
reasonable margins at or above the loan amount. There is a reason why
market professionals refer to the enterprise value component of the
support for a loan as the "airball."

Our third concern in this area is with the increasingly equity-like
appearance of many leveraged loan structures and whether banks are
appropriately recognizing and mitigating the risks inherent in these
loans. In addition to relying on enterprise values, many such loans also
evidence weakened structures that diminish a bank's controls, rights and
collateral protection, extended maturities that defer meaningful
repayment, and reliance on refinancing or re-capitalization of the
borrower as a primary source of repayment.

As we said in the leveraged lending advisory we issued earlier this
year, bankers need to be able to identify the amount of leveraged loans
in their portfolios, and should also be able to identify those loans
where the *financing gap* \-- the "airball" \-- between the value of
assigned collateral and the amount financed relies on enterprise value.
Bankers should carefully analyze the assumptions used to support
underlying enterprise values and be realistic in challenging those
assumptions under normal and stressed conditions. Where identified
financing gaps are large relative to the overall portfolio, the bank's
allowance, or its capital, bankers should be developing plans to reduce
these gaps in an orderly manner and to augment the allowance or capital
as necessary.

Bankers must not assume that economic conditions and the capital markets
will always be conducive to a refinancing or re-capitalization needed to
close the financing gap when a loan comes due. I particularly hope that
some bankers are not complacent because they implicitly assume that
their "section 20" securities affiliate will be available to arrange a
market transaction that will extract the bank from the loan. Where a
bank has such an affiliate, it must not only guard against that
assumption infiltrating its credit decisions, but also ensure that its
conflict of interest policies are up to date and vigorously enforced.
With the prospect of "financial modernization" legislation that will
enhance the ability of banks and securities firms to be affiliated, it
becomes essential that bankers assure that their credit decisions are
not being shaded by the prospect that they will be rescued from
questionable loans by their securities affiliate.

Bankers that will be successful \-- in good times and bad \-- will be
the bankers who recognize risk earliest and move decisively to control
it and reduce it where warranted. This can only be done with good
intelligence \-- meaningful and accurate MIS, reliable and timely risk
ratings, effective and objective internal loan review and, most
importantly, credit risk management that is adept at assessing the data,
the trends, and relevant market intelligence. Bankers should be asking
themselves: "Am I comfortable that my bank's culture and credit
controls, including my credit risk rating system, would prevent the
problems bankers suffered in the late 1980's and early 1990's?" And bank
CEOs, in particular, should be asking: "Are my independent risk
identification and control functions telling me what I *want* to hear,
or what I *need* to hear?

Downsizing to improve efficiency ratios and efforts to achieve
merger-related synergies must not reduce the effectiveness of your
credit risk control processes. Given the higher risk inherent in bank
portfolios today, bankers need to be more skilled at quantifying and
mitigating the credit risk they undertake compared to a decade ago. Risk
management advancements need to be pursued with the same enthusiasm as
new business and revenue generation activities. And, risk management
functions need the independence and empowerment to candid about risk in
the portfolio.

You in this room, our industry's credit risk managers, face all these
challenges. I urge you to take them up with vigor. Your efforts will be
key to the industry's stability and success as we enter the next
century.