Commercial Mortgage Limits Not Enforced

I have written several times about the problems in the commercial real estate market. Although it differs from the residential mortgage market, it appears to have overheated as well. A Bloomberg article today casts some light on one of the reasons why. Regulators failed to enforce commercial real estate loan limits on banks. Luckily, I think this is a problem easily remedied going forward: enforce regulations!

Here's the news, from Bloomberg:

The FDIC's Office of Inspector General analyzed 23 lenders taken over by regulators from August 2008 to March and found that for 20, the agency's examiners didn't identify the issue early enough or should have taken stronger supervisory action after recognizing the banks had dangerously high levels of the loans before they failed.

So why did banks want so many commercial real estate loans? Well, they were traditionally pretty safe bets if originated properly. Moreover, many such loans were easily sold off into commercial mortgage-backed security pools. When times were good in the real estate market, both of these features only intensified banks' interest in ramping up their origination of these assets.

Here's a key excerpt from a Bloomberg source, identifying the problem:

"We should ask the prudential regulators why they did not do more to push banks to pay attention to their guidance," Representative Brad Miller, a Democrat from North Carolina, said in an interview. "If they thought their conduct was unsafe, it's unsound, they certainly should have stopped it."

Indeed! Why weren't current regulations enforced? Many regulation opponents have noted that more regulation might not be needed as a response to the crisis, because current regulation already would have taken care of many of the problems -- if it only were enforced.

This kind of reminds me of those iPhone commercials. Policymakers scream, "We should have limited commercial real estate exposure!" Regulators respond, "There's a Reg. for that." This answer then produces the legitimate gripe: well, why wasn't it enforced? Regulators either need to make sure the rules or followed, or those rules should be eliminated, if truly unnecessary.

So assuming all regulations on the books should be enforced, there's obviously a problem in ensuring that all are being followed. There are just too many regulations to be able to perform thorough due diligence on all of the financial industry. You would need a staff of regulators virtually as large as the financial industry itself to do this, maybe larger.

One solution would be to place burden of keeping up with regulatory compliance on the firms' shoulders. Demand all companies understand all rules that apply to its business and have their internal auditors file reports with associated regulators like the FDIC. The reports can prove that they're staying within the lines.

While this is already done in some cases, little more than a slap on the wrist is given when it's found that firms fail to comply. Regulators should develop a philosophy of holding firms to the standard of having to know and follow all regulations. Of course, along with this, regulatory authorities need to make their rules crystal clear, so to avoid no confusion. But when such clarity is provided, maybe criminal charges could be used as a good deterrent for ignoring the rules. If bank management faced jail time for ignoring commercial mortgage concentration limits, maybe it would have thought twice.