The combination of reduced cash flows and higher rates of return required by investors leads to lower valuations, and many existing buildings are selling at a loss. As a result, credit conditions in this market are particularly strained. Commercial mortgage delinquency rates have soared. According to our October survey of senior loan officers, banks continued to tighten standards on CRE loans and, presumably in light of the poor economic outlook for the sector, appear to have been reluctant to refinance maturing construction and land development loans. In addition, the CMBS market has only just recently seen its first activity in a year and a half.

In this environment, a turnaround in CRE is likely to lag the improvement in overall economic activity.

To repeat my current assessment, while the CRE problem is very worrisome for parts of the banking industry, I don't see it posing a broad risk to the financial system. Nonetheless, CRE could be a factor that suppresses the pace of recovery. As the recovery develops, the CRE problem will be a headwind, but not a show stopper, in my view.

The proposed guidance is not intended to cap or restrict banks' participation in the commercial real estate sector, but rather to remind institutions that proper risk management and adequate capital are essential components of a sound CRE lending strategy. In fact, both of these components are already in place at many institutions. No element of the proposed guidance is intended to act as a "trigger" or "hard limit" signaling the need for an immediate cutback in or reversal of CRE lending; rather, the thresholds in the proposed guidance are intended as benchmarks identifying cases for further review.

I noted that CRE underwriting appears substantially better compared to the late 1980s and early 1990s. However, we have noticed some recent slippage. Therefore, the proposed CRE guidance underscores the existing interagency guidance on real estate lending standards.

A bank with significant concentrations may need to both strengthen its control environment and hold capital well above regulatory minimums. In certain cases, it may be prudent for an institution to reduce its concentrations. This is particularly important, since CRE lending in recent years has occurred under fairly benign credit conditions and, naturally, those conditions are unlikely to continue indefinitely.

During previous downturns in the credit cycle, banks with high commercial real estate concentrations suffered significant losses.

Federal Reserve staff is currently considering supervisory guidance on sound risk-management practices for commercial real estate exposures, with the goal of issuing the guidance on an interagency basis.

[Commercial real estate lending] accounted essentially for all of the asset growth at these institutions in 2003 and 2004...There is no indication at this time that the overall credit quality of CRE exposures at community banks has deteriorated, although there are signs that some underwriting standards have been under assault from competitive pressures.