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in a bank's exam, if the test shows a significant decrease in risk-based capital, for example, and it may affect the bank's CAMELS rating, Cole says. So banks stress test themselves in anticipa- tion of the exam, usually with a third-party firm or software, to foresee what the exam results would be. Banks with an abundance of HE- LOCs, for example, could suffer a significant impact from interest rate moves, he says. A bank regulator may cite stress test results The Local Level By proposing that community banks raise their capital levels to those that will be required by Basel III international banking standards, regulators are having yet another influence on how smaller banks should account for potential economic crises, Cole says. The Basel III stan- dards, which are scheduled to start being phased in next year and start coming into full effect by 2015 and 2016, would have a significant impact on mortgages at community banks, he says. In addition to requiring higher capital ratios, allowance, a bank factors in its reserves for impaired loans, the historical analysis, and a qualitative allowance, which for the Iowa bank includes a consideration that local agricultural land values may go down, Johnson says. He also notes that the future HELOC When calculating the appropriate loan-loss to keep the payments coming, I think that's the way the lender is likely to behave. Banks are not going to force a property into foreclosure on a HELOC." That's because the average price of properties payment spike that will be a factor for a lot of larger banks is not significant for his bank and is expected to be mitigated by the rebound locally for home prices. Hazarding the 'Best Guess' Banks should be allowed to build up their Basel III would require banks to account for residential mortgages with significantly different risk weights, Cole says. Banks would have to ac- count for mortgages based on their loan-to-value ratios at eight levels, instead of two, ranging from 35 percent to 200 percent. Balloon-mortgage risk, for example, would be rated at 100 percent instead of 50 percent. Basel III, combined with new mortgage servicing requirements, risk retention rules, and Dodd-Frank Act requirements on proving a customer's ability to repay, will hurt the ability of community banks to make residential loans, Cole says. "The cumulative effect will force many banks to get out of mortgage lending," he said. ICBA is campaigning to change the Basel III requirements as they would apply to community banks, with a 4,000-banks petition. Michael Johnson, director of internal control for Central Bancshares, Inc., says the $650 mil- lion Iowa bank company has taken a conservative approach with its loan-loss allowance ratio, keep- ing it at 1.79 percent—the same level as at the height of the credit crisis and a little higher than in 2007. "Our particular case is consistent with a lot of community banks," he said. Banks have been required by federal regula- tors to look back two years when calculating factors for their loan-loss allowances, instead of looking at a longer historical period, Johnson explains. That change was implemented to make sure the credit crisis years were given sufficient weight. But now that the two-year look-back period no longer includes the credit crisis, the calculations may produce smaller recommended loan-loss allowances than regulators are comfort- able with, he notes. 58 loan-loss reserves in good times and draw them down when the economy is suffering, says H. McCall Wilson Jr., president and CEO of the Bank of Fayette County, a $300 million bank in Tennessee. But banks are discouraged from building those reserves during economic upswings because of accusations that they are hiding earnings, he says "But you can't build it up when there's no sold in foreclosure is one-third less than the aver- age for properties sold by the owner, Feder says, and most properties are worth less than when a home equity loan was borrowed, so in many cases a second-lien lender would have nothing after a foreclosure sale. Feder says that while he thinks that housing is currently oversold and undervalued, he doesn't see prices going up anytime soon. "I happen to believe we have not hit bottom," he said. "But [the market] will go up in time, and when it does, it will go up fairly aggressively." Because of the 4 percent to 6 percent seasonal earnings," because that creates a loss for the bank's investors, which makes customers want to leave, Wilson said. Bank of Fayette County has a loan-loss decline from summer to winter sales, Feder says, and the 2012 peak was barely above the 2010 trough, this winter's seasonal decline will create new lows for the housing market. That will be psychologically oppressive, he contends. The OCC sees the foreclosures environment as reserve of $3 million, or 1.35 percent, up from 1.2 percent a year ago, Wilson says. Historically the percentage has ranged from 1 percent to 1.5 percent. If the bank strings together several good years, it may build that to 1.6 percent, he adds. Beyond the specific characteristics of the bank's loan portfolio, Wilson says there are the unknown issues with the overall economy, such as: What happens if the euro collapses, or if Congress and the president don't come to a bud- get agreement and the so-called fiscal cliff creates a worse recession? "We do the best we can do in the allowance calculation; we get close," Wilson said. "We put in as much as we can. It's an art; it's not a science. Truthfully, it's your best guess." More Lows in the Offing? As for home equity loans, Wilson says that his bank has a floor interest rate of 5 percent for HELOCs, usually with a balloon after five or 10 years, and he doesn't anticipate any significant problems with the portfolio. With only 5,000 customers total, it's easy for the bank to work with individual borrowers if they have problems repaying, he says. With home equity loans, because few bankers are going to be willing to pay off the first lien to get to the second lien, they basically are unse- cured loans, Wilson says "Lenders are not stupid," said Michael Feder, president and CEO of Radar Logic, Inc. "If a homeowner can reduce or modify a HELOC still producing risks for banks. While asset quality improved for small and large banks, housing-relat- ed loans showed above-average delinquency and charge-off rates, the OCC said in its semiannual risk report. The percentage of seriously delinquent mortgages rose to 5 percent at the end of 2011 from 4.9 percent on June 30, 2011, but was down from 5.3 percent at the end of 2010. The percent- age of foreclosures in process was 4 percent on December 31, 2010, 4 percent on June 30, 2011, and 4.1 percent at the end of 2011. For large banks with extensive mortgage op- erations, "the overhang of severely delinquent and in-process-of-foreclosure residential mortgages" is a significant continuing challenge, the OCC reported. The overhang of foreclosures "suggests that many areas may see further declines in home prices. Any slowing in the economy could affect the recovery in real estate values, a key compo- nent of problem assets in the banking industry," the OCC report stated. And foreclosure processing flaws are pro- ducing large remediation and litigation costs, penalties, and reputational damage for mortgage servicers, cutting profitability and productivity. Addressing weaknesses in the foreclosure process and mortgage servicing is a key priority for some of the largest banks, the bank regulator said. "Mortgage servicing problems emerged as a key operating weakness and drew a strong regu- latory response through the consent order pro- cess," the report stated. "The OCC's supervisory staff continues to focus on lapses in operational processes and the implementation of upgrades to systems and processes to meet enhanced mort- gage servicing requirements."

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