Get Started for Free Contexxia identifies hard-to-find pieces of information in SEC filings. No more highlighters, no more redlining, no more poring over huge documents. CULLEN/FROST BANKERS, INC. (39263) 10-K published on Feb 06, 2019 at 4:43 pm
Reporting Period: Dec 30, 2018
As of December 31, 2018, commercial real estate mortgage loans comprised approximately 29.2% of our loan portfolio. Commercial real estate mortgage loans generally involve a greater degree of credit risk than residential real estate mortgage loans because they typically have larger balances and are more affected by adverse conditions in the economy. Because payments on loans secured by commercial real estate often depend upon the successful operation and management of the properties and the businesses which operate from within them, repayment of such loans may be affected by factors outside the borrower’s control, such as adverse conditions in the real estate market or the economy or changes in government regulations. In recent years, commercial real estate markets have been experiencing substantial growth, and increased competitive pressures have contributed significantly to historically low capitalization rates and rising property values. Commercial real estate prices, according to many U.S. commercial real estate indices, are currently above the 2007 peak levels that contributed to the financial crisis. Accordingly, the federal banking regulatory agencies have expressed concerns about weaknesses in the current commercial real estate market. Our failure to have adequate risk management policies, procedures and controls could adversely affect our ability to increase this portfolio going forward and could result in an increased rate of delinquencies in, and increased losses from, this portfolio, which, accordingly, could have a material adverse effect on our business, financial condition and results of operations.
We are subject to changes in tax law that could increase our effective tax rates. These law changes may be retroactive to previous periods and as a result could negatively affect our current and future financial performance. Furthermore, the full impact of the Tax Cuts and Jobs Act, which was enacted on December 22, 2017, on us and our customers remains uncertain, creating uncertainty and risk related to our customers' future demand for credit and our future results. Increased economic activity expected to result from the decrease in federal income tax rates on businesses generally could spur additional economic activity that would encourage additional borrowing. At the same time, some customers may elect to use their additional cash flow from lower taxes to fund their existing levels of activity, decreasing borrowing needs. The elimination of the federal income tax deductibility of business interest expense for a significant number of our customers effectively increases the cost of borrowing and could make equity or hybrid funding relatively more attractive. This could have a long-term negative impact on business customer borrowing. There is no assurance that presently anticipated benefits of federal income tax reform for us will be realized.
We are subject to federal and applicable state tax regulations. Such tax regulations are often complex and require interpretation and changes in these regulations could negatively impact our results of operations. In the normal course of business, we are routinely subject to examinations and challenges from federal and applicable state tax authorities regarding the amount of taxes due in connection with investments we have made and the businesses in which we have engaged. Recently, federal and state taxing authorities have become increasingly aggressive in challenging tax positions taken by financial institutions. These tax positions may relate to tax compliance, sales and use, franchise, gross receipts, payroll, property and income tax issues, including tax base, apportionment and tax credit planning. The challenges made by tax authorities may result in adjustments to the timing or amount of taxable income or deductions or the allocation of income among tax jurisdictions. If any such challenges are made and are not resolved in our favor, they could have a material adverse effect on our business, financial condition and results of operations.
Our model for the determination of the allowance for loan losses is largely prescriptive, based on policy, and calculated using quantitative data related to our loan portfolio. This calculation yields the minimum level of allowance required (“minimum calculated need”). In that the model is constructed to address aspects of the loan portfolio quantitatively as they move over time (both good and bad), the model output of the minimum calculated need will move directionally with the overall health of the portfolio and inherent losses in the portfolio at any period end. While the model inherently captures loan portfolio characteristics and actions such as risk grade migration, required specific reserves, net charge-offs, among other things, the model contains a degree of imprecision arising from various items and portfolio risk factors that are not and cannot be incorporated in to the model but nonetheless have an impact on the overall level of allowance deemed appropriate by management. To adequately address this imprecision, our methodology to determine the allowance for loan losses provides for additional reserves in excess of the minimum calculated need. This process entails the application of management judgment related to various non-model items and portfolio risk factors not addressed by the quantitative model but reflective of inherent losses in the portfolio. These additional reserves, which are reported as a component of our macroeconomic valuation allowances, are determined at the portfolio level and allocated as reserves for general economic risk to our various portfolio segments based upon management judgment.
The reserve allocated to commercial and industrial loans at December 31, 2018 decreased $11.0 million compared to December 31, 2017. The decrease was primarily due to decreases in macroeconomic valuation allowances, specific valuation allowances and historical valuation allowances. Macroeconomic valuation allowances for commercial and industrial loans decreased $5.9 million from $16.5 million at December 31, 2017 to $10.6 million at December 31, 2018. The decrease was primarily related to a decrease in the general macroeconomic risk allocation (down $4.3 million), as further discussed below. The decrease was also partly related to a decrease in the distressed industries allocation (down $1.6 million), as certain industries are no longer considered to be distressed. Specific valuation allowances for commercial and industrial loans decreased $5.0 million from $7.6 million at December 31, 2017 to $2.6 million at December 31, 2018. The decrease was primarily related to the charge-off of a credit relationship which had an associated specific valuation allowance totaling $5.9 million at December 31, 2017. Historical valuation allowances decreased $1.1 million from $26.4 million at December 31, 2017 to $25.4 million at December 31, 2018. The decrease was primarily related to a decrease in the volume of classified loans graded as "substandard - accrual" (risk grade 11) as well as non-classified loans graded "watch" (risk grade 9) and "special mention" (risk grade 10) partly offset by the impact of an increase in the volume of pass-graded loans and an increase in the historical loss allocation factor applied to loans graded "substandard - non-accrual" (risk grade 12). Classified loans consist of loans having a risk grade of 11, 12 or 13. Classified commercial and industrial loans totaled $78.9 million at December 31, 2018 compared to $144.0 million at December 31, 2017. The weighted-average risk grade of commercial and industrial loans was 6.30 at December 31, 2018 compared to 6.41 at December 31, 2017. Commercial and industrial loan net charge-offs totaled $22.4 million during 2018 compared to $17.5 million during 2017. Charge-offs in 2018 included $19.8 million related to nine credit relationships, four which had an associated specific valuation allowances totaling $6.4 million as of December 31, 2017. General valuation allowances for commercial and industrial loans increased $950 thousand from $9.1 million at December 31, 2017 to $10.1 million at December 31, 2018. The increase was primarily related to an increases in the allocations for highly-leveraged transactions (up $1.4 million) and excessive industry concentrations (up $536 thousand) partly offset by an increase in the adjustment for recoveries (up $522 thousand) combined with a decrease in the allocation for loans not reviewed by concurrence (down $297 thousand).