Exposure to Real Estate in Bank Portfolios

Article excerpt

Abstract

We implement a three-step procedure to assess the extent of exposure to real estate in commercial banks. First, we investigate the determinants of delinquency on real estate loans. We find the changes in interest rates and income to be the major determinants of aggregate delinquency rate. In the second step, we adopt a stress testing approach to calculate the potential impact on banks' position of any adverse changes in these determinants. These calculations suggest that a 1.3 percentage point increase in mortgage interest rate leads to a 20% decrease in a typical bank's distance to default. Finally, we look at the cross-sectional differences to identify the most vulnerable banks. Banks with rapid loan growth along with high cost-income ratio appear to be the most likely to experience a deterioration in their soundness.

In 2006, the federal banking agencies issued two guidelines to address their concern that financial institutions have become overexposed to the real estate sector while credit standards and risk management practices in real estate lending have been deteriorating. In particular, the concern was that concentration in commercial real estate loans has reached a level that could lead to undesirable outcomes in the event of a significant downturn. Moreover, expanding use of nontraditional mortgage loans, yet to be tested in a stressed environment, were argued to warrant increased scrutiny.1

Such exposure to the real estate sector is a legitimate cause for concern especially when it coincides with increasing property prices giving rise to the financial accelerator effect as demonstrated by Kiyotaki and Moore (1997). Regulators feared a repeat of the widespread commercial real estate failures inciting turmoil in the banking sector in the 1980s and 1990s. Additionally, they urged the lending institutions to maintain strong risk management practices for residential real estate loans as well, reasoning that credit standards tend to deteriorate during the upward phase of economic cycles2 and certain nontraditional mortgage loans can introduce risks that are unfamiliar to both lenders and borrowers.

Yet, practitioners argued that part of commercial real estate loans (to be specific, multifamily housing) have lower default risk (as traditionally assumed for other residential real estate loans) and, moreover, commercial real estate loans were much better-secured than they were before, thanks to the developments in mortgage-backed securities markets. Moreover, they worried that a zealous industry-wide attempt to contain risks might choke the lending sector by "slamming the brakes on good loans," (BNA Daily Report for Executives, Sept. 15, 2006) and lead to the failures that it actually aims to avoid. Instead, practitioners favored a well-measured supervisory response specifically targeted at the institutions with poor risk management practices.

The regulators' concerns happened to be justified in the summer of 2007 when the news of increasing defaults on subprime mortgage loans hit mortgage-backed securities and triggered what turned out to be one of the most severe financial crises in history. It is an interesting question whether analysis of detailed data on banks and the overall economy could have revealed early warning signs of the problems the banks currently are suffering from.

This paper analyzes the exposure to the real estate sector in commercial banks prior to the financial crisis. We follow a three-step procedure. We first estimate a model of delinquency rates as a function of aggregate variables to identify the factors driving defaults on real estate loans. Then, detailed bank-level data are used to calculate the impact on the soundness of banks of plausible changes in key variables. Finally, we document the distinguishing characteristics of the banks that appear to be the most vulnerable. The novel features of the study, in addition to combining micro and macro data, are the recognition of the two-way causality between credit and real estate cycles and the focus on the impact of widespread real estate loan defaults on bank soundness. …