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Real Estate Credit in Perspective

-Management Challenges and Lessons from the Recent Crisis

Gregorio MoralTuriel
Head of the Analysis and Methodological Advice Unit SupervisionDepartment Banco deEspaa

The views expressed in this presentation are those of the author and do not necessarily represent those of the Banco de Espaa. All figures, and graphs used as examples are for illustrative purposes only and not intended to be representative of any particular jurisdiction or actual bank

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RealEstateLending(REL)
Loansorcreditfacilitiessecuredbyalienona p p y realstateproperty Twomainreasonsbehindrealestatelending
To T buy b (develop (d l orbuild) b ild)aproperty t (expensive) ( i ) Togetfunding(extractequity)usingtheproperty (valuable)ascollateral

Many ydifferenttypes: yp borrowers,assets, , instruments,goals,


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Classificationofrealestatelending
Focusingontheborrower
Commercialrealestate( (CRE) )and Retailrealestate(RRE)

Types T of fCRElending l di
Commercialconstruction,residentialconstruction, developers,othercommercialrealestate SometimessimilartoProject j Finance, ,inother casestheperformanceoftheborroweristhe mostimportant p factor(Corporate ( p Models) )
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Classificationofrealestatelending
ManytypesofRetailRealEstate
Mortgagesloanstobuyahome(usuallyfirstlien)
Owneroccupied Rentalhousing

Refinancing Mortgages g g toextractequity q y


Conventionalhomeequity(LTV<=80%) Highloantovalue(HLTV)homeequity

Primeborrowersvs.subprimeborrowersand conformingvs. vs notconforming


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SomecommonthemesinREL
Existenceofcertaintypeofcollateral(real )that estate)
Isdifficulttovalue.Differencesamong
Value(differentvaluationmethods, methods thepurpose matters,affectedbymanyfactors) Cost(historical,replacement) Price(heterogeneousproduct,opacityandinfrequent trades) )

Withhightransactioncosts
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SomecommonthemesinREL
Prerequisites:anadequateLegalEnvironment andaccesstokeyinformation
ImportanceoftheLegalandRegulatory Environments
Proborrowervs.prolender,complexity,costsof foreclosures, ,timeforrepossessions, p ,etc.

andoftheexistenceofreliableRealEstate Registers:
Informationonrights(ownership)and encumbrances e cu b a ces ( (i.e. e first stlien e mortgages) o tgages)
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SomecommonthemesinREL
Manyrelevantfactors(macroandmicro)and complexinteractionsaffectboththebehavior ofpricesandthedynamicofdefaults
Modelingofdefaultandrecoveryrisksisdifficult

Largeamountsandapropensitytogenerate concentrationrisks(geographical (geographical,name) Inmanycases,longmaturities


Needforstablefundingsources,risksassociated withmaturitytransformation
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RetailResidentialRealEstateLending
WhyisretailRREsoimportant?
Households:inj jurisdictionswithlarge g middle classesandhigh%ofhomeownership,
ahomeistheirmostimportantinvestmentand, thelargestloanthattheywilleverhaveisamortgage yahome loantobuy

Banks:manyretailbankskeeplargeportfolios,other
financialinstitutionsinvestinsecuritiesbasedonthese assets

Systemic y natureinmany yjurisdictions j


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RetailRRE:Mortgages
Mortgages Mortgages canbeverydifferentdepending onthejurisdiction
Full F llrecourseagainst i the h borrower b ornot(e.g., ( Spain,Canadavs.someestatesintheUS) Typicalmaturities(term)canbe:short(<10y), medium(1520y),long(2530y),verylong(40y)

InitialLTVratioscanbedifferent(legallimitations) InterestRates:Fixed Fi drates t mortgages t (FRM), (FRM)


variablerates(ARM)ormixtures
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RetailRRE:PublicIntervention
Policymakersinmanycountrieshave promotedtheincreaseofhomeownership
PublicprogramsofAffordableHousing, Housing creation ofpublicorquasipublicagencies,taxincentives

US: US P Public bli Agencies A i and dPrograms P


Thehomeownershipratereachapeakof69%in2004, f from 45%in i 1940,with i hvalues l fluctuating fl i around d64% % duringnearlythreedecades

Sustainable bl h homeownership: h Notinallcasesis


sensibletobecomeahomeowner!
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Lessonsfromtherecentcrisis
CyclicalBehavior
Housep pricesareprone p toboomandbustcycles y butthedurationofthesecyclesvariesgreatly Theboompartofthelastcyclehasbeenverylong Bankmanagersshouldrecognizethatisvery difficulttoparticipateinthebenefitsfromthe boomphasewithoutsufferingsomeof consequencesofthebust(ordownturn)

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Lessons:CyclicalBehavior

Form: How Long Do Housing Cycles Last? A Duration Analysis for 19 OECD Countries Countries. Philippe Bracke. Bracke WP/11/231. WP/11/231 October 2011

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Lessons:CyclicalBehavior
Duringtheboomphase
Portfolioscangrowveryquicklyandseemtobe almostriskfree Thecompetitiontendstoincreaseovertimeaffecting pricingandunderwritingconditions Banksadapttheirpoliciestothecurrentsituation Thereisroomforstrategieswithverydifferent implications p intermsofriskprofile p Thebestbanksstartchangingpoliciesbeforethebust
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Lessons:CyclicalBehavior
Whenwilltheboomgobust?
Itisnotascience, ,itdepends p onmany yfactors( (not onlyhouseprices!)andhumanpsychology Triggers:Asuddenstopinhousingtransactions, transactions a fallinhouseprices,asustainedhighrateof unemployment anincreaseinuncertainty, unemployment, uncertainty scarcityoffunding,interestrateincreases,other. However, However therearemanyusefulmicroandmacro indicatorsandwarningsignals
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Lessons:Cyclical y Behavior
Indicatorsandwarningsignals Socio S i demographic d hi trends t d vs.demand d d
Rateofhouseholdformation,demographic structureandtrends,immigration

Inventoryofemptyandunsoldhomes Averagehousepricestoaveragehousehold di disposable bl i incomeand d d debt btto t income i ratios ti Currentp pricetorentratiovs.historical average(relativecostofrentalhousing)
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Lessons:CyclicalBehavior
Indicatorsandwarningsignals
EvolutionofLTVatorigination,maturities Growthinnumberofloansandinexposures Verylowlevelsofinterestratesandhigh%of adjustable dj bl ratemortgages Proliferationofrefinanceandcomplex p mortgageproducts Loosening L i of flending l di standards t d d

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Lessons:(Credit)RiskTransfer
Risktransfermechanismstoathirdparty
Tendtomaintainput p backrisks, ,whichemerge g underextremescenarios Ifthereisconcentrationonthesamethirdparty party, therisktransferwontbeeffectiveincaseof systemicproblems(US:70%ofallnewloansinthe1st semesterin2011werepassedtotheGSES)

E Evenifth thethi third dparty t is i apublic/quasi bli / ipublic bli agency(FreddieFannie)


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Lessons:(Credit)RiskTransfer
Originatetodistributemodel
Motivation:Efficiencyandregulatoryarbitrage Problems
Moralhazard,looseningofunderwritingstandards, complexityandfragility,

Proposalstooverhaulsecuritizationmarkets
Allmortgagesshould h ldmeethi higher h underwriting d i i standards, d d regardlessofwhetherthemortgagesaresoldinto securitizationsorretainedbylenders Riskretentionprovisions(skininthegame) Definequalifiedresidentialmortgages
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Lessons:DestructiveSpirals
Individualdefault
Foreclosure,deteriorationoftheproperty,vacanthomes, costs potentialfurtherdeterioration costs,

Localdefaults
Severaldefaultsinthesamearea,deteriorationof neighborhoods,sales,localmarketvaluesdecline,new defaults firesales defaults,

Globaldefaults
Underwatermortgages,shortsales,furtherdepressionof houseprices,increaseinstrategicdefaults,firesales,no demandforhousing,tighteningofmortgagecredit
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Managementduringtheboom
Underwritingpracticesandpolicies
Roleofmodelsandautomatedsystems
Scoring gsystems y ( (PDoriented), ),( (D)LGD ) (estimates), ( ), economiccapitalneeds,regulatorycapitalneeds Automatedunderwritingsystems(limitOpRisk) Automatedvaluationsystems(canhelptodetect anomalies)

Humanjudgmentandtraditionalappraisals Useofexternalinformation,outsourcingandrisk transfermechanisms


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Managementduringtheboom
Focusongrowth(profitableintheshortterm) Commonmistakes
Tothinkthatyouarethesellerwhenyouarethe buyer y Incentivesbasedonvolumeand/orshortterm measuresofprofitability

Managementchallenge
Conservativeperformancemeasurementand incentivesbasedonlongtermresults
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Managementduringtheboom
Policies o c esa and dkey eyaspects aspects:
Maximumamount,maturities,LTVratio,debtto incomeratios(debtservicerequirements) requirements),internal scoreorscorecardcutoffs, Pricing, P i i management tof fexceptions ti t topolicies, li i etc. t

Duringtheboomphase,herdbehavioris pervasivebutthereisroomfordifferentpolicies (riskyandlessrisky!) Thefollowingexamplesillustratecertainaspects


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Managementduringtheboom
Banks can apply different policies in terms of LTV over time

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Managementduringtheboom
Over time, different policies in terms of LTV produces very different structures of LTV for the current portfolio p

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Managementduringtheboom
Different banks tightened the origination policies at different dates

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Managementduringtheboom
Differences in policies related to maturities

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Managementduringtheboom
Balance by origination date can exhibit different patterns

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Managementduringtheboom
Differences in banks policies are better recognized by observing several characteristics at the same time (in this example: distribution of EAD in the space {Origination Date, LTV} for a particular portfolio)

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Managementduringtheboom
To seriously analyze banks policies it is necessary to explore the former aspects at sub-portfolio level

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Managementduringtheboom
Mortgagepricingisquitecomplex
Creditrisk,prepaymentrisk,operationalrisks, Butincompetitive p marketstheseinternalp pricing g are onlyareference However,asaminimumbanksshouldcovercertain minimumcosts:(EL+UL)capitalcosts+fundingcosts Intheboomphaseincreaseincompetitioncanpromote unsustainableprices

Challenge: g Toestablishacompetitive p and soundpricingscheme


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Managementduringtheboom
Pricing: as a first approximation, by assuming g one single g p period ( (!!!), ), equilibrium spreads can be computed easily

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Managementinthedownturn
Optionsdependheavilyon
Thevirulenceofthedownturnphase
Ifthe h h housing i market k collapses, ll there h arenoquick i kor easysolutions

The Th policies li i applied li dd during i th theb boomphase h


Ifthesepolicieswereveryaggressiveyouroptionswill beverypoor

Thestrengthofthefirm
Ifyouhavehighcapitalratios,enoughliquidity,other businessormarketswithadifferentcycle,youroptions willbefarbetter
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Managementinthedownturn
Ifthedownturnissevere
Lenderswillhavetouseextensivelysensiblemortgage modifications Modifying dif i selected l dpastdue d loans l Refinancingselectedperformingloansatlowerrates Usingforeclosuresandrepossessionsonlyafteracareful costbenefitanalysis Their Th i successorfeasibility f ibilit depends d d on Theunderwritingpolicies,risktransfermechanismsand fundingmethods Challenge:Howtomanageforeclosureproceduresand repossessedproperties
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Managementinthedownturn
Cooperationamongpublicanprivateinstitutions Policymakerscanhelptostabilizemortgage markets
Atlocallevel,promoteneighborhoodstabilization initiatives Foreclosureprevention
Refinancingprogramswithpublicsupport,forexample aimedatlowornoequityloans(e.g., (e g HARPprograminthe US)

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Anyquestions?

THANKYOU!
gregorio.moral@bde.es

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