gregorio moral final

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Real Estate Credit in Perspective-

Gregorio MoralTuriel

Head of the Analysis and Methodological Advice UnitBanco 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

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Loansorcreditfacilitiessecuredbyalienona

realstate

ro ert

Twomainreasonsbehindrealestatelending

o

uy

eve op

or

u

a

proper y

expens ve Togetfunding(extractequity)usingtheproperty

(valuable)ascollateral

Man

differentt es:

borrowers

assets

instruments,goals,

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Focusingontheborrower

Commercialreal

estate

CRE

and

Retailrealestate(RRE)

ypes

o

en ng Commercialconstruction,residentialconstruction,

developers,othercommercialrealestate

Sometimessimilar

to

Pro ect

Finance,

in

other

casestheperformanceoftheborroweristhe

mostim ortantfactor Cor orateModels

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Mortgages

loans

to

buy

a

home

(usually

first

lien)

Owneroccupied

Rentalhousing

Refinancing Mort a estoextracte uit

Conventionalhomeequity(LTV


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Existenceofcertaintypeofcollateral(real

estate)that

Isdifficulttovalue.Differencesamong

,

matters,affected

by

many

factors)

Cost historical re lacement

Price(heterogeneousproduct,opacityandinfrequent

trades)

Withhightransactioncosts

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Prerequisites:anadequateLegalEnvironment

andaccess

to

key

information

ImportanceoftheLegalandRegulatory

Proborrower

vs.

pro

lender,

complexity,

costs

of

foreclosures,timeforre ossessions,etc.

andoftheexistenceofreliableRealEstate

Informationonrights(ownership)andencumbrances i.e.firstlienmort a es

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complex

interactions

affect

both

the

behavior

Modelingofdefaultandrecoveryrisksisdifficult

Largeamounts

and

a

propensity

to

generate

,

In

many

cases,

long

maturities

Needforstablefundingsources,risksassociatedwithmaturitytransformation

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WhyisretailRREsoimportant?

Households:in

urisdictions

with

lar e

middle

classesandhigh%ofhomeownership,

a home is their most im ortant investment and

thelargest

loan

that

they

will

ever

have

is

a

mortgage

loantobuyahome

Banks:manyretailbankskeeplargeportfolios,other

financialinstitutions

invest

in

securities

based

on

these

assets

S stemicnatureinman urisdictions

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on

the

jurisdiction Fu recourseagainstt e orrowerornot e.g.,

Spain,Canadavs.someestatesintheUS)

Typicalmaturities

(term)

can

be:

short

(


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Policymakersinmanycountrieshave

promotedtheincreaseofhomeownership

,ofpublicorquasipublicagencies,taxincentives

:

u c

genc es

an

rograms Thehomeownershipratereachapeakof69%in2004,

rom45 in1940,wit va ues uctuatingaroun 64

duringnearlythreedecades

Sustaina e omeowners ip:Notinallcasesissensibletobecomeahomeowner!

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CyclicalBehavior

House

ricesare

rone

to

boom

and

bust

c cles

butthedurationofthesecyclesvariesgreatly

Bankmanagersshouldrecognizethatisvery

boomphasewithoutsufferingsomeof

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. . .2011

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Portfolios

can

grow

very

quickly

and

seem

to

be

a mos r s ree

Thecompetitiontendstoincreaseovertimeaffecting

pricingand

underwriting

conditions

Banksadapttheirpoliciestothecurrentsituation

Thereisroomforstrategieswithverydifferent

im licationsin

terms

of

risk

rofile

Thebestbanksstartchangingpoliciesbeforethebust

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Whenwilltheboomgobust?

Itis

not

a

science

it

de ends

on

man

factors

not

onlyhouseprices!)andhumanpsychology

,

fallin

house

prices,

a

sustained

high

rate

of

, ,

scarcityoffunding,interestrateincreases,other.

,

indicatorsandwarningsignals

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Lessons:C clicalBehaviorIndicators

and

warning

signals

oc o emograp c ren svs. eman

Rateof

household

formation,

demographic

structureandtrends,immigration

Averagehousepricestoaveragehouseholdsposa e ncomean e tto ncomerat os

Current

riceto

rent

ratio

vs.

historical

average(relativecostofrentalhousing)

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Lessons:CyclicalBehaviorIndicators

and

warning

signals

EvolutionofLTVatorigination,maturities

Verylowlevelsofinterestratesandhigh%of

a justa erate

mortgages

Proliferationofrefinanceandcom lexmortgageproducts

oosen ngo

en ng

s an ar s

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Risktransfermechanismstoathirdparty

Tendto

maintain

ut

back

risks

which

emer e

underextremescenarios

,

therisk

transfer

wont

be

effective

in

case

of

st

semesterin2011werepassedtotheGSES)

ven

e

r

par y

sa

pu c quas

pu c

agency(FreddieFannie)

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Lessons: (Credit)RiskTransferOriginatetodistributemodel

Motivation:Efficiencyandregulatoryarbitrage

Moralhazard,looseningofunderwritingstandards,

Proposalsto

overhaul

securitization

markets

mortgagess ou meet g erun erwr t ngstan ar s,regardlessofwhetherthemortgagesaresoldinto

Riskretentionprovisions(skininthegame)

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Foreclosure,deteriorationoftheproperty,vacanthomes,,

Localdefaults

Severaldefaultsinthesamearea,deteriorationof

neighborhoods,sales,localmarketvaluesdecline,new

,

Globaldefaults Underwatermortgages,shortsales,furtherdepressionof

houseprices,increaseinstrategicdefaults,firesales,no

,

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Underwritingpracticesandpolicies

Roleofmodelsandautomatedsystems

Scorin

s stems

PDoriented

D LGD

estimates

economiccapitalneeds,regulatorycapitalneeds

Automatedunderwritingsystems(limitOpRisk)

Automatedvaluation

systems

(can

help

to

detect

anomalies)

Humanjudgmentandtraditionalappraisals

transfermechanisms

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Commonmistakes

Tothinkthatyouarethesellerwhenyouarethebu er

Incentivesbased

on

volume

and/or

short

term

Managementchallenge

Conservativeperformancemeasurementandincentivesbasedonlongtermresults

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Policiesandke as ects:

Maximumamount,maturities,LTVratio,debtto

,

scoreorscorecardcutoffs,

r c ng,managemen o excep ons opo c es,e c.

Duringtheboomphase,herdbehaviorispervasivebutthereisroomfordifferentpolicies

risk and less risk !

Thefollowingexamplesillustratecertainaspects

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M n m n rin h mBanks can apply different policies in terms of LTV over time

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Over time, different policies in terms of LTV produces verydifferent structures of LTV for the current ortfolio

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Different banks tightened the origination policies at differentdates

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M n m n rin h mDifferences in policies related to maturities

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Balance by origination date can exhibit different patterns

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ManagementduringtheboomDifferences in banks policies are better recognized by observing severalcharacteristics at the same time (in this example: distribution of EAD in thespace {Origination Date, LTV}for a particular portfolio)

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

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Mortgagepricingisquitecomplex

Creditrisk,prepaymentrisk,operationalrisks,

Butin

com etitive

markets

these

internal

ricin

are

onlyareference

However,asaminimumbanksshouldcovercertain

minimum

costs:

(EL+UL)

capital

costs+

funding

costs

Intheboomphaseincreaseincompetitioncanpromoteunsustainableprices

Challenge:To

establish

a

competitive

and

soundpricingscheme

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ManagementduringtheboomPricing: as a first approximation, byassumin one sin le eriod (!!!),equilibrium spreads can be computedeasily

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Thevirulenceofthedownturnphase

I t e ousingmar etco apses,t erearenoquic oreasysolutions

epo c esapp e ur ng e oomp ase

Ifthesepolicieswereveryaggressiveyouroptionswilleverypoor

Thestrengthofthefirm

Ifyouhavehighcapitalratios,enoughliquidity,otherbusinessormarketswithadifferentcycle,youroptions

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M n m n in h wn rn Ifthedownturnissevere

Lenderswillhavetouseextensivelysensiblemortgagemodifications

Mo i yingse ecte past ue oans

Refinancingselectedperformingloansatlowerrates

Usingforeclosuresandrepossessionsonlyafteracarefulcostbenefitanalysis

e rsuccessor eas y epen son

Theunderwritingpolicies,risktransfermechanismsand

Challenge:Howtomanageforeclosureproceduresand

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Policymakers

can

help

to

stabilize

mortgage

markets

initiatives

Refinancingprogramswithpublicsupport,forexample

. .,

US)

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nyques ons

[email protected]

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