Markets tend to myopia in times of extreme optimism. Risingprices fuel a brighter outlook, drawing additional capital and morefavorable credit terms. For a moment, a market’s momentum canoverwhelm the inertia of rational behavior. Prices decouple fromfundamentals. This pattern might describe any sector. Inspecifically describing the last decade's upswing and downturn incommercial real estate, property markets have earned their peeragewith other mainstream asset classes over the last decade.

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Leading up to the peak of capital inflows to the sector, theassessment of risks associated with lending against commercialproperty adjusted in favor of current metrics and away fromlong-term cyclical measures. Some lenders offered crediblearguments that structural changes in the industry meant that morerecent data was more relevant. For other lenders, the bias indefault and loss expectations did not reflect a greater tolerancefor risk; in many cases, it simply reflected a basic mismeasurementof those risks in a worldview where defaults and losses could beobviated by the resilience of a positive and uninterrupted pricingtrajectory.

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In the early stages of the commercial property boom, regulatorsand policy makers voiced concerns about the industry's capacity tomeasure and mitigate attendant risks. These concerns were difficultto quantify, and remain so. As Brad Case pointed out in a 2003white paper prepared for the Federal Reserve's work on Basel II,"An especially challenging limitation has been the paucity ofloan-level data covering multiple CRE credit cycles." These datalimitations continue to confound the modeling of default and lossat the full range of regulator bodies, research firms, and ratingsagencies.

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Regulatory concerns, based on a mix of anecdotal and empiricalevidence, were ultimately formalized in policy guidance aimed atbalancing perceived excess in some corners of creditmarkets. In early 2006, a subset of the FFIEC agenciesreleased proposed guidance, Concentrations in Commercial RealEstate Lending and Sound Risk Management Practices, in response tohow commercial real estate exposures on the balance sheets of manybanks had increased over the previous two or three years. In the 11months that passed before the final concentration guidance waspromulgated, regulators and policy makers had to contend with asometimes-visceral response to the perceived interference.

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At the time, the market was enjoying a seemingly perfectalignment of rising fundamentals and even more rapidly risingprices and transaction volumes. During the comment period, a letterfrom one of the industry’s leading trade associations stated that"the burden should be placed on the examining authority todemonstrate that the risk characteristics of a bank’s commercialreal estate portfolio warrant enhanced risk-management practices orincreased capital." Following the promulgation of the finalguidance, another leading association released a position statementstating that it "objects to banking agency restrictions thatunnecessarily constrain CRE lending."

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The view that commercial real estate had matured to a point thatwas not fully credited in the regulatory guidance cannot bedismissed outright, even if history later proved that problematicloans were being made. As Dr. Case pointed out in hisaforementioned research, "... historical loss severities during theearly 1990s provide reasonable estimates of those likely to prevailin future periods of high default rates. An important issue iswhether these assumptions are valid, especially given improvementsover the past decade at many banks in the underwriting and riskmanagement of CRE loan portfolios."

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In practice, responses to regulatory oversight are rarely sodidactic. The proposed Concentration Guidance elicited anunprecedented response from market participants. All told, theagencies received over 4,400 comment letters: "The vast majority ofcommenters expressed strong opposition to the proposed guidance andbelieve that the Agencies should address the issue of CREconcentration risk on a case-by-case basis as part of theexamination process … Several commenters asserted that today’slending environment is significantly different than that of thelate 1980s and early 1990s, when regulated financial institutionssuffered losses from their real estate lending activities due toweak underwriting standards and risk management practices."

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In 2006 and today, such a view proves to be dangerously na

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Dr. Sam Chandan

An irreverent take on the macroeconomic environment. Dr Sam Chandan is President and Chief Economist of Chandan Economics and an adjunct professor in real estate and public policy at the Wharton School of the University of Pennsylvania.