As reported in our most recent Bank Default and Lending Report, the combined default rate on banks' commercial and multifamily mortgage loans fell to 3.75 percent in the third quarter of 2011. The new accounting reflects a 19-basis point drop from the second quarter's 3.94 percent default rate and a 67 basis point decline from the cyclical peak of 4.42 percent a year earlier.

Most Banks Still Drawing Down Exposure to CRE

In spite of the improvement in legacy loan performance, many banks are still drawing down their exposures to the property sector. The outstanding balance of banks' multifamily and commercial real estate loans fell by $3.1 billion during the third quarter, reflecting a small net increase in multifamily loans and a larger offsetting decline in commercial loans.

Banks' aggregate lending activities are being curtailed by a combination of factors. Among them: tight credit standards in secondary and tertiary markets and for non-core assets; increasing competition from non-bank lenders in primary markets and for core assets; in some areas, relatively weak loan demand apart from the market for refinancing; and, undoubtedly, a combinatin of internal and regulatory pressures. Overall, banks have reduced their exposure to multifamily and commercial real estate by $35.0 billion since the market peak, a 2.7 percent decline following several years of rapid expansion.

Banks With Healthier Legacy Portfolios More Likely to Lend Anew

The pattern revealed in the bank-by-bank analysis is intuitive. Nonetheless, it is also instructive for our assessment about of the headwinds facing banks that remain encumbered by large pools of non-performing loans. As the first chart shows, the distribution of changes in banks' CRE loans over the last year is characterized by a long right-hand side tail. This positive skewness in the distribution indicates that a relatively small number of banks are leading this foundational class of lenders back to the CRE financing market. As of yet, reengagement is not widespread.

Equally important, the analysis shows a statistically signficiant relationship between the health of banks' legacy loan portfolios and their current CRE lending activities. The estimated coefficient is economically signficant, as well.

In the simple linear relationshiop illustrated below, banks with lower default rates in Q3'10 were more likely to have grown their balance sheets over the ensuing year. A number of behavioral relationships can be posited for this finding, not least amongst them a more constructive supervisory relationship and a more limited preocccupation with the mangagement of distress.