The tribulations of peak-era CMBS issues have been well chronicled by media outlets such as this one and by information providers such as Trepp. But the industry has been down this road before, and last time the path was rockier.

Would you believe a default rate exceeding 50%, with the rate climbing to 84% for securities issued just before the bottom dropped out of the market? That’s what happened to the commercial real estate bond market of the 1920s and early 1930s, according to a study by two analysts at the Federal Reserve Bank of New York that charts both parallels and differences between then and now.

Titled “Defaults and Losses on Commercial Real Estate Bonds during the Great Depression Era,” the study by Tyler Wiggers and Adam B. Ashcraft found that CRE bonds issued prior to the 1929 stock market crash were marked by “underwriting with overly optimistic assumption being baked into cash flow and risk expectations.” That, of course, was also the case with non-institutional CMBS and bank loans of 2005- to 2007-vintage. Similarly, both the CRE bonds of the Roaring Twenties—which peaked at $544 million in 1928—and the CMBS of five to seven years ago focused on “less-coveted properties in an intensely competitive market.”

Market conditions were also comparable prior to the Great Depression and prior to the housing market collapse and near-meltdown of the banking sector in 2008. “Like the 2000s, the US economy in the 1920s was characterized by a significant boom in activity in both residential and commercial real estate markets,” the study’s authors write. “The effects and results of World War I (1914 to 1918) laid the groundwork for the commercial real estate bubble and the use of the commercial real estate bond to fuel the speculation.”

Yet when it comes to the consequences for investors, the similarities end there. A key difference, Wiggers and Ashcraft write, is that unlike 80 years ago, “standardized processes and structures are now in place” for dealing with delinquent borrowers, including the pooling and servicing agreements that are part of every CMBS transaction. And the “outright fraud” that some bond issuers perpetrated in the ’20s is now protected against, thanks to regulatory oversight. The bottom line: not only delinquency rates, but also losses, were higher for CRE bonds eight decades ago than they are for present-day CMBS, with traditional loss severities peaking at an average of nearly 51% for 1930-vintage bonds. Resolutions took longer on the whole, with many not occurring until after the Second World War.

Obviously, the onset of the Great Depression was a key factor in triggering the failure of CRE bonds. However, Wiggers and Ashcraft cite a number of other reasons for the high rate of default, including origination practices. “There was a significant difference in underwriting standards that existed in the CRE bond market relative to other lenders: inflation of appraisals due to both fraud and inflated expectations, over-reliance on leverage metrics as opposed to cash flow as the primary indication of riskiness, use of pro-forma underwriting, use of new loans to refinance delinquent loans and the use of reduced amortization,” the authors write.

In contrast to the many institutional buyers of CMBS, sophisticated investors of the ’20s avoided the CRE bond market, “which preyed on the general public who had gotten accustomed to buying Liberty Bonds during the First World War,” the authors write. Bond houses went after unsophisticated investors “through the use of small denominations and high coupons, and were compensated through large up-front fees paid by the borrower.” Servicing practices on the bonds in those days were also prone to conflicts of interest.

This largely-forgotten episode in the history of CRE finance holds lessons for today, given the large number of sub-performing CRE assets that need to be worked out, the authors write. The episode demonstrates that whether the year is 1927 or 2007, loans with higher loan-to-values will be at greater risk of default.

Further, they note that while the number of defaults from the CRE bonds of the ’20s was high, the losses were “normal” compared to the performance of other types of loans during the period. That had a lot to do with the correlation between the defaults and subsequent losses and the general business cycle: “unprecedented GDP losses and unemployment increases” in the early ’30s, followed by rapid GDP and employment growth as the US entered World War II.

“While the data points to better loss performance the quicker a problem loan is dispatched with, the old banking adage ‘your first loss is your best loss’ may not hold true when there is a rapid recovery around the corner,” Wiggers and Ashcraft write. “Rational market participants should make a realistic determination of how long they will be required to be involved with a particular asset and couple that with realistic macro-level projections for the hold period to determine whether it will be best to quickly dispose of the property or to stay involved over the long-run.” To access the complete 44-page study on the New York Fed’s website, click here.