A Decade of Defaults

Markets tend to myopia in times of extreme optimism. Rising prices fuel a brighter outlook, drawing additional capital and more favorable credit terms. For a moment, a market’s momentum can overwhelm the inertia of rational behavior. Prices decouple from fundamentals. This pattern might describe any sector. In specifically describing the last decade's upswing and downturn in commercial real estate, property markets have earned their peerage with other mainstream asset classes over the last decade.

Leading up to the peak of capital inflows to the sector, the assessment of risks associated with lending against commercial property adjusted in favor of current metrics and away from long-term cyclical measures. Some lenders offered credible arguments that structural changes in the industry meant that more recent data was more relevant. For other lenders, the bias in default and loss expectations did not reflect a greater tolerance for risk; in many cases, it simply reflected a basic mismeasurement of those risks in a worldview where defaults and losses could be obviated by the resilience of a positive and uninterrupted pricing trajectory.

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

Regulatory concerns, based on a mix of anecdotal and empirical evidence, were ultimately formalized in policy guidance aimed at balancing perceived excess in some corners of credit markets. In early 2006, a subset of the FFIEC agencies released proposed guidance, Concentrations in Commercial Real Estate Lending and Sound Risk Management Practices, in response to how commercial real estate exposures on the balance sheets of many banks had increased over the previous two or three years. In the 11 months that passed before the final concentration guidance was promulgated, regulators and policy makers had to contend with a sometimes-visceral response to the perceived interference.

At the time, the market was enjoying a seemingly perfect alignment of rising fundamentals and even more rapidly rising prices and transaction volumes. During the comment period, a letter from one of the industry’s leading trade associations stated that "the burden should be placed on the examining authority to demonstrate that the risk characteristics of a bank’s commercial real estate portfolio warrant enhanced risk-management practices or increased capital." Following the promulgation of the final guidance, another leading association released a position statement stating that it "objects to banking agency restrictions that unnecessarily constrain CRE lending."

The view that commercial real estate had matured to a point that was not fully credited in the regulatory guidance cannot be dismissed outright, even if history later proved that problematic loans were being made. As Dr. Case pointed out in his aforementioned research, "... historical loss severities during the early 1990s provide reasonable estimates of those likely to prevail in future periods of high default rates. An important issue is whether these assumptions are valid, especially given improvements over the past decade at many banks in the underwriting and risk management of CRE loan portfolios."

In practice, responses to regulatory oversight are rarely so didactic. The proposed Concentration Guidance elicited an unprecedented response from market participants. All told, the agencies received over 4,400 comment letters: "The vast majority of commenters expressed strong opposition to the proposed guidance and believe that the Agencies should address the issue of CRE concentration risk on a case-by-case basis as part of the examination process … Several commenters asserted that today’s lending environment is significantly different than that of the late 1980s and early 1990s, when regulated financial institutions suffered losses from their real estate lending activities due to weak underwriting standards and risk management practices."

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