Capital Management Archives

The Effect of Deal Structures on Current Expected Credit Loss

Introduction
In a recent paper, we looked at the effect of forecasts on IFRS-9 and Current Expected Credit Loss (CECL) deductions. This paper goes a step further to explore what lenders can do with deal structures to limit the expected losses. This can be viewed in three ways:

Approaches to reduce the CECL deductions
Approaches to reduce the actual risk
Approaches to arbitrage anyone who does not take these features into account

In the previous paper, we looked at several variations on a commercial real estate deal under three forecasts. In this paper, we take the most-risky combination and show the effect of changing the loan structure. The stylized "moderately negative" central forecast used was as follows:

Interest rates, inflation and vacancy rates increase 0.5% per year for three years and then flatten
Capital values and rental rates fall 5% per year for three years and then flatten

The loan is towards the risky end of the spectrum. It is for a Boston office with an LTV of 75%, initial DSCR of 1.35, floating-rate interest, 20-year amortization and a maturity of 5 years. There are four equal leases with a 1% probability of tenant default, one lease expiring in year three, the others expiring after year eight, and all leases repricing to the market annually.
Analysis
Using the Specialized Finance System's cashflow simulation, we quantified the effect of six variations in the financing structure:

Reduced loan amounts
Alternative amortization profiles
Interest rate caps
Sweep amortization (i.e., also taking all excess income to pay-down the loan)
Sweep triggered by covenants on Loan to Value (LTV)
Sweep triggered by covenants on Debt Service Coverage Ratio (DSCR)

The details of each variation are described later. Let us first look at the overall results. [...]

May 8th, 2017|

The Effect of Forecasts on IFRS-9 and Current Expected Credit Loss

Introduction
The Financial Accounting Standard Board's (FASB's) new IFRS-9 and the Current Expected Credit Loss (CECL) approach requires banks to deduct the Expected Loss from the balance-sheet value of a loan. Furthermore, it requires the Expected Loss to be estimated using a reasonable forecast of the future market. Now consider this recent quote on Bloomberg:
"Apartment rents in cities such as New York and San Francisco will need to fall as much as 15 percent for a glut of high-end developments to be absorbed, according to billionaire real estate investor Richard LeFrak"
This leads to questions as to how much difference do the forecasts make to the CECL and what kind of deals are most affected?

This short paper outlines the answers to those questions for commercial real estate by testing a range of mean-reverting forecasts against typical example deals. The approach used to assess the risk is the comprehensive cashflow simulation embedded in the Specialized Finance System (SFS). The simulation tests the deals under thousands of dispersed random scenarios, centered around forecasts for inflation, interest rates, capital values, rental rates and vacancy rates.
Analysis
Three simplified forecasts are used for illustration here:

Basecase:

Simulation is around a flat forecast relative to today

Mildly negative central forecast:

Interest rates, inflation and vacancy rates increase 0.25% per year for three years and then flatten
Capital values and rental rates fall 2.5% per year for three years and then flatten.

Moderately negative central forecast:

Interest rates, inflation and vacancy rates increase 0.5% per year for three years and then flatten
Capital values and rental rates fall 5% per year for three years and then flatten.

The loans are all for a Boston office with an LTV of 75%, initial DSCR of 1.35, 20-year [...]

April 5th, 2017|

Solvency II Compliance achieved with Risk Integrated’s Specialized Finance System

FOR IMMEDIATE RELEASE:
Solvency II Compliance achieved with Risk Integrated’s Specialized Finance System
New York / London – April 12, 2016 – Risk Integrated, the leading technology firm focused on risk measurement for commercial real estate, today announced that a leading global insurer has gained regulatory approval to use the Specialized Finance System as their internal model to calculate regulatory capital requirements under Solvency II. Risk Integrated’s Specialized Finance System (SFS) is also being used for gathering detailed data on its commercial real estate loans, reporting on the assets’ risk profile and structuring new loans.

At a time of increasing regulatory and risk management pressures, the client is using the SFS to strengthen the reporting of its commercial real estate (CRE) assets to give management, the board and regulators an increased understanding of the portfolio. They are also using the SFS to provide a competitive advantage when originating new transactions by gaining deeper insights into the sources of risk. A senior executive risk manager in the organisation commented that "We see the SFS as providing both regulatory compliance and a competitive advantage. This tool is a key factor for integrating all the aspects of risk management across the business".

At the core of the SFS there is a set of highly detailed cashflow simulation models. The models are transparent and under the control of the client's analysts to incorporate its business expertise. The resulting reports allow users to see the interaction of the risk factors within each deal's structure. Examples of detailed cashflow risk reports are shown at this link: Dissecting CRE Loan Risks

Dr. Yusuf Jafry, Risk Integrated's CTO, commented that "I am delighted that they have selected the SFS. From a technical point of view, our system's [...]

April 12th, 2016|

IFRS-9, CECL and Pro-cyclicality

Introduction
The International Accounting Standards Board (IASB) and the US Financial Accounting Standard Board (FASB) are updating the approach for setting Allowances for Loan and Lease Losses (ALLL). In International Financial Reporting Standard 9 (IFRS-9) the IASB require allowances to be set according to the lifetime credit losses weighted by the estimated probability of default 12-months from the reporting date. A modified version of this is FASB’s Current Expected Credit Loss Model (CECL). With CECL, FASB requires financial institutions to set their ALLL according to each transaction’s Expected Loss (EL). One of the effects of IASB-9 and CECL is that ALLL for unimpaired loans will increase during an economic recession. Depending on how the financial institution implements the PD or EL grading, from top to bottom of an economic cycle the ALLL may increase significantly, e.g., by a factor of 10. However, with more careful choices in the ratings framework, the increase in ALLL may be much smaller, e.g., less than a factor of 2. This has a very significant effect on the reported solvency of the bank. Critically, the degree of this pro-cyclical swing depends on the choices made when the rating framework is first implemented by the institution. This paper outlines why the swing occurs and recommends how rating frameworks should be designed to minimize pro-cyclicality.
The Inherent Pro-cyclical Nature of IFRS-9 and CECL
Currently banks assess their Allowance for Loan and Lease losses (ALLL) only for loans classified as impaired. With IFRS-9 and CECL, ALLL will be based on the Expected Loss (EL) for all loans, including those which are not currently impaired. One of the concerns of the American Bankers Association is that the pro-cyclicality of CECL should be better understood. For IFRS-9 [...]

October 28th, 2015|

Cost-of-Funds for Commercial Real Estate

Introduction
This paper gives a brief introduction to cost-of-funds, (also known as transfer pricing) and the difficulties of setting the cost of funds for commercial real estate (CRE) lending operations. It then suggests a relatively straightforward approach which avoids these difficulties.
The Importance and Difficulty of Setting the Cost-of-Funds
The Cost-of-Funds (CoF) is the rate charged by the institution’s central treasury on money they give to individual lending units when those units request funds to lend on to customers. The CoF is the primary cost used in measuring a business unit’s profitability and typically it directly impacts the compensation of the lending teams. It therefore acts as a strong incentive in defining the nature of the assets being originated. Very simply:

The CoF has four potential components:

The risk-free rate for the term and rate profile of the loan to the customer
An operating cost
A subsidy from senior management to guide the relative growth of businesses
The cost of risk

This paper is focused on the cost of risk. A common practice is to link the cost of risk to the capital to be held for the asset. Pricing according to capital has several problems and is particularly difficult for CRE as CRE loans have long-terms and are highly-structured with time-varying risk profiles. Pricing according to the regulatory capital is especially problematic because regulatory capital typically only reflects the average risk of similar assets. The objective of regulatory capital is to ensure that the portfolio as a whole is backed by sufficient capital so regulatory capital does not necessarily reflect the risk of individual assets, and typically does not capture the changing risk profile of CRE assets over time. Regulatory decisions to require additional safety may also mean [...]

August 3rd, 2015|