Publication

Validation of the Specialized Finance System

Introduction
Commercial real estate (CRE) is a complex asset class with a relatively long investment horizon which makes it hard to assess the long term risk of any given deal. Furthermore, as an asset class that tends to constitute a significant portion of the balance sheet, having a rigorous and comprehensive risk management platform should be a key objective of any financial institution involved in CRE lending or investment.

In this note we present results from a recent study of the predictive ability of the Specialized Finance System (SFS). The SFS is a comprehensive risk management platform for CRE that provides in-depth analysis to address the needs of financial institutions lending to or investing in CRE. The results show that the SFS provides very good discriminatory power that can help an institution improve the management of their CRE assets.
Data
The validation study is based on three snapshots (in time) of a well-diversified income producing CRE portfolio plus information about which deals had defaulted and the time of their default1.

The portfolio snapshots consisted of complete deal information, including all financing and property variables (incl. rent-roll) for each deal within the portfolio at a given point in time;

September 2007
September 2008
September 2009

The snapshots thus allowed us to evaluate how the SFS performed in the environment leading up to the onset of the recent financial crisis (i.e., the default of Lehman Brothers in September 2008) as well as the first couple of years into the crisis.
Methodology and Results
We conducted a discriminatory power test by taking all deals in a given portfolio snapshot, e.g., September 2007, and grading them using the SFS with neutral macro-economic outlooks. We recorded the results and [...]

  1. The recorded defaults stretched from 2007 through 2012 ↩
January 14th, 2014|

Beyond the Simplicity of DSC and LTV

All Publications >> Risk Methodology

The credit risk of a Commercial Real Estate (CRE) deal is associated with a highly complex and non-linear deal structure. Historically the approach to assessing the risk has therefore been to try and reduce the complexity to a linear weighting of key factors or ratios, e.g., into a scorecard. The weights assigned to each factor may be determined either through expert judgment, or if sufficient data is available, through a regression analysis. A scorecard has the advantage of being easy to explain and simple to understand. A very simple example of such a model would be to have a look-up table using Debt Service Coverage (DSC or DSCR) and Loan-to-Value (LTV) to assess the risk of a CRE deal.

In this paper we will demonstrate that taking such a simplified approach does not capture the essential risk of a CRE deal over time. Two deals with the same DSC and LTV may have significantly different risk profiles when looked at in their entirety. In fact, for the example provided in this paper, the risk (and therefore the economic capital and price) can differ by more than a factor of ten. This has significant implications for institutions that are subject to regulatory capital that is mainly dependent upon only DSC and LTV.

November 19th, 2013|

Linking Market & Credit Stresses to Economic Stresses

Introduction
This paper describes a mathematically rigorous approach for defining market and credit stresses given a set of economic stresses. This approach is directly applicable to regulatory stress-test reporting.

Recent regulations such as CCAR and Basel III have adapted the long-standing risk measurement approach of stress-testing and made it applicable to new regulatory purposes. The current regulations require institutions to estimate losses in a base-case and in a stressed condition in which the condition is defined by stresses on a selection of macro-economic variables such as GDP and interest rates. A very direct estimate of the risk can then be obtained by using risk models that include economic and market conditions, for example regressions on historical default data where market conditions are included in the regressors1, or cashflow simulation where the cashflows are conditional on factors such as vacancy and rental rates. However, these direct approaches require the estimation of the remaining market conditions or credit factors that are not already specified in the regulatory stress.
Approach
As an example, consider the task of assessing the increased risk of loans to commercial offices in Pittsburgh, conditional on a set of regulatory stresses. Intuitively we know that if macro factors such as GDP are depressed, then market factors such as rents and vacancy rates will also tend to be worse. However, for any given level of GDP, the exact change in the market factors will be uncertain, e.g., if GDP was down 4%, rents might fall 10% on some occasions or 25% on others. More formally, defining the overall economic conditions removes much of the systemic risk, but leaves idiosyncratic risk[2. Here the term “idiosyncratic” can have different [...]

  1. See Risk Integrated’s paper: “Linking Stress Tests to the Real Economy" ↩
October 24th, 2013|

Capital, Arbitrage and CRE Lending

All Publications >> Capital Management

Risk Integrated’s latest white paper explores the pricing distortions likely to be caused by the latest regulatory capital proposals for commercial property loans and the subsequent opportunities for profit and loss. For the full text please use the following link:

September 3rd, 2013|

Enterprise Risk Management and Commercial Real Estate Lending

All Publications >> Risk Methodology

This paper discusses how Enterprise Risk Management (ERM) can be implemented horizontally across asset-classes and vertically up the chain of risk management functions for each asset, with a particular focus on integrating commercial real estate into an ERM framework.

July 3rd, 2013|

Beyond Regulation: Using Risk Measurement in Profitably Growing the Commercial Mortgage Business

All Publications >> Portfolio Management

March 6th, 2013|

Asia Looks to Cloud Computing

All Publications >> Implementation Technology

In the December 2012 issue of AsiaRisk magazine, Risk Integrated is featured in a lengthy article on vendors providing their services via cloud computing. For many banks in the region, cloud computing is the latest, greatest innovation in computer technology. The creation of huge pools of processing and data management resources, made available online and on demand, are expanding their access to complex technology otherwise not affordable or manageable in-house.

Please contact us for a full copy of the article.

December 19th, 2012|

Deutsche Pfandbriefbank Selects Risk Integrated's SaaS Offering for CRE Risk Reporting

All Publications >> Case Studies | Implementation Technology

PBB is now using Risk Integrated's SFS SaaS, which is a fully outsourced solution, to further improve the effectiveness, quality and management of the risk reporting on their commercial real estate loans and the portfolio's risk profile.

November 5th, 2012|

Cloud Computing Revolutionizes CRE Risk Management

All Publications >> Implementation Technology

Cloud computing is quickly changing the entire financial services industry in the U.S. and Europe. Many simple and complex software applications are now available to industry professionals via any browser window. More complex financial software applications are following closely behind. For example, in risk management for commercial real estate lending, the migration of risk models to the cloud makes sense because of the huge reduction in operating expenses for a financial institution and a fantastic improvement in computational time.

September 7th, 2012|

Cloud Computing for CRE Risk Management

All Publications >> Implementation Technology

With the cloud, the increase in the computational power now makes it possible to do a much better job in quantifying, differentiating and structuring the risk in commercial real estate deals.

August 6th, 2012|