Stress Testing

Introduction
We are living the stress test. In this crisis it is the responsibility of risk managers to avoid compounding the medical and economic crises with a financial one. For commercial real estate lenders this means understanding the potential impact on borrowers and getting ahead of the game to restructure their loans and avoid the costs and dislocations of bankruptcy. That restructuring needs to be economically sensible, robust to the range of different possible outcomes, and transparent so that investors do not need to have unfounded fears of financial difficulties.

The financial industry has been increasingly guided by financial risk models. However, normal credit models have been broken by the COVID-19 crisis because there is no historical default data for such an event. Now banks are turning to scenario analysis. That too has limitations, because it only tests a handful of possibilities. In this note we are looking at what can be learned from cashflow simulation. For those unfamiliar with scenario analysis and simulation, Appendix 1 gives a brief introduction.

The note is organized in four sections:

Qualitative discussion of the short and medium-term impacts on real estate
Converting those considerations into specific scenarios that will drive cashflows
Quantification of the increased risk of default for a typical deal
The effectiveness of restructuring alternatives

Of the restructuring alternatives tested, an 18-month interest roll-up and a sweep were effective in reducing the loss.
Qualitative Discussion of the Impacts on Commercial Real Estate
In the next few months there will be historic levels of unemployment, economic disruption and government interventions. These will play out unevenly across geographies and sectors.

Looking at the short term there will be lease defaults by “non-essential” retail businesses and many office-based businesses. It will be nearly impossible to [...]

Introduction
Risk Integrated, the leading provider of client-specific risk systems for CRE, has run its Specialized Finance System (SFS) with the 2015 CCAR scenarios published by the Federal Reserve Board (FRB). The analysis shows the base, adverse and severely adverse losses for a standard US bank’s portfolio of commercial real estate loans.

The key results are the quarterly expected losses for the portfolio as illustrated below:
Figure 1. Quarterly Expected Loss

Table 1. 9-Quarter Cumulative Loss Rates

Loss estimates are shown under four different sets of assumptions: the unconditional base case, the conditional base case, the conditional adverse scenario and the conditional severely adverse scenario. The unconditional base case takes the FRB’s base-case to be the central tendency for the economy, but still allows for variations in economic and market conditions. The conditional case takes the economic scenarios to be fixed, i.e., the conditional base-case gives the losses conditional on it being known that the overall economy will be benign.

The SFS estimates these results using a transparent detailed cashflow simulation model. The model projects the debt servicing cascade and collateral values for the individual deals in thousands of alternative economic and market scenarios conditioned by the central forecasts and the historical volatility structures. These market conditions interact with idiosyncratic risks such as tenant defaults and re-leasing to determine whether the loan will default and if so, what will be the subsequent loss (if any). The models are completely transparent and can by customized by each client to match their markets, deal structures, available data and experience. In this case the limited data set of the FRY-14Q is used, but the model uses more detailed information per asset if it is also being used for grading and Basel capital.

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All Publications >> Stress Testing

In a full presentation, Risk Integrated's Dr. Chris Marrison explains in detail the objectives of stress testing the commercial real estate portfolio. He discusses the shortcomings of the current prevalent methods such as adapting C&I stress testing models for use with very different CRE loans. In conclusion, full cashflow simulation is shown to be the most flexible, durable approach.

Please contact us Risk Integrated for a full copy.

All Publications >> Stress Testing

Improvements to a facet of Risk Integrated's Specialized Finance System were launched today by Risk Integrated to help risk and portfolio managers stress portfolios of highly varied asset types, including retail and corporate lending and mortgages, CRE, equity and securitizations.