06/08/2009 05:12 am ET Updated May 25, 2011

The Stress Tests and Commercial Real Estate

As part of its ongoing program to restore confidence in the financial system and safeguard banks' ability to lend to creditworthy borrowers, the Board of Governors of the Federal Reserve made public the results of the bank stress tests (formally, the Supervisory Capital Assessment Program) after the market's close yesterday. Engineered to uncover the potential losses at each nation's nineteen largest bank holding companies under baseline and "more adverse" economic scenarios, the tests have established new capital requirements for each institution.

The genesis of the banks' challenges has been the losses in their respective residential mortgage portfolios. But the spillovers of the housing crisis into the real economy have inevitably undermined the performance of banks' consumer lending, commercial and industrial lending, and commercial mortgage lines of business. Under the stress tests' more adverse scenario, losses on commercial mortgage portfolios -- which in the Fed's definition include land and development loans for houses -- amount to $53.0 billion in 2009 and 2010. The implied loss rate of 8.5% is well below the 22.5% loss rate estimate for credit card loans but higher than the 6.1% loss rate estimate for commercial and industrial loans. For the 18 bank holding companies with commercial real estate exposures the loss rate estimates range from 2.1% for MetLife to 45.2% for Morgan Stanley.

A string of high-profile commercial mortgage defaults over the last few months has pushed commercial real estate into an uncomfortable spotlight. Investors' general assessment that commercial mortgage distress will increase sharply over the coming quarters is consistent with two clear trends: on one hand, deteriorating property fundamentals are impinging on the highly-levered borrower's capacity to meet its recurring principal and interest obligations. At the same time, the paucity of credit is coinciding with a rising volume of maturities. Real Estate Economics estimates that, excluding land and development loans, $246 billion in commercial mortgages will mature in 2009. An even larger number will mature in 2010. As a result of the imbalance in the supply and demand for credit, default rates are expected to double from their current levels by the end of this year. By our measure, they have already doubled from the levels that prevailed at this time a year ago. Bank credit officers' own assessments of the commercial mortgage outlook are sobering. The results of last week's Federal Reserve Senior Loan Officer Survey show that over 90% of domestic banks except commercial mortgage quality to deteriorate. One in four domestic banks and over half of the foreign banks with offices in the United States expect that deterioration to be substantial.

Within commercial mortgage pools themselves, the seeds of deterioration were sown in the collapse of underwriting quality -- in the domain of commercial mortgage-backed securities, in particular -- which characterized the market in the preamble to the current crisis. As for policy makers' assessments, the stress tests' commercial real estate loss estimate is less than 9% of the bank holding companies' total estimated losses in the economy's downside scenario. We view this to be implausibly optimistic. The combination of property price declines, the imbalance in the demand and supply of credit in support of pending maturities, and the deterioration in collateral properties' capacity to meet current principal and interest obligations all suggest that the downside case for bank holding companies' commercial real estate holdings is more severe than for the broader economy. An adverse scenario with aggregate losses in excess of 20% is not inconceivable.

In support of their tests, the agencies required that each bank holding company submit information on the characteristics of its portfolio, including property types, location, loan-to-value ratio, debt service coverage, and maturity schedules. Separating construction, multifamily, and non-farm non-residential loans and employing internal and vendor models, the examiners estimated loss severities relating to the refinancing risks for loans maturing in 2009 and 2010, as well as the term risks for loans with later maturity dates. As for the question of how assumptions for economic growth, house prices, and unemployment have supported an assessment of commercial mortgage default rates, we know little more.

Aside from questions about the appropriateness of the baseline and adverse economic scenarios -- for example, the adverse unemployment rate scenario seems to underestimate the severity of the contraction in the labour market -- investors should consider the results of the commercial real estate tests with skepticism. Few if any models of commercial real estate mortgage performance have been proven robust in anticipating mortgage defaults and loss severity. The pervasiveness of poor underwriting and the credit rating agencies' green-lighting of CMBS deals in 2006 and 2007 is evidence of this. Absent a more complete disclosure of modeling approaches and data quality, it is impossible to determine if the tests employed by the agencies (i) capture the risks of individual commercial mortgages with any degree of accuracy or (ii) are unbiased in their assessments of banks' whole commercial mortgage portfolios.

Whether the stress tests accurately capture the outcome of the "what if" scenario is of critical importance. Rather than being able to accept or dismiss the report, the absence of transparency around the inner workings of the tests themselves renders the exercise of limited relevance. Neither investors nor the public should accept policy makers' and regulators' assertions that the tests of commercial real estate have been undertaken carefully. The onus rests with policy makers to validate the tests' conclusions. In the most extreme case, the deterioration in the performance of banks' commercial mortgage pools may threaten the stability of specific institutions and, by extension, the stability of the financial system. If not at the largest banks that will benefit from government support, the risks are real for the hundreds of smaller regional and community banks that may have more concentrated commercial real estate portfolios. In either case, the stakes are too high for us to acquiesce to an opaque determination of commercial real estate portfolios' robustness.