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Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices Originally presented as a part of a Moody’s Analytics/PRMIA webinar | June 2014 SUMIT GROVER, ASSOCIATE DIRECTOR, PRODUCT MANAGEMENT CHRISTIAN HENKEL, DIRECTOR, RISK CONSULTING

Commercial Real Estate Credit Risk Solutions and Best Practices

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Page 1: Commercial Real Estate Credit Risk Solutions and Best Practices

Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices Originally presented as a part of a Moody’s Analytics/PRMIA webinar | June 2014

SUMIT GROVER, ASSOCIATE DIRECTOR, PRODUCT MANAGEMENT CHRISTIAN HENKEL, DIRECTOR, RISK CONSULTING

Page 2: Commercial Real Estate Credit Risk Solutions and Best Practices

2 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Agenda

1. Credit Risk Management Challenges

2. Best Practices

3. Stress Testing Model and Approach

4. CRE Risk Tools

5. Questions

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3 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Speakers

Sumit Grover is an associate director of product management with Moody’s Analytics in San Francisco. He manages Commercial Mortgage Metrics and also supports other commercial real estate offerings including spreading, scoring and stress testing solutions. Sumit holds an undergraduate degree in Information Systems and a MBA from Indiana University Bloomington.

Chris Henkel is a Director in the Enterprise Risk Solutions group with Moody’s Analytics where he leads the risk measurement delivery team throughout the Americas. He has vast experience offering advisory services and custom quantitative risk solutions to clients. Chris has served as a credit risk instructor and is a frequent lecturer in industry conferences and organizations. He received his master’s and undergraduate degree from the University of Texas and graduated Valedictorian form the Southwestern Graduate School of Banking at Southern Methodist University.

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4 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

CRE Credit Risk Management Challenges 1

Page 5: Commercial Real Estate Credit Risk Solutions and Best Practices

5 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Challenges in CRE Risk Management

Updated Property

Information

Valued - $95M in 2007

Now?

Foresight into Market

Fundamentals

Intuition vs quantitative validation

Assessing the impact of macro

economy

Default history and modeling

expertise

• Data captured at origination may not be complete for data analysis.

• Data management is important for historical and

forward looking analysis

• Sound forecast that differentiates between property

types and submarkets is

important is not available

• Default history over multiple

credit cycles and from multiple

sources is important for

sound modeling and CRE data history is not

captured

• Several qualitative factors can impact the analysis and

risk measures and integrating quantitative models with

intuition can be a challenge

• Different cities and neighborhoods

react differently to an economic recession or expansion

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6 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

CRE Best Practices 2

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7 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Insufficient income (NOI) to make the mortgage payment• Rising vacancy and loss of rental income during recessions• Deterioration of certain neighborhoods or properties even during

boom years

Perceived inability to sell the property for the loan amount • LTV comes into play when the borrower is having cash-flow problem

or during the time to refinance

Lack of reserves and additional outside resources available to cover cash flow shortfalls • Both ability and willingness to pay shortfalls decrease during

recessions • Size of shortfall likely to matter: $1 million >> $1000

Understanding why CRE credit events occur

Page 8: Commercial Real Estate Credit Risk Solutions and Best Practices

8 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Employing a modeling framework that reflects business practices

Starting with collateral • Forecasting cash flow

under various scenarios

• Property value influences default decision mostly during cash flow stress

• Macro and local market condition matters

Modeling default behavior

• Option A: Continue payment out of pocket, expecting market recovery

• Option B: Default on loan

Empirical Evidence • Inability to reach

consensus triggers credit events

• Borrowers are more likely to default in a recession than in an economic expansion

Page 9: Commercial Real Estate Credit Risk Solutions and Best Practices

9 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

A granular market forecast can improve model accuracy

$-

$500

$1,000

$1,500

$2,000

$2,500

$3,000

0 1 2 3 4 5 6 7 8 9 10

A forecast should:

• Differentiate between different cities and neighborhoods to identify high risk concentration

• Provide visibility into how market behavior might change under various economic conditions

Using a multi-pass forecasting to identify the volatility in individual property value and income can help improve confidence in the model

Page 10: Commercial Real Estate Credit Risk Solutions and Best Practices

10 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Default history should span across the industry and economic cycles

Data Source: Mortgage Bankers’ Association

- Different segments/origination groups have experienced each

economic cycle uniquely

- Insurance segment saw high losses in the early 90’s and have since been able to maintain high

quality portfolios

- Commercial banks experienced moderate losses in the recent

financial crises

- CMBS portfolios experienced highest losses in the recent crisis

Page 11: Commercial Real Estate Credit Risk Solutions and Best Practices

11 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

CRE Stress Testing Model and Approach 3

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12 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Items Commonly Stressed

» Income (revenues) » Expenses » Rates on interest earning assets » Rates on interest bearing liabilities » Provisions for loan losses » Balances and volumes » Non-performing loans » Charge-offs » RWAs » Capital levels (regulatory and economic) » Capital ratios

Our focus for today is on the loss forecasting components of stress testing

-1.00%

0.00%

1.00%

2.00%

3.00%

4.00%

5.00%

6.00%

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

Total RE C&D CRE Multifamly

NCOs/Loans (1992-2013) All FDIC Insured Institutions

Source: FDIC

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13 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Stress testing loan losses is not a new concept - but it has our attention now more than ever

» Historically based on stressed loss-rate analysis based on call report categories

» “Top-down” approach with a focus on material credit concentrations

» Loss rates applied to specific segments

» Included scenario and sensitivity analysis:

- “What if” questions - Impact on earnings and capital - Integrated with overall risk management,

ALCO, and capital planning

» Still relevant for smaller institutions

» Loose link between macroeconomic conditions to stressed losses

Common Approach to Stress Testing (pre-DFAST) Enhanced Approach and Requirements

Page 14: Commercial Real Estate Credit Risk Solutions and Best Practices

14 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

If unemployment rate rises above 10%, what would be the impact to the credit quality in my CRE portfolio?

0

2

4

6

8

10

12

Q12001

Q42001

Q32002

Q22003

Q12004

Q42004

Q32005

Q22006

Q12007

Q42007

Q32008

Q22009

Q12010

Q42010

Q32011

Q22012

Q12013

Q42013

Q32014

Q22015

Q12016

Q42016

Une

mpl

oym

ent R

ate

(%)

Quarter

US Unemployment Rate

Actual Projected (Fed Sev. Adverse)

Source: Federal Reserve

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15 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Translation Engine

Cap Rate

Rent Vacancy

It is important to first translate the forecast of macrovariables into a forecast of RE variables

CRE loans

Macroeconomic Scenario

Translation Engine

Fed Fund Rate

GDP Unemployment Rate

National and Local Real-Estate Market

Factors

Forward-looking Volatility

Stressed Losses

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16 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Changes in unemployment certainly influence changes in real estate factors, but differently through time

Recession Trough to Peak Unemployment Rate Change

Trough to Peak Vacancy Rate

Change

∆𝑉𝑉𝑉𝑉𝑉𝑉𝑉∆𝑈𝑉𝑈𝑈𝑈𝑈𝑈𝑉𝑈𝑈𝑉𝑈

2001-2002 2.2% 5.6% 2.5 2008-2010 5.4% 4.5% 0.8

Comparison of Changes in Vacancy Rate and Unemployment Rate (1988 – 2013)

Page 17: Commercial Real Estate Credit Risk Solutions and Best Practices

17 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

With a stressed RE forecast, we can estimate factors such as DSCR and LTV – and, in turn, PDs and LGDs

NOI

Debt Service

T t0 t

Distribution of future NOI

A

B

C

Realized NOI

Point

DSCR

A 1.20

B 0.95

C 0.30

Note: Values do not necessarily reflect actual model coefficients; they are presented to illustrate the

concept.

…calibrated to the historical experience

Empirical Default

Rate

0.50%

5.00%

15.00%

Empirical Loss Given

Default

5.0%

25.0%

40.0%

Future values of NOI relative to debt service…

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18 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

In the end, the impact of a given scenario can be translated into a loan-level estimate of expected loss

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19 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

CRE Risk Tools 4

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20 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

What is CMM® (Commercial Mortgage Metrics)

» CMM is the leading analytical model and risk management tool for assessing credit risk in commercial real estate loans

» CMM offers:

» State-of-the-art model

» Built on extensive, proprietary dataset and calibrated to recent financial crisis

» Flexible framework that allows clients to customize the models

» Robust scenario analysis/stress testing capabilities that support regulatory compliance

» Enterprise-class software

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21 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

CMM Inputs, Outputs & Uses

CMM Inputs » Loan Details

» Loan Amount, Term/Amort * » Rate: Fixed, Floating, Other * » Structure *

» Property details » Property type, Location,

Property Value, NOI * » Rent, Vacancy, Cap Rate, Lease

rolls, Expenses

» Asset Volatility » Systematic and Idiosyncratic

volatility

* Required input

CMM Outputs » Estimated Property Value

» Estimated NOI

» Expected Default Frequency (EDF)

» Loss Given Default (LGD)

» Expected Loss (EL)

» Yield Degradation (YD)

» Stressed Risk Measures » Stressed PD, LGD

» Unexpected Loss

» Implied Moody’s Rating

» Customer Rating (Based on customer rating scale)

CMM Uses » Stress Testing

» Identify sources and causes of risk

» Price new loans

» Monitor loan expected performance as markets change

» Early Warning System

» Identify loans for potential sale

» Identify periods of maximum risk

» Respond to management and regulators

» Efficiently size capital allocations vis-à-vis competing asset classes

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22 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

CMM capabilities at a glance

» Report risk measures at portfolio and loan level; also integrated with our spreading,

loan origination and stress testing solutions » Supports back-testing by allowing historical analysis on a portfolio » Supports regulatory stress testing, by enabling you to generate risk measures under

ECCA, supervisory scenarios and user-defined (organization specific) macroeconomic scenarios into CRE specific forecast and determine related losses on your portfolio

» Provides flexible framework that is adjustable to your default experience

Save your CRE portfolio on the Cloud and access from anywhere

Combine your CRE portfolio and macro forecast and instantly see the impact on risk measures

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23 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Spread, Score, Store, Workflow & Reporting Solutions

Financial Analysis CRE Data Templates -Income Producing -Land Development -Home Builder

Data Collection Consistent

Single Source – RiskAnalyst & RiskOrigins

Scorecards Quantitative

EDF/LGD score combined with qualitative factors

Scoring

CMM EDF & LGD

Scenario Analyzer Dashboard

Portfolio Reports

Stress Testing

Page 24: Commercial Real Estate Credit Risk Solutions and Best Practices

24 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Questions 5

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25 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

Thank you.

Page 26: Commercial Real Estate Credit Risk Solutions and Best Practices

26 Commercial Real Estate (CRE) Credit Risk Solutions & Best Practices, June 2014

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