Why Are CMBS Multifamily Delinquency Rates So High?

The 60 day delinquency rate for multifamily CMBS loans is skyrocketing. From a Fitch release:

Declining performance, particularly in oversupplied markets, as well as in secondary and tertiary markets, has pushed the multifamily delinquency rate to 4.55%, the highest of all property types. Multifamily properties have been highly susceptible to default in CMBS during the current economic downturn.

Fitch seems to suggest the problem is the asset class, but there’s something else at work – delinquency rates on Fannie and Freddie multifamily loans are less than a tenth of the CMBS figure. From an MBA release on June 2:

Fannie Mae: 0.34 percent (60 or more days delinquent)
Freddie Mac: 0.09 percent (90 or more days delinquent)

Why are the agency loans performing so much better? I think there are several factors at work, but the main reason is the originators of Fannie Mae and Freddie Mac loans had much to lose by selling bad loans to the agencies.

Most of Fannie’s multifamily business has been originated through their Delegated Underwriting and Servicing program. Fannie agreed to buy multifamily loans which were within their underwriting parameters without prior review. The originating lenders retained the top 5% loss exposure, and shared losses after that to a maximum of 20%. A very limited number of lenders were allowed to participate (never more than 30 nationwide). Sell a bad multifamily loan to Fannie under the DUS program, and you not only shared in the loss, you risked losing a valuable franchise.

Freddie took a different approach. They didn’t require originating lenders to share in the loss, but the ability to sell to Freddie was if anything even more tightly controlled, with a limited number of lenders restricted to specific geographic areas (see current list here). Again, sell a bad loan to Freddie, and you risk losing your franchise.

By contrast, CMBS origination was wide open. But, that may be changing. The lead story in yesterday’s Financial Times:

Treasury plans strict rules for securitisation

The US Treasury is planning a sweeping overhaul of securitisation markets with tough new rules designed to restore confidence by reducing the incentive for lenders to originate bad loans and flip them on to investors…

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared.

Would such a rule have prevented bad CMBS loans? Probably not; I believe the risk of franchise loss was a much more important determinant of lender behavior. But, it’s a start.

Don’t Blame Loan Officers for Poor Loan Performance

The Obama Administration thinks loan officer pay should be tied to the quality of their loans. From the Wall Street Journal:

The Obama administration has begun serious talks about how it can change compensation practices across the financial-services industry, including at companies that did not receive federal bailout money, according to people familiar with the matter…Among ideas being discussed are Fed rules that would curb banks' ability to pay employees in a way that would threaten the "safety and soundness" of the bank -- such as paying loan officers for the volume of business they do, not the quality.

This idea reflects a fundamental misunderstanding of how loan origination works. Loan officers do not approve their own loans; there is always some kind of credit approval structure with people other than the originator signing off. I’m not saying that system doesn’t break down (for example, see my post, “Why Did WAMU Abandon Underwriting Standards?”). However, if a lender does a lot of bad loans, it means senior management made bad decisions and/or looked the other way.

VoxEU addresses the issue in their article, “Bonus Incensed”:

Until the 1970s, the predominant institutional form for risk taking in financial institutions specialising in speculative trading was partnerships, with partners’ unlimited liability a central element.

Employees were entitled to bonuses, but entirely at the discretion of the partnership. Employee traders producing significant profits were very well paid; those generating losses did not get bonuses, were often dismissed, and even blacklisted. The partners had a highly developed sense of risk and their asymmetric exposure to it, in no small part because failure could also mean personal bankruptcy.

Partnerships have disappeared over time, and the predominant institutional structure in the financial industry is now the limited liability corporation. This transformation is a key reason for the emergence of the bonus culture, because it substantially reduces the incentive of senior management to monitor risk taking. Any financial institution engaged in speculated trading faces the inherent danger of individual traders taking so much risk that it threatens the firm. It is the role of the senior management to prevent that.

Their solution:

Financial institutions should adapt elements of partnership structures to the limited liability financial institutions of today. Senior management (the partners of old) need to have a substantial part of their compensation deferred over a long period of time, with the amount of compensation directly related to the long run fortunes of the firm. Any senior manager in an institution receiving public assistance should lose all of their deferred compensation. By contrast, the supervisors should not mandate deferral of trader bonuses or regulate junior employee compensation. This provides management with an incentive to check for gaming.

When I’ve been in a credit position, I’ve always been impressed with how effectively experienced loan officers triage their loan applicants. Spending time on a loan application which is not going to be approved is a waste of time, and good loan officers can’t afford to waste time. In my experience, applications for bad loans are almost invariably taken by inexperienced loan officers who don’t know a good loan from a bad one and/or who are desperate to establish a client base. Changing their compensation structure is not going to solve that problem – you need good credit people willing to say no to bad deals and senior management willing to back them up.

To the extent bad loans are originated, the problem lies with the lender’s credit people and senior management, not the loan officer.

The Commercial Real Estate Risk Culture at Deutsche Bank

Zero Hedge has published a letter from a former risk manager at Deutsche Bank which speaks to the difficulties of being a risk manager in a lending institution. Some excerpts:

For more than two years, I have been working internally to improve the inadequate governance structures and lax internal controls within Deutsche Bank. I joined the firm in 2006 in one of its foreign subsidiaries, and my due diligence revealed management failures as well as inconsistencies between our internal actions and our external statements.
Beginning in late 2006, my conclusions were disseminated internally on a number of occasions, and while not always eloquently stated, my concerns were honest. Unfortunately, raising concerns internally is like trying to clap with one hand. The firm retaliated, and this raises the question: Is it possible to question management’s performance without being marginalized, even when this marginalization might be a violation of law? Two years later, our mounting losses are gaining attention, and I offer my experiences and my thoughts in the hopes of contributing to the shareholder and public policy debate…

I joined Deutsche Bank in 2006 to build an investment business within its commercial real estate lending operation, and I was generally surprised by the aggressive sales culture within our firm. While many people consider the banking sector’s problems to be caused by residential lending, I witnessed multibillion-dollar loan proposals for commercial property.
With funds provided at more than 90 percent loan-to-value, these loans were “priced to perfection” and assumed that property prices and rental rates would continue to rise. For perspective, a single billion-dollar commercial real estate loan is equivalent to 2,000 residential loans of $500,000.
In general, my colleagues are hard-working, decent people, but the system of incentives encourages people to take risks. I have seen honest, high-integrity people lose themselves in this cowboy culture, because more risk-taking generally means better pay. Bizarrely, this risk comes with virtually no liability, and this system of O.P.M. (Other People’s Money) insures that the firm absorbs any losses from bad trades…

There’s much more at this follow up Zero Hedge post.

Related Post: Fox Guarding the Henhouse?  Bear Stearns Risk Manager Now at the Federal Reserve

Executive Compensation and Market Share

I’ve previously argued the decision by Fannie and Freddie to stray from conforming conventional loans was attributable to their CEOs' desire to earn their pay by maintaining market share. Bloomberg, reporting on testimony by Dan Mudd, Fannie’s former CEO, before the House Oversight and Government Reform Committee:

A June 27, 2005, internal presentation by Fannie shows the company at a “strategic crossroad” to either “stay the course” or “meet the market” by increasing risk and entering the subprime market. In staying the course, Fannie noted that it would continue to lose market share, and generate lower revenue and profits. In meeting the market, the document shows that Fannie identified the subprime market as a source of growth. “The choice was presented relatively starkly in order to identify what the key issues were,” Mudd said in response to a question from Representative John Tierney, 57, a Massachusetts Democrat.

I see this as a compensation issue – you can’t reasonably expect executives being paid eight figure annual compensation to take actions (or refrain from actions) which will result in loss of market share.

More on Banker Compensation

Compensation is a hot topic these days. From The Big Picture:

One of the maddening features of the financial crisis has been Wall Street’s constant insistence that without its mind-boggling compensation, talent will go elsewhere. On the face of it, this seems an empty threat from a group of hysterical prima donnas who don’t want to have to suffer the consequences for their actions. We focus a lot on pay for the top few at a public company (my, how that term has a new ring to it after the bailout) because public companies disclose the pay of those at the top.

Felix Salmon is ready to take the plunge:

Andrew Ross Sorkin is worried about what happens if you don't pay bankers enough money:

The trick, of course, is to dole out enough rewards to keep executives working, and working hard, but not to dole out too much...
Citigroup and other firms need to find ways to keep and attract talented people who can make smart decisions, without lavishing pay on them or rewarding them for shoddy performance...
Mr. Pandit and others -- to the extent you believe they are the right leaders of Citigroup -- or whoever takes their roles are unlikely to hang around if they're not amply paid.
The risk, Mr. Johnson said, is that if we taxpayers don't offer the possibility of a payday, we won't get the performance. "If you were in senior management and you knew you'd never get paid, you're not going to work as hard or you'll leave," he said. "It's actually worse if they stay. If you have a bunch of demoralized people hanging around, it will kill you."

I say, let's take the risk, and see what happens. I've now reached the point at which I simply don't believe people when they say that lower pay for bankers will result in worse performance -- especially since it looks very much as though it was higher pay for bankers which was at least partly responsible for much of the present crisis. Let's bring down pay, a lot, and see whether performance really falls.

Angry Bear provides a link to a history of the legislative efforts to limit executive compensation (the short story – meaningful restrictions were not passed).

Finally, Richard Epstein touches on the topic in a very interesting podcast on Happiness, Inequality, and Envy. Epstein believes the reason the wealthy are not measurably happier than others is that they have undertaken jobs whose conditions make them unhappy in exchange for high compensation. Pity the poor investment bankers who have to work 18 hour days and fly to Europe at a moment’s notice to close deals – where would the world be without them? We don’t envy them, because we understand the highly compensated bear a heavy burden. As Epstein notes, nurses don’t envy doctors, but the idea of people not pulling their weight makes us crazy.

I don’t think Epstein has it quite right; I’m with Felix on this one. I had one of those jobs. The work was challenging and felt important, and the people I worked with were interesting. Of course, the hours were long and travel gets old, but nice hotels and five figure closing dinners go a long way towards easing that pain. Is it really necessary to pay mid six figures and up to find good people to make that kind of sacrifice? I think not.

Epstein is right about the “pulling your weight” part. That is precisely why Robert Rubin disclaiming any responsibility for Citigroup’s problems makes people crazy.

 

 

Internalizing, Externalizing, and Compensation

There’s a great post at Naked Capitalism skewering Robert Rubin for his unwillingness to take responsibility for his role in Citigroup’s troubles. Rubin is an externalizer – bad things happened as a result of external forces and other people beyond his control (the opposite is an internalizer, who, when bad things happen, attribute the cause to themselves).

As Yves points out, it’s a little hard to justify paying someone $115M if, when things go badly, they claim they couldn’t have influenced events.

Fox Guarding the Henhouse? Bear Stearns Risk Manager Now at the Federal Reserve

Carol Baum has an opinion piece on the Bloomberg site about the New York Fed decision to hire Michael Alix, who was former chief risk officer at Bear Stearns at the time of its collapse. This story is interesting in itself, but it also provides an update on the status of a number of others associated with financial fiascoes, all of whom appear to have landed on their feet. Hopefully this is survivorship bias at work. I would like to believe for every scoundrel who lives happily ever after there are ten scoundrels toiling as clerks at Walmart whose stories won't make the paper.

Actually, as a former chief credit officer (for a much, much smaller organization than Bear Stearns, just $12B in income property loans), I have some sympathy for Mr. Alix. Although he had the chief risk officer job since just 2006, Alix was an 11 year employee at Bear and he had to be aware of the high wire the company was walking. But, if you were him, what would you do with that knowledge?

I think an apt analogy is the classic WWII movie scene in which there's a bunch of guys in a foxhole, and the enemy throws a hand grenade into the hole. Some credit officers in that situation see their role as saying something like, "Excuse me, but an object that looks like a hand grenade is now in our foxhole, and if it is a hand grenade and it explodes we could be injured or killed. But it might not be a hand grenade, and if it is it might not explode, and even if it does explode we might survive." Under this approach the credit officer has done his duty, tried to mitigate risk within the system, and he and his compatriots are probably dead.

Another approach is for the credit officer to yell "Grenade!" and, if no one reacts, throw himself on it. This would be the equivalent of telling your coworkers they're screwing up, and if they don't stop, calling up your regulator to shut the place down. Like throwing yourself on a grenade, this involves some personal risk and a great deal of courage. Here's a link to the fascinating story of a former coworker of mine who took that route at Indymac.

A third route is to shout "Grenade!" and, if no one reacts, exit the foxhole as quickly as possible. I think most people would say this is the course of action Mr. Alix should have taken, and before 2001 I think I would have agreed without thinking much about it. When I took my first big credit job (1997), I viewed myself as a circuit breaker. If the company I worked for overloaded, I would trip, and while I knew I was probably done with that company I thought I could go to another company who needed a circuit breaker. When the 2001 recession started and it made sense to turn deals down, it dawned on me that finding a replacement position during a recession might not be all that simple. The times when an assertive credit person is most likely to find his or her services no longer needed are the times they are least likely to find a new job. My response to this realization was to stockpile food in the basement and prepare for a long period of underemployment if necessary (thankfully, it wasn't), but another understandable approach would be for the credit person to step back and not make waves.

Compensation enters into this balancing act, but not in the obvious way. The standard view is that a credit person sells their soul to keep the big bucks rolling in, and I am sure that happens. However, the converse is also true; if you're not financially independent doing the right thing can be a hardship. This is especially true if others are dependent on you. Economists would like to believe you can structure compensation to incentivize people to do the right thing. I don't think that's possible with credit officers; in the end it's a character issue, not an economic one.

So, I have sympathy for Mr. Alix; he was in a difficult situation facing difficult issues. But, he should not have been hired by the Fed, as any economist knows. A basic tenet of principal-agent theory is that the threat of termination of the relationship is one of the ways to keep an agent from acting against the interests of the principal. If a credit person knows association with a major financial disaster will terminate his or her credit career, he or she is more likely to do the right thing. The hiring of Mr. Alix by a regulator to be a regulator is the most effective action I can think of to undermine that principle.