Borrower Risk, Net Worth, and Liquidity

You are considering making a $10,000,000 loan to one of two borrowers. Both borrowers have a $10,000,000 net worth and $1,000,000 in cash. Your astrologer has told you one borrower will default and the other won’t, but she can’t tell you which one. You are allowed to ask each borrower three questions. What do you ask?

Here are my questions:

What are your total liabilities (contingent and non-contingent)? A borrower with $10,000,000 in net worth with $20,000,000 in assets, $10,000,000 in liabilities and $1,000,000 in cash is a great risk. A borrower with the same net worth and liquidity comprised of $100,000,000 in assets and $90,000,000 in liabilities is toast in a significant downturn.

How did you make your money? If the answer is investing in the same market and kind of real estate as the loan you are considering (for example, multifamily in Dallas), the borrower is a good risk. Any other answer (selling a software company, dentistry, UPS driver, playing poker, aerospace engineer) is a problem. I know this from personal experience because I’ve approved and subsequently regretted making loans to borrowers with these former occupations. Each time I thought we had mitigated the risk – I now believe you can’t mitigate inexperience.

What was the value of CRE assets you owned in 2001? The answer should be at least $2,000,000 – enough to tell you they had some holdings in the last downturn. If the answer is less than that it means they made all their money in easy times. Ideally, a borrower would have been through the 1989-1994 trough, but those guys all have a net worth a lot bigger than $10,000,000.

I believe the answer to these three questions tells you pretty much everything you need to know about a borrower.

Illiquidity = Risk, Commercial Real Estate is Illiquid, Therefore Commercial Real Estate is Risky

Illiquid investments are risky. From the Knowledge at Wharton Post “Why Economists Failed to Predict the Financial Crisis”:

"When there's a default in one kind of bond, it causes reassessment of all the risks," says Wharton economics professor Richard Marston. "I don't think we have really fully learned from the LTCM crisis, or from other crises, the extent to which things are illiquid." These crises have shown that market participants can rely too heavily on the belief they can quickly unload securities that decline in price, he says. In fact, the downward spiral can be so rapid that it leaves investors with losses far larger than they had thought possible.

In the current crisis, he says, economists "should get blamed for the overall unwillingness to take into account liquidity risk. And I think it's going to force us to reassess that."

The dotcom bust and accompanying recession had little effect on commercial real estate market, in part because problems were concentrated in high tech markets, and mostly because falling interest rates freed up cash flow and boosted leveraged returns. You need to go all the way back to the early 1990’s to recreate the current sensation of free falling commercial real estate values. Almost twenty years was plenty of time for investors who had no idea how illiquid CRE can be to enter the market (see my post Waves of Stupid Money for a discussion of how investors who don’t understand the risks can skew a market).

Complexity, Predictability, and Cascade Effects

Duncan Watts has a great piece in the The Boston Globe titled, “Too Complex to Exist.” I love the illustration:

Some excerpts:

ON AUG. 10, 1996, a single power line in western Oregon brushed a tree and shorted out, triggering a massive cascade of power outages that spread across the western United States. Frantic engineers watched helplessly as the crisis unfolded, leaving nearly 10 million people without electricity. Even after power was restored, they were unable to explain adequately why it had happened, or how they could prevent a similar cascade from happening again - which it did, in the Northeast on Aug. 14, 2003…

Traditionally, banks and other financial institutions have succeeded by managing risk, not avoiding it. But as the world has become increasingly connected, their task has become exponentially more difficult. To see why, it's helpful to think about power grids again: engineers can reliably assess the risk that any single power line or generator will fail under some given set of conditions; but once a cascade starts, it's difficult to know what those conditions will be - because they can change suddenly and dramatically depending on what else happens in the system. Correspondingly, in financial systems, risk managers are able to assess their own institutions' exposure, but only on the assumption that the rest of the world obeys certain conditions. In a crisis it is precisely these conditions that change in unpredictable ways.

In the article Watts proposes some regulatory steps to limit the complexity of financial systems. I am not optimistic; it is very hard to restrict activities until a problem is obvious (see my post “Rising Markets Create Lender Losses” for more on this). I think a more pragmatic route is for institutions to create firewalls within the organization so that the failure of one business line doesn’t take the whole institution down (e.g., AIG’s CDS operation pulling down the insurance business).

Debacle at 250 Montgomery Street: Other People’s Money

GlobeSt.com has a story about the debacle at 250 Montgomery Street in San Francisco:

Realty Finance Corp. of Connecticut has sold its original $47-million loan on a class A office building here for approximately $25 million or $200 per square foot, according to a source familiar with the transaction. The building is 250 Montgomery St., a 15-story, 126,736-square-foot office building completed in 1989 at a cost of about $41 million.

The borrower, Lincoln Property Co., paid approximately $47 million or $405 per square foot for the building in late 2006 and defaulted on the loan in late 2008. Prior to the note sale Lincoln agreed to hand over the property to its new creditor in lieu of foreclosure…

In its first quarter filing with the SEC in March, Realty Finance said the loan matured in March 2009 without payment, pushing it into default. At the time, Realty Finance expected to lose between $0 and $11 million on the sale. The actual loss appears to be closer to $22 million. Whitehall Street Real Estate Funds reportedly had an additional equity position in the building that has been completely wiped out.

So Lincoln paid $47 million in 2006, Realty Finance loaned $47 million, and Whitehall had an equity position? That would suggest Lincoln had little if anything in the deal at any point. Call me old fashioned, but when a major investor like Lincoln (which at the time was perfectly capable of raising cheap equity or borrowing at a low cost of funds) brings in an equity partner like Whitehall, the only conceivable reason is to eliminate it’s risk in the deal. Red flags should go up under these circumstances – I’d love to know what Whitehall and Realty Finance were thinking.

The Commercial Real Estate Landslide

Disasters are interesting, as evidenced by the success of shows like Destroyed in Seconds (30 minutes of one disaster after another, courtesy of the Discovery channel). A while ago the show aired this video of a landslide in Japan:

The images have stuck with me, and I think there are some strong parallels to what is going on in commercial real estate:

• First and most obviously, a disaster is going on, and if you’re in its path it’s a very bad thing.
• As bad as it is for those to be caught in the path, it’s important to realize the whole mountain is not involved. The landslide affects only a portion of the exposed area of the mountain – most of the mountain remains unchanged.
• The earth in the landslide moves from an unstable position to a stable position.

I was reminded of these facts while visiting with a very experienced real estate investor last weekend. I’m guessing he was in his 70’s, and had some money in a development deal that has a poor prognosis. In this CRE landslide he is going to lose a small portion of his net worth in an unstable deal which was exposed. But, he is confident he will buy other people’s exposed deals at stabilized, lower prices which will recover his losses and more over time.

It’s easy to forget that most CRE is not actively traded, is not fully leveraged, and is owned by people with substantial resources who are looking forward to buying busted deals.

Waves of Stupid Money, and One Eye Money

 The Psy-Fi Blog has a post on Edward Miller’s research into irrational gambling, which gives some insight into bubble psychology. An excerpt:

Edward M. Miller in Do The Ignorant Accumulate the Money has done some research around the effect on the stockmarket of slot machine investors and reckons that there are periods where waves of stupid money can genuinely cause the rough efficiency of the market to break down. He also shows that these effects can’t last forever – if the stupid money is going into unproductive assets the lower return on these will eventually affect prices, especially as sensible money will be going into cheaper, productive ones.
In fact this isn’t too surprising to anyone with a background in social psychology – you don’t need to really understand economics to recognise that waves of irrational behaviour can sweep through groups linked by social ties. One of the oddest forms of behaviour is that a group’s overall opinion on some subject will tend to be more extreme than the average opinion of the group members. This polarisation effect is to do with the instinct towards group conformity and in the markets can lead people into taking more extreme and committed positions on individual stocks and markets than they would have taken on their own.

“Waves of stupid money” is an apt description of commercial real estate investors and lenders at the peak. Similarly, a general partner I know characterized the money he received from some investors as “one eye money”; cash someone whose primary business was not real estate would give him to invest, and which they would keep only one eye on.

Don’t be part of the wave, and keep both eyes on your money.

Construction Lending Blues

Although most of what you read about CRE loan problems refers to CMBS loans, the reality is construction loan defaults are a much, much bigger problem. The reason you hear so much about CMBS is availability bias; CMBS loan performance is closely monitored and loan level data is readily available, while construction loan performance data is extremely fragmented.

John Reeder at Real Property Alpha notes:

When you go home at night and turn on the lights, you don’t have to think about what it took for that light switch to turn on.  Somebody had to develop a power plant.  Somebody had to develop the utility infrastructure to deliver the power.  The neighborhood you live in is likely part of a development that somebody had to get approved.  The store where you buy your groceries is part of a retail center that had to be built.  It wasn’t always there.  But these are things we take for granted.  The difficulty of development does not weigh on us.

And yet development is hard.  Even experienced developers fail… all of the time.  In order to bring projects online you have to make it through a gauntlet of challenges that includes buying the land right, proposing a marketable project, obtaining environmental clearances, getting discretionary zoning actions approved, getting through construction within budget, and enduring market cycles.

If a construction project makes the headlines, it’s usually a big deal that’s blown up in a conspicuous way. For example, construction at the Las Vegas Fontainebleau hotel, pictured at left, is currently shut down as a result of the construction lenders’ unwillingness to advance funds. The borrower is in bankruptcy and and all parties are litigating (more on the story at the Zero Hedge post  Fontainebleu Fiasco Soon To Get Epic). However, big projects are just the tip of the iceberg; for every big project there are ten smaller ones in trouble.

Here’s a list of the way construction loans can go wrong. Some of these are “normal” risks in getting a development done, while others are cyclical. I’ve put the cyclical issues which are currently in play in italics.

Jurisdiction Approval Issues. This category of issues creates delays or cost overruns which put the property in jeopardy.

• Failure to obtain necessary jurisdiction approvals. These could be big, obvious approvals (e.g. a building permit) or an obscure approval which wasn’t obvious at closing (for example, an approval for an off-site bridge over a stream for an access road to get to the project).
• Change in infrastructure requirements or fees post closing with no grandfathering
• Change in code requirements post closing with no grandfathering

Construction Issues

• Costs underestimated in the initial project budget
• Unanticipated site conditions (for example, soils problems) leading to delays and/or cost overruns
• Exceptionally bad weather leading to delays and/or cost overruns
• Labor or material cost increases post closing (e.g., the price of plywood goes up after the budget is set)
• Labor strikes or unavailability leading to delays
• Material unavailability leading to delays
• Failure of the contractor or major subcontractor(s) due to financial problems unrelated to the project (this often creates delays or cost overruns which puts a property in jeopardy)
• Construction or design defects (for example, water infiltration) which must be cured, leading to delays and/or cost overruns

Leasing Issues

• Decline in rents from the original pro forma
• Slower than anticipated lease up
• Higher than anticipated tenant improvement costs (in a soft leasing market, developers have to offer more tenant improvements to get tenants to sign up)
• Deteriorating financials or bankruptcy of a major tenant

Construction Loan Issues

• Increase in interest rates resulting in early depletion of the interest reserve
• Insolvency of or regulatory restrictions on the construction lender

Permanent Financing Issues (these issues may prevent the construction loan from being refinanced before it matures)

• Increase in interest rates
• Increase in operating expenses compare to the original pro forma (for example, real estate taxes assessed at a higher rate than anticipated)
• Increase in cap rates (resulting in a value decrease such that a permanent loan can’t be obtained)
• Tightening of underwriting standards
• Deteriorating financial condition or credit of the sponsor unrelated to the project (for example, foreclosures on other projects)

This list is not complete, but it gives you a sense of how unpleasant it is to be a construction lender (or borrower) these days.

Leverage and Return on Investment

Last week Barry Ritholtz at The Big Picture had a good post on  interest only CRE mortgages. In the comments I talked about why borrowers wanted IO (to goose the initial cash on cash return numbers), and in response one of the commenters made the point:

Maximizing leverage implies boosting ROI.

No, no, no. If anyone should have learned anything in the last two years, it’s that maximizing leverage does not always boost ROI. For leverage to boost ROI, income has to go up. When income goes down, leverage destroys you.

There are a couple more subtle cases where leverage doesn’t help you. Even if income goes up, leverage doesn’t help you much until you exit the investment, because debt service sucks up a lot of cash flow. And, there’s no guaranty cap rates won’t go up and/or financing will be unavailable when your leverage is due (again, a lesson that should be painfully obvious today).

Finally, leverage hurts you when equity is cheaper than debt (i.e., cap rates are lower than interest rates). This doesn’t happen often, because since equity takes the first loss it typically has a higher return than debt. But, it does happen. The usual case is in an inflationary environment when interest rates are up and equity is relatively cheap because investors believe rent boosts will provide additional return.

Below are some examples of how the numbers work. The first set of examples are high, normal, and no leverage scenarios when cap rates are lower than interest rates. The cash on cash returns are towards the bottom, and show what happens when net operating income (NOI) goes up a little, a lot, and down. Note NOI has to increase 38% to get the same return as a non-leveraged deal:

 

A small decline in NOI eliminates cash flow on a highly leveraged deal, but has a minimal impact on an unleveraged project.

The next example shows what happens when cap rates are higher than interest rates:

The next time someone extolling the virtues of leverage, you can send them to this post.

My Securitization Misconceptions

I am not a CMBS insider – although I’ve been doing nothing but income property finance for 30 years, it’s almost always been for whole loan lenders. However, a good chunk of that time was spent originating Fannie Mae multifamily loans and competing against CMBS lenders for business, and we lost that competition on many, many deals. I found this surprising – how could pricing be better on a securitized deal than the pricing offered by an institution with an implicit government guarantee? How could CMBS lenders offer better pricing on deals that had screamingly obvious flaws? At the time, I came up with some answers I thought made sense, but it turned out I was wrong.

Simple securitization is not complicated. You take a pool of loans and project the aggregate principal and interest cash flows from the pool. Picture the cash flow as a river with a series of waterfalls. First the cash flow goes to the A piece buyer, and the remainder goes to the B piece buyer. If the cash flow falls a little short because there are losses on some loans, the A piece buyer still gets his return but the B piece buyer gets shorted. If the cash flows are massively short (for example, many loans default as a result of a global financial meltdown), the B piece buyer is wiped out and the A piece buyer will also suffer some losses. If you’re a do-it-yourselfer, I recommend Keith Allman’s book, Modeling Structured Finance Cash Flows with Microsoft Excel; spend an afternoon with it and a laptop and you can do your own securitization model.

My first misconception was how value was created out of this process. The idea was the aggregate value of the allocated cash flow was worth more than the whole, much like the value of the packages of meat in the supermarket cooler are worth more than the whole cow. Some people want sirloin, some want hamburger, and by giving people what they want the parts are worth more than the whole.

Although to some extent value was created in this process, the real problem is the securities were simply mispriced. From The Economics of Structured Finance, A paper by Joshua Coval, Jakub Jurik, and Erik Stafford:

The rapid growth of the market for structured products coincided with fairly strong economic growth and few defaults, which gave market participants little reason to question the robustness of these products. In fact, all parties believed they were getting a good deal. Many of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives, such as corporate bonds. The “rated” nature of these securities, along with their yield advantage, engendered significant interest from investors.

However, these seemingly attractive yields were in fact too low given the true underlying risks. First, the securities’ credit ratings provided a downward biased view of their actual default risks, since they were based on the credit ratings agencies’ naïve extrapolation of the favorable economic conditions. Second, the yields failed to account for the extreme exposure of structured products to declines in aggregate economic conditions (i.e. systematic risk). The spuriously low yields on senior claims, in turn, allowed the holders of remaining claims to be overcompensated, incentivizing market participants to hold the “toxic” junior tranches. As a result of this mispricing, demand for structured claims of all seniorities grew explosively. The banks were eager to play along, collecting handsome fees for origination and structuring. Ultimately, the growing demand for the underlying collateral assets lead to an unprecedented reduction in the borrowing costs for homeowners and corporations alike, fueling the real estate bubble that is now unwinding.

My second misconception was that the B piece buyers were the canaries in the mine. Rating agencies blessed the cash flow projections, but the real safety valves were the B piece buyers – since they were to take the first loss, they had a strong incentive to make sure the projections were reasonable. If the deals were too risky, B piece buyers would stop buying. This is what happened when CMBS spreads widened in 1998 after Russia defaulted on its bonds, so I thought that B piece buyers were an effective check on the market.

We now know, however, that B piece buyers were repackaging their exposure, obtaining a triple AAA rating of most of it, and selling their pieces as CDOs. Baseline Scenario provides a good explanation of how this worked in this post. Since the B piece buyers weren’t retaining the risk, there was no canary to signal the problem.

For more on securitization, Derivative Dribble is an excellent source. I recommend starting with Tranches and Risk.

How Big a Hit Can Lenders Take on Note Sales?

I’ve previously posted on how driving away borrowers can leave a bank in a better position to handle losses on the remaining portfolio (link here). Here is the simplified balance sheet side of the math:

In this example, $250,000,000 in loans are paid off and used to reduce liabilities. The loss reserve and equity are unchanged, but have increased in size relative to the remaining portfolio, so the bank is in a better position to absorb losses in that portfolio.

This suggests that a bank could sell loans at a discount without damaging its ability to deal with future losses. Here is the same transaction above, but the bank sells the loans at an 11% discount:

Note that there is an actual loss of $27,500,000 which needs to come from somewhere in order to pay off the liabilities. In this example, it comes from cash and a reduction in the cash held in the loss reserve (but still maintaining a reserve level of 2% of remaining loans). Even though they took an 11% hit, the banks ability to weather additional losses remains unchanged. However, note the bank’s cash position has declined substantially.

What happens when the discount is 22%?

The bank is in a worse position, and has wiped out it’s cash position.

The real world is obviously much more complicated, but the rule of thumb is a bank can take a 10% hit on a note sale without much pain because the capital and loss reserves are already on the balance sheet to handle the loss. In general, as the market deteriorates banks have been building reserve levels, and specific loss reserves are being taken against some assets. To the extent these reserves exist, bigger discounts can be taken.

According to Zero Hedge, the FDIC commercial loan auctions are clearing at a 50% discount. For a bank to take that kind of hit on a note sale of any size, they would need to have built up very large reserves, or have substantial excess capital, or both. There aren’t many (any?) banks with substantial CRE exposure in that position, hence there are not a lot of note sales going on.

Why CRE Lending Needs its Own Center for Disease Control

Imagine there is a disease that lies dormant for between 5 and 20 years, and then, over a 3 to 5 year period, kills 5 – 10% of our population. Now, suppose the first signs of a new outbreak are occurring. Would it surprise you if there was no central data repository to monitor the spread of the disease? That no teams of scientists study who survives, and who doesn’t? That no theories are developed to avert the next outbreak?

Of course, that would never happen in the United States. Virtually every disease outbreak and death in the US is reported to the Center for Disease Control (CDC), which identifies trends and coordinates research on the causes and prevention of disease. Any serious outbreak receives almost immediate attention and study.

There is nothing like the CDC when it comes to reporting and studying underperforming CRE loans. Obviously, human lives are more important than avoiding losses on loans, but it still puzzles me that there is no systematic, comprehensive effort to track defaults, diagnose the problems, and autopsy the failures. It’s apparent we are going to see major performance issues on CRE loans (see, for example, this post from Zero Hedge). Who is going to collect data and study what happens this time so we can avoid or minimize future losses?

There are some counterarguments to making the effort. Some people believe the problems are already diagnosed – for example, underwriting standards (LTV, DSC, interest only structures, etc.) were too aggressive. Undoubtedly that’s true, but it doesn’t explain everything. For example, here’s a table from the previously mentioned Zero Hedge post showing losses some CMBS loans:

(Click on image for a larger version in a new window)

The last loan on the list is Coastal Carolina Campus Point. Costar had this to report when the loan hit the watch list:

Coastal Carolina Campus Point, Myrtle Beach, SC
The loan on this 144-unit multifamily student housing apartment complex was transferred to the special servicer in January 2005 due to monetary default and became real estate owned in November 2005. The property is 67% occupied. The total exposure on the loan was $11.6 million as of November 2006. The property is listed for sale with Marcus & Millichap with an anticipated February 2007 disposition date.

I’d like to know how it’s possible to lose almost 70% of principal on a multifamily deal that became REO in 2005. Does anyone really believe there are no lessons to be learned from deals like this?

You might say that figuring out the lessons are the responsibility of individual lenders. However, even the biggest lenders only see a small portion of the defaults. You might say that this is a function for the rating agencies, and I would agree with you, but do we really want this information to be proprietary? Also, rated deals are only a fraction of all CRE deals, and there are some sectors which are not covered by the rating agencies at all (for example, construction loans). Finally, as I’ve previously argued, most lenders and rating agencies are not focused on the right variables. 

Like the CDC, I think this is something that is best done by the government. The information should be in the public domain, and only regulatory agencies have access to all the information. As I’ve previously discussed, CRE loan underwriting never seems to improve, in part because the feedback cycle is very long. The current downturn is the first severe test of CRE loans since the early 1990’s, and is an opportunity to learn from our mistakes which probably won’t be repeated for many years. Will we take advantage of it, or just bury the bodies?

Which Transactions are the Riskiest?

Medium sized, infrequent ones. That’s Bob Blakley’s conclusion in his post, The Zone of Essential Risk. An excerpt:

If you conduct infrequent transactions which are also small, you'll never lose much money and it's not worth it to try to protect yourself - you'll sometimes get scammed, but you'll have no trouble affording the losses.

If you conduct large transactions, regardless of frequency, each transaction is big enough that it makes sense to insure the transactions or pay an escrow agent. You'll have occasional experiences of fraud, but you'll be reimbursed by the insurer or the transactions will be reversed by the escrow agent and you don't lose anything.

If you conduct small or medium-sized transactions frequently, you can amortize fraud losses using the gains from your other transactions. This is how casinos work; they sometimes lose a hand, but they make it up in the volume.

But if you conduct medium-sized transactions rarely, you're in trouble. The transactions are big enough so that you care about losses, you don't have enough transaction volume to amortize those losses, and the cost of insurance or escrow is high enough compared to the value of your transactions that it doesn't make economic sense to protect yourself.

The chart below summarizes the problem:

Blakley is talking about eBay transactions, but I think there is a loan underwriting parallel too. If you’re doing large transactions frequently, you probably have the staff and expertise to do them right. If you do large transactions infrequently, you probably are very focused on your execution and/or bring in the required expertise to help. If you only do a few small transactions you’re never going to lose much, and if you do a lot of small or medium size transactions you will both develop expertise, and an occasional miss will be spread over a large base. But, if you do infrequent medium size transactions you can get into trouble because you never develop the expertise and the transactions aren’t large enough to justify hiring experienced people to do them.

This could be an explanation of how community and small regional banks ran into trouble in the residential construction and land development segments.

Land Values at Zero?

Land loans are generally regarded as the riskiest type of real estate lending. Here are the FDICIA regulatory maximums for the various types of construction and development loans:

Why? Because land values evaporate in a severe downturn. From an interview with Bob Voit, a legendary Southern California real estate investor posted on Lansner on Real Estate:

Bob: …You could build a case that many real estate assets have zero value today that were worth millions a couple of years ago.

Us: Why?

Bob: It’s because, let’s say you have a beautiful site to build a high-rise office building on in downtown wherever. The combination of market forces, which would include construction costs, lack of availability of financing and the lack of available tenants that support your rental rate. What makes the development of an office structure economically unfeasible. If it’s unfeasible, nobody wants to buy it. Whoever may want to buy it can’t get the money.

Us: You’re talking basically of a collapse.

Bob: A relative collapse in temporary values. The same thing happened 20 years ago. Then market forces readjust, and off we go again.

An example shows how this is possible. Here is a breakeven analysis on a development project:

Now let’s suppose, for the reasons Bob talked about, the completed asset is worth 10% less. Here are the new numbers:

There goes the equity, the lender is now at 100% LTV. Same example, but suppose the completed asset is worth 28.6% less:

The land value is now $0. How likely is it asset values will fall 28.6%? Very possible, as discussed here.

But, of course, you don’t see many signs offering land for free. The reason the land value is zero is because the construction cost equals the end asset value. Build it for less, or find an end use worth more, and there’s still value there. Unfortunately, although construction costs are down, they’re not down that much, and the end values of all types of real estate tend to move down together. So, as Bob says, you wait for the market to readjust. Here are a couple of alternative uses for the land in the meantime:

Why Do Bankers Take Excessive Risks?

There are plenty of economic explanations being offered  to explain bankers’ risky behavior (e.g., poorly designed incentive plans, inadequate risk modeling). On a more basic level, the old standbys ignorance, hubris, and greed are called on. I’m sure some people were ignorant of the risks, and some people were in it for the money. But how do you explain the participation of very intelligent people who were aware of the risks, had every reason to protect their good reputations, and had no economic reason to jeopardize their already very lucrative positions? And it’s not just bankers – why do successful real estate investors continue to leverage their portfolios to the max and take on high risk deals, when they could secure their positions and be able to ride out any storm?

Maybe it’s their brain chemistry; human brains get high on challenges. From Gregory Berns’ book, Satisfaction: The Science of Finding True Fulfillment:

Any stressor, especially a physical one, results in the release of cortisol. The biochemical interaction of cortisol and dopamine in the striatum suggests that these two chemicals are involved in the achievement of satisfaction, perhaps even transcendence. Alone, neither compound can provide a state resembling satisfaction. Dopamine may be associated with transient euphoria, but you need cortisol to get that satisfying feeling. And because cortisol is released most effectively by stressful situations, the road to satisfying experiences must necessarily pass through the terrain of discomfort.

At the most basic level, people take risks because the biochemical results make them feel good. Understanding this goes a long way towards explaining obviously self-destructive risky behavior.

Whose Error was the Housing Crisis?

Who is responsible for the housing crisis? Some candidates are borrowers, lenders, rating agencies, and securities investors.  Attempts to blame one party or another fail, because the crisis is the result of a combination of errors by different parties which all aligned. Think of a wedge of Swiss cheese; to see through it, all the holes must line up. This approach is explained in James Reason’s Human Error, and illustrated in a diagram from that book:

In the housing crisis, here are some errors which had to align to get to where we are today:

1) Borrowers took out loans they couldn’t afford

2) Lenders made loans to borrowers which the borrowers couldn’t afford

3) Ratings agencies rated securities comprised of these loans as safe

4) Security purchasers relied on the erroneous ratings and bought the securities

Any of these parties could have averted the crisis had they avoided their respective error.

I am not saying that every member of each class made their error; plenty of potential borrowers didn’t borrow, not every lender made bad loans, not every rating was bad, and not every investor bought bad securities. But, enough of each class made these mistakes to trigger the events leading to the current situation.

Also, I am not saying that individual actors didn’t benefit from their actions at the time – there were certainly some winners. And, looking at each individual decision made, it’s not clear that any of them were irrational at the time. These were errors in the sense that, in hindsight, collectively we would have been better off if people had acted differently.

In any complex system, it’s often more likely that a major breakdown is the result of an alignment of errors, rather than the failure of a single component.

Why Would a Bank Try to Drive Its Borrowers Away?

Yes, some banks are trying to drive away their borrowers (the usual terms for this are “running off the portfolio”, or ”shrinking the balance sheet”). Why would they do this? It’s not intuitively obvious, but in theory at least it puts the bank in a better position to cope with future losses.

Unfortunately, to understand this it’s necessary to work through the numbers. Here is a simplified bank income statement and balance sheet:

I hope this is all obvious (I’m happy to address any questions in the comments). The scenario assumes all the loans are performing, but banks keep a loss reserve on their balance sheet just in case of future trouble. The bottom number is the key to understanding this topic; if things get really bad the bank is wiped out if it suffers a 12.2% loss on its loan portfolio.

Next, let’s assume a quarter passes with and there are no new loans or payoffs. The bank makes another $50,000,000 which increases its equity and ability to handle losses:

Now, let’s say instead of no new loans the bank drives away $500,000,000 of loans (how to do this is a separate topic). The bank no longer needs the deposits to fund those loans, so it drives them away too. Income goes down, but the ability of the bank to handle losses on the remaining portfolio goes up:

Is this a good strategy? There’s some problems with it (again, a separate post topic), but if your regulator tells you to increase your capital ratio its one of the few approaches you can take in this environment.

Turning Around the Creston Apartments

Here’s an interesting account of efforts to turn around a high crime, poorly maintained apartment project in Kansas City which was affecting the entire neighborhood. The short version:

• Aggressive policing
• Political involvement
• On site security
• Maintenance

I’m not sure if this can really be categorized as a success story though, since it apparently ends in the demolition of the project.

Why Fewer Reasons Are Better; Dead Cats and Cul de Sacs

When turning down a workout request or a loan application, you need to explain why. Borrowers expect a fair reason for being turned down, and loan officers and underwriters can learn from each experience and hopefully prevent reoccurrences in the future. You have a choice – you can try to provide a comprehensive understanding of your entire thought process, or you can relate just the factors which are the most important to your decision. In my experience, the latter approach is better, because what people remember won’t be your best reasons.

For example, back in the mid-1980’s I worked for Cambridge Capital originating multifamily loans (the company is long gone and not related to any of the Cambridge Capitals currently doing business). The principals were very hands-on, bright guys who personally inspected every deal we did, and I know I learned a lot about real estate from them. But, my only specific recollection is one deal which was turned down because, when the principal did his inspection of the property, there was a dead cat in the parking lot. I’m sure there were other things he didn’t like about that deal, but I don’t remember them.

I did something similar during a presentation sponsored by a chapter of the Earthquake Engineering Research Institute in Oakland. After the Northridge Earthquake I did consulting work for the Los Angeles Housing Department, and one of the things I did was a drive-by inspection of all the red and yellow tag structures damaged in the earthquake. This was an inductive approach to learning – after you look at a few thousands damaged buildings you start to see patterns. A lot of these patterns were obvious. For example, proximity to the epicenter, hillside or liquefaction zone locations, and brick construction are all know risk factors, and the audience didn’t react when I relayed that information. I did get a reaction, though, when I told them that cul de sac streets were a risk factor. On reflection, this isn’t surprising. Orientation of the structure to the ground motion wave is an important variable, and on a cul de sac one or more structures are guaranteed to be oriented for maximum damage. Also, in Los Angeles a cul de sac is usually related to e geographic risk factor (the cul de sac terminates at a drainage ditch prone to liquefaction or a hillside, for example). But, I didn’t explain this during the presentation, and I know there are people out there who remember me as the idiot who thinks earthquake damage is linked to cul de sac streets.

There is a neurological basis which explains why people lock in on unexpected reasons. From Jonah Lehrer’s “How We Decide”:

The brain is designed to amplify the shock of these mistaken predictions. Whenever it experiences something unexpected – like a radar blip that doesn’t fit the usual pattern, or a drop of juice that doesn’t arrive – the cortex immediately takes notice. Within milliseconds, the activity of the brain cells has been inflated into a powerful emotion. Nothing focuses the mind like surprise.

This is why if you tell a loan officer you’re turning down his loan because the borrower lacks liquidity, the building is poorly maintained, the income is trending down, and there’s a dead cat in the parking lot, you will forever be remembered as the guy who is fixated on dead cats. Unless that’s what you want, you’re better off keeping that reason to yourself.

More on Loan Modifications and Moral Hazard

I’ve previously argued that moral hazard risks are overrated for a number of reasons (see this post). Niall Ferguson has a piece in the Australian which identifies another really good reason not to worry too much about moral hazard in the context of granting loan modifications. You need to evaluate how often a similar set of circumstances is likely to occur, and if a reoccurrence is unlikely, moral hazard risk is low. An excerpt:

The second step we need to take is a generalised conversion of American mortgages to lower interest rates and longer maturities…Another objection to such a procedure is that it would reward the imprudent. But moral hazard only really matters if bad behaviour is likely to be repeated. I do not foresee anyone asking for, or being given, an option adjustable-rate mortgage for many, many years.

We Worry Too Much About Moral Hazard

James Surowiecki has a good post on how we overemphasize the risk of moral hazard. Even the classic case of moral hazard turns out to be unsupported; people who are insured often have fewer accidents, not more.

Surowiecki identifies three reasons why this is so. The first is it’s often unclear if a bailout will occur and on what terms. It’s unlikely people rely on a safety net if it may not be there.

Secondly, when we’re talking about the actions by companies like banks, it’s more likely that the risks they take are driven by individual decisions, and not the interests of the institution itself. Trader and banker incentives, not moral hazard, is the issue.

Here’s Surowiecki on the final reason:

Finally, the biggest reason that moral hazard matters less than it might is that it can operate only if people actively countenance the possibility that their decisions could lead to complete disaster. But it’s well documented that people generally, and investors particularly, are overconfident and significantly underestimate the chances of being wiped out. The moral-hazard fundamentalists argue that banks and other financial institutions will act recklessly if they think they’ll be rescued in the event of failure. But Wall Street was reckless because it never believed that failure was even a possibility.