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Weekly UpdatesINTRODUCTION
The purpose of this article is to propose Basel II regulation to significantly reduce the risk of another real estate boom-bust cycle threatening the viability of the U.S. financial system. This proposed Basel II regulation identifies speculation risk and better manages portfolio risk using a relative index methodology within regulated financial institutions. The methodology could also be applied to Commercial Mortgage-Backed Securities (CMBS). The author contends that the recent boom-bust cycle could have been prevented through appropriate regulation and risk management.
BASEL II: CORE COMMERCIAL BANK CAPITAL ADEQUACY REGULATION
Basel II is a worldwide regulation framework describing a comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rulemaking and adoption procedures. Core banks (the biggest multinational banks, e.g., BNP Paribas) must adhere to the highest standards and already began implementation as early as 2006. The U.S. officially adopted the framework into its regulation policy in April 2008, although banks have the option to adopt a less stringent standardized approach approved by U.S. regulators. The Basel II implementation submittal deadline for review by U.S. bank boards of directors was Oct. 1, 2008. The approved Basel II implementation plan is to be implemented in a three-stage process over a three-year period, utilizing a parallel approach to the bank's existing risk management and capital adequacy measurements.
All multi-national banks are in the process of implementing the highly complex and advanced measurements of the Basel II regulations. However, Basel II may have a flaw that can be mitigated by U.S. banks and all banks governed under the Bank of International Settlements--using the CPI-adjusted TBI price value methodology. A similar type of price value index that tracks changes in prices on a quarterly basis could be created for all other countries. William M. Isaac, chairman of the Federal Deposit Insurance Corp. from 1981-1985, explains its potential negative impact in an opinion piece published in the Wall Street Journal on Sept. 19, 2008, as follows: "Basel II requires the use of very complex mathematical models to set capital levels in banks. The models use historical data to project future losses. If banks have a period of low losses (such as in the mid-1990s to the mid-2000s), the models require relatively little capital and encourage even more heated growth. When we go into a period like today where losses are enormous (on paper at least), the models require more capital when none is available, forcing banks to cut back lending."
Mr. Isaac certainly understands regulatory changes and its impact on lending markets. Once the probability of loss and loss severity estimates are set for income property in all institutions, the Basel II regulated financial institutions will pursue those lending opportunities that best fit its credit risk profile. Most likely, a herd mentality will cause bank officers to seek those opportunities identified as lower risk. Such behavior would lead banks to overshoot the market, creating market speculation risk leading to higher realized loan defaults and losses than would otherwise be projected, based on historical loan default and loss data. If the credit decision process becomes more systematic and complex, the system will create its own systemic credit related losses--perhaps with a worse outcome than exists today.
At HSH Nordbank, a Basel II Risk Adjusted Return of Capital (RAROC) system was implemented between 2005 and 2007. As RAROC was applied in practice at the field level, it may have been manipulated to meet loan underwriting and management goals. In addition, RAROC did not factor into its system a relative index methodology to determine how much market speculation risk it was taking on the collateral for its loans at the high market price levels. This version of RAROC did not manage risk but proliferated the taking of more risk since it applied a system-dependent risk management evaluation as opposed to a more simplistic inflation-adjusted relative index methodology. What financial institutions do not need today is more complex regulatory processes and procedures that may result in less control over their destiny. If the president of the bank does not understand how the capital allocation system works within his/her own bank, this regulation policy is prone to engender systemic losses, loss of control over its performance and increase the probability of bank failure.
Another major potential issue related to Basel II is that capital will be allocated within banks on the probability of loss and loss severity on a specific asset class as experienced by the entire industry. It does not reward those financial institutions that, due perhaps to conservative underwriting standards, experienced a better default and credit loss recovery than the average financial institution.
A commercial bank's incurring a high probability of loss and loss severity on real estate loans is not a sustainable and viable function of its business model. One enhancement of Basel II policy would identify market speculation risk in new loan applications and existing income property loan portfolios via a relative index methodology. This relative index methodology would create a lending system that identifies all lending risk simply and transparently enough to be relatively easy to implement and regulate. Such a methodology should provide a higher degree of confidence to the marketplace by reducing the probability of loss and loss severity on loans originated by worldwide regulated institutions.
A major advantage of the spirit of Basel II is that this worldwide commercial banking regulation proposed by the Bank of International Settlements is adaptive to product and system innovations. Basel II has introduced the use of Advanced Measurements Approaches for capital adequacy regulation and risk management. The relative index methodology proposed for incorporation with Basel II regulation was developed to appropriately assess the probability of loss and loss severity in existing income property loan portfolios. This relative index methodology also will help investors and credit rating agencies to correctly determine risk ratings within tranches of CMBS issuances for each vintage year.
DEFINING MARKET SPECULATIVE RISK AND RELATIVE INDEX RISK
This article defines "market speculative risk" and "relative index risk" on income property real estate investments. A previous article by this author in Real Estate Issues' explored why the credit rating agencies, conduit underwriters, investment banks, commercial banks and investors "did not know what they did not know" in assessing probability of loss and loss severity to determine the appropriate amount of leverage and tranche amounts in CMBS loans from 2004-2007. The objective of this article is to restore confidence in both commercial banks and CMBS investors, and thus restore the nonfunctioning banking and CMBS markets to healthy and growing lending markets.
The U.S. has gone through an interesting period in which investors purchased a variety of "innovative" types of debt securities. Income property investors were caught up and benefited from it, as did commercial banks and other financial intermediaries. Although the CMBS system has its flaws, including missed risk assessments by credit rating agencies, conduit loan underwriters, investment banks and investors, it can be fixed with the appropriate use of the proposed CPI-adjusted relative index approach. This methodology combines an index, such as the MIT Center for Real Estate Transactions-Based Index (TBI), (2) proposed underwriting policies, five-year minimum time scales and an oversight board. Adding a relative debt service constant index to assess market speculation risk provides stability to the country's financial system. Within the next three to five years, CMBS issuances in the 2005, 2006 and 2007 vintages will be subject to probability of loss risks in the 23-34 percent range. It is possible to hedge risks that are well identified.
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It is expected that the thesis, recommendations and probable loss estimates described here will be controversial to many credit rating agencies, investors, lenders and bank regulators. It is important to be aware of the potential ramifications of implementing this relative index methodology in CMBS pricing and, for that matter, the estimated value of most debt secured by income property on the balance sheets of commercial banks. The bubble, or over-leverage, can be estimated to be $750 billion to $1.1 trillion on the loan underwriting amount on income property debt held by all financial intermediaries and investors. If this relative index methodology were applied to single-family mortgage portfolios, the impact would be much higher, given that the scale of that debt bubble is $3.5-$5 trillion.
Although the implementation of a relative index methodology would be negative to the economy, if fully integrated as a regulation today, it would best be integrated gradually and phased into Basel II regulation for U.S. banks over a three-year period. At the end of this period (Jan. 1,2012), the negative impact should not be as severe and would provide a discipline for lending from that time forward. Although the over-leverage bubble estimates stated here may be high, the estimates of probability of loss and loss severity using a relative index methodology on real estate secured portfolios are sound and will stand the test of time.
RELATIVITY TO INDEX VALUE METHODOLOGY DEFINED
One of the critical reasons for error in assessing probability of loss and loss severity by the credit rating agencies is that the agencies are conditioned by the U.S. capital markets to assess all types of risk on varying investment classes on both a quarter-over-quarter and year-over-year time scale. But, the overall risk in providing debt on income property real estate can be assessed only in longer time scales. As a consequence of not incorporating a longer time scale in CMBS overall risk assessment models, the probability of loss and loss severity on income property portfolios is likely far greater than credit rating agencies have concluded. This has serious consequences for the U.S. and world economies for years to come. Real estate cycles are much longer than other investment cycles, such as those for the more liquid stock and bond investment segments. Because of this time issue and the enormous amount of over-leveraged real estate in the U.S., in a best-case scenario, U.S. income property real estate prices, in aggregate, will begin to appreciate in 2015. It will take at least that long to clear the market of over-leveraged real estate; for loan foreclosures that depress prices to cease from occurring; and for lenders to once again become confident about lending in mass. This assumes collateral deflation risk has dissipated from the markets. If inflation rapidly increases within this period, recovery could come sooner than 2015.
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