Real estate quantified; benchmarking commercial Mortgage PD: an update

RMA Journal, The, Sept, 2002 by George J. Pappadopoulos

In general, the model underestimated the earlier origination cohorts and overestimated the later cohorts. Part of the overestimation may be explained by the fact that many later loans have not yet matured. In other words, these cohorts have not yet seen all the defaults that will ensue. Perhaps a more significant factor, however, is changes in underwriting. According to conventional wisdom, underwriting standards have improved since the 1980s. Certainly, criteria were much more stringent during the credit crunch period of the early 1990s, and the modeled results support this view.

Obviously, more encompassing and detailed data would improve the calibration, but it appears that this tool is nonetheless very useful for differentiating the expected credit risk of various mortgages and portfolios. A single predictive measure of default risk that is directly comparable among markets and property types nor only helps to meet Basel guidelines, but it also allows for some very helpful objective comparisons. The benefits are not only widespread, but also have significant impact. Profitability improves through implementation of a pricing strategy that ensures compensation commensurate with the true risks, and refined capital allocation places downward pressure on reserve requirements and upward pressure on earnings and company value.

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Contact Pappadapoulis by e-mail at george@ppr-research.com

[c] 2002 by RMA. George J. Pappadopoulos, CFA, is director of Risk Management and Debt Research with Property & Portfolio Research, Inc. (PPR), Boston, Massachusetts. PPR is an independent real estate, research, and consulting firm that works with fund managers, REITs, investment banks, commercial banks, pension funds, insurance companies, and private capital sources to help them meet their portfolio performance and risk management objectives. PPR can be contacted by phone (617-426-4446) or fax (617-426-4443).