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Six Ways to Better Manage Commercial Real Estate Loans

By Jodi Alperstein, managing director, Moody's Analytics Recently, a congressional watchdog panel warned that mounting commercial real estate losses could endanger the banking system and thwart economic recovery. The panel discovered that a total of $1.4 trillion in commercial real estate loans will require refinancing within the next four years. Today, more than half of those loans are underwater, because they were underwritten for properties whose value has dropped significantly. In

By Jodi Alperstein, managing director, Moody's Analytics Recently, a congressional watchdog panel warned that mounting commercial real estate losses could endanger the banking system and thwart economic recovery. The panel discovered that a total of $1.4 trillion in commercial real estate loans will require refinancing within the next four years. Today, more than half of those loans are underwater, because they were underwritten for properties whose value has dropped significantly. In total, the expected losses when loans go bad could hit between $200 billion to $300 billion and threaten 3,000 small and mid-size banks with a disproportionate share of commercial real estate assets on their books.Historically, the commercial mortgage underwriting process has been a very disconnected, paper-intensive process that is subject to human error during the multiple stages of the loan origination. Most commercial loan processes are developed within silos, separate from the rest of an organization's risk management solutions and lacking sufficient controls. Commercial lenders and underwriters need to move forward with a timely, coordinated and effective process that will allow banks and financial institutions to understand the true impact of a large loan transaction on the overall loan portfolio and the company balance sheet before it is underwritten. Based on discussions with risk professionals across many leading commercial banks, below are some of the best practices for managing commercial mortgage origination and the monitoring process. While some of these might seem "common sense," it is astonishing how many organizations still do not have these resources and processes in place.

1. Standardize the way data is collected - Commercial mortgage data is often captured in a variety of different formats, using a range of different technology tools across geographies. While this may work at a local level, spreading financials and capturing other commercial real estate data in an inconsistent manner poses problems when it comes time to analyze the bank's overall portfolio. Information needs to be captured, documented, and archived in accordance with a financial institution's origination policies - across geographies and departments.

2. Consolidate your data - Once data has been captured in a consistent way, it needs to be saved in one central repository for a "single source of truth." Take the extra step and capture data about a deal - such as fees - that can help provide understanding about the returns of a portfolio. By having access to data in one centralized location, banks will have one of the key building blocks in place to develop sound credit practices.

3. Use optimized and standardized probability of default and loss given default measures for commercial real estate loans - The end goal is to get probability of default and loss given default measures correct for every deal. Although it seems unrealistic, institutions need to apply frameworks and enforce bank policies to prevent user error. Within these frameworks, banks should use best-in-class models consistently across their portfolio and across geographies. If they choose to develop their own models, they should either use outside models as an input to their own model or use benchmarks to ensure accuracy. Further, the inputs and outputs of historical PD and LGD calculations should be archived to enable model validation and risk modeling improvements going forward.

4. Tie single-obligor risk into portfolio-level risk assessment - Banks need the ability to evaluate individual deals on a stand-alone basis as well as understand the impact a specific deal has on the overall portfolio. This analysis needs to be done at origination, not after a deal is booked. Just because a loan doesn't look good at the individual level doesn't mean it isn't a good deal for the organization when the loan is considered in the context of the overall portfolio. A leading practice that is being adopted by several lenders around the world involves computing the impact of a new loan or a deal that gets added to their portfolio in real time. Understanding the Return on Risk Adjusted Capital for any prospective deal is a huge competitive advantage for them.

5. Monitor exposures of all kinds - Lenders need a way to consolidate and view all their exposures worldwide - from subsidiaries, business units, banking books to trading books. Exposures should be compared with pre-defined limits for counterparties, economic sectors, countries or product types and a monitoring system should trigger alerts when limits are breached and when a "watch-list" customer engages with the lender.

6. Create a workflow that integrates with internal loan systems and front-office systems - Throughout the commercial mortgage origination and underwriting process, lots of hands touch lots of different processes. This process needs to be more automated to reduce errors and save valuable time. Banks must identify who needs to be involved - and who can make what decisions, when. Risk managers should identify workflow solutions that tie into their own internal loan systems and enforce consistent lending policies to ensure that accurate portfolio information is available in real-time.

Bringing all of these best practices together is no easy feat, but the business benefits - such as pricing risk and optimizing risk-return ratios - can yield big improvements to the bottom line. In order to implement standardized loan processing, decision policies and demonstrate compliance to regulators, risk managers should adopt an integrated platform to standardize the commercial mortgage origination process - from initial assessment and underwriting through monitoring and servicing. Firms are just starting to apply these best practices today, but many still have a long way to go.

Jodi Alperstein oversees product management and marketing for the software division of Moody's Analytics. She has over 15 years' experience developing products and market strategies in the financial technology sector. For more information about Moody's Analytics, send an email to RiskAnalystInfo@moodys.com.

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