REAL ESTATE LENDING

UNIVERSITA DI TOR VERGATA PAPER DISCUSSION- Francesco Di Leo PAPER: William L. Weber and Michael Devaney (Bank Efficiency, Risk-Based Capital, and Real Estate Exposure: The Credit Crunch Revisited, Real estate Economics, 1999 V27 (1): 1-25

INTRODUCTION AND AIM (1/2)

During 1990-1993 banks shifted their assets reducing real estate loans.

The research focuses on how the implementation of risk based capital (RBC) standards effects real estate lending and banks assets. RBC established a system of weights that requires more equity capital for risky assets.
The aim of the paper is to answer to these questions:

Credit Crunch depends on demand or supply side real estate lending?

How is possible to measure the supply side real estate lending efficiency?

INTRODUCTION AND AIM (2/2)

The authors want to identify the impact of RBC standards on real estate lending measuring the technical efficiency for banks adopting the output distance function. Hypothesis: Banks Overall technical efficiency(OTE) is the sum of pure technical efficiency (PTE), scale efficiency(SCALE) and regulatory efficiency(REG), If a bank is inefficient in any of this component, it can expand real estate lending reducing the inefficiency. Thesis: Banks could realized a better managerial oversight of the real estate loan portfolio, moving from constant return of scale (CRS), increasing capital requirements. They study for the US market in 1990 and 1993 how reducing each inefficiency affects banks real estate lending portfolio considering five assets: construction, one to four residential loan, multifamily loans and other loans.

LITTERATURE REVIEW (1/4)

Tuccillo (1991)- calls the reallocation of banks assets due to reducing real estate loans Credit crunch Keeton (1994): describes the asset shift as an increase in banking security holdings focusing more on credit rationing to small business Hancock and Wilcox (1994)-Peack and Rosengren (1994): bad real estate loans determine crisis and new constrains coming from banking authority Seiders (1989)-Tuccillo (1991): aggressive interventions regulators may have increase banks liquidity problems by

Berger, Hunter and Timme (1993): studying banks efficiency, one bank is a multi output firm that use some inputs (physical capital, labor and deposits), combining them in a productive process.

LITTERATURE REVIEW (2/4)

Fergus and Goodman (1994): real estate environment of the early 1990s depends on 1980s disintermediation, changes in tax law, aggressive lending policies. The Financial Institution Reform, Recovery and Enforcement Act (FIRREA Act of 1989) penalized long term credit channels, the Resolution Trust Corporation (RTC) settled to help dispose of the assets failed thrift cause anxiety among lenders due to inventories of problem properties. Moreover the Office of Comptroller of the Currency (OCC) put some pressure on CEOs and board directors about real estate lending policies and many believed that it was a signal of a general crackdown. Overall they suggest in a dynamic market, Credit Crunch depends on the difference between present landing policies and standard credit practice at the same time of the business cycle.

LITTERATURE REVIEW (3/4)

Peak and Rosengren (1995): Credit Crunch is a supply-induced restriction in the availability of credit. They analyzed capital constrained bank. Lenders that fail to meet minimum capital standards, need more equity capital or have to reduce higher risk assets categories or have to shrink in size. They found evidence in early 1990s, analyzing New England banks that despite severe downturn in real estate markets, the proportion of real estate lending in bank portfolio didnt explain credit shrinkage. Berger and Udell (1994): analyzing six different explanation for the increase of bank security holdings, four depends on supply side two on demand. They test that RBS standards influenced more capital requirements. Shepard (1953)-Fire (1998): defined an output distance function starting from a multi-output and multi input production technology (methodology literature)

LITTERATURE REVIEW (4/4)

Grosskorp (1986): discussed in detail the construction of technology, under different assumption of returns of scale and analyzing different inputs and outputs disposability (methodology literature) Sealey and Lindley(1977)-English et al.(1993):used an asset approach using balance sheet data to define outputs (methodology literature) Spong (1994): summarized risk weight asset categories and RBC standards (methodology literature)
Hughes at all (1996): scale economies increase as bank grow larger (methodology literature)

SAMPLE (1/2)
. Data are taken from FFIEC Call Reports. They consider US banks with over $1 billion in assets in 1990 and 1993, because banks with this size reported the value of assets in each risk category. There are four weight-risk assets categories, 0%,20%,50%,100%. Banks with research standards are 247 in 1990 and 267 in 1993 Inputs are labor (number of full time equivalent workers employed), physical capital(value of premises and fixed assets) , deposits (interest and non-interest bearing) Outputs are: 1)Cash, Treasury Securities, Government Agency Securities: 0% risk weighted assets 2)Securities issued by State and Local Governments, other US Governments securities: 20% risk weighted asset 3)Real Estate loans to one-to-four family, some multi-family properties, MBS, State and local bond issuances: 50% risk weighted assets 4)All other loans and industrial development revenue bonds, asset value of premises, fixed assets, real estate owned, intangible assets: 100% risk weighted assets

SAMPLE (2/2)

METHODOLOGY (1/7)
They use a non-parametric linear programming (LP) methods to measure bank efficiency when banks produce multiple outputs using multiple inputs and are subject to regulatory constraints.
Vector of M outputs Vector of N inputs Production possibilities set

The output distance function

Each k bank belong to K bank observed kth observation on inputs and outputs

Assuming CRS (Constant Rates of Scale) and strong disposability of outputs and inputs: Linear production possibility for bank k
weighted average outputs and inputs of all banks at t time

METHODOLOGY (2/7)

Construction of P(x) and the Output Distance Function

Suppose three k using same inputs (x1, x2, x3) to produce two output (u1,u2) Observation of outputs= a,b,c fb cg = extension of production technology with strong outputs bc = production technology weighting two outputs for two banks 0fbcg = Production Possibility Frontier a = point were an hypothetical bank produce inside the Production Possibility h= point were the hypothetical bank expanding production became efficient

reciprocal of OTE gives the maximum expansion of each outputs given the banks level of input usage

max 1 when bank produce on the Frontier, <1 when bank produce inside the Frontier
OTE= Overall Technical Efficiency, is the value of the Output Distance Function

METHODOLOGY (3/7)

The LP method used to estimate the distance function define the best practice reference technology for each bank:

m and n are constrains

intensity variables serve to form convex of combinations of x an u for K banks

bank under observation at period t

This model consider CRS, adding VRS (Variable Rate of Scale) in the technology we add the constraint:

METHODOLOGY (4/7)
The Scale efficiency is SCALE=TCRS/TVRS Inefficiency means bank is not operating in the range of CRS

Regulation may influence production possibility set. Given: (E)=amount of Equity (Aj)=value of Asset j (SumAj)=total assets (wj)=weight of asset by regulation (L)=minimum leverage ratio put from regulatory authority (R)=minimum risk-weighted capital ratio set by authority
Leverage-ratio constraint Risk-weighted ratio constraint Let M outputs as a subset of j assets Leverage-ratio constraint Risk-weighted ratio constraint The two regulatory constraints linerized:

METHODOLOGY (5/6)
Given the two regulatory constraints and the VRS technology (TVRS) subject to the two regulatory constraints they calculate the PTE (Pure Technical Efficiency) that is the reciprocal solution of this LP problem:

Level of Regulatory Efficiency Level of Scale Efficiency Level of Overall Technical Efficiency In a given period (t) each measure of efficiency is constructed assuming a constant bank output mix At t+1 can change: bank output mix, bank position on the frontier, frontier (shift)

METHODOLOGY (6/7)
There are three banks employing the same inputs, the outputs are a,b,c The Unregulated Production Possibility Frontier=0fbcg Equation of risk-weighted capital-ratio constraint (segment RR):

In absence of regulation: Banks c and b OTE=1 bank a OTE=0a/0h=0,67 potential u=1/OTE=1/067=1,5 u=(1,5,1,5) Bank a OTE=0a/0h PTE=0h/0i REG=0i/0h Example: SECURITY (u1) RISK WEIGTHED (w1=0,2) REAL ESTATE LOANS (u2) RISK WEIGTED (w2=0,5) Bank a u=1,1 Bank b u=2,1 Bank c u=1,2 With regulation constraints: Hypothesis: R=0,08 other assets dont exist u1<E/(O,2*0,08)-(0,5/0,2)u2 u1<E/0,016-2,5u2 u1<62,5E -2,5u2

METHODOLOGY (7/7)
Example (continuing)

Solving LP problem with regulatory constraint, (bank a) can have an efficiency yield of 0,7 -production=1/0,7=1,44 so output could just expand to u=(1,44 1,44) REG=0,67/0,7=0,95 and lost of potential output=((1/0,95)-1)%=5,3% E have to expand to E>0,084 maintained its original output mix, if bank decide to maintained the same E have to change is outputs mix to u1/u2 1,67/1,33

RESULTS (1/13)

Since OTE is multiplicative in its components, they reported the geometric means of the components of OTE OTE improved from 53% to 61% realizing OTE=1 potential output in 1990 is ((1/0,53)-1)%=89% and ((1/0,61)-1)%=64% in 1993 The FDIC Improvement Act took effect in December 1991, the data from 1990 show that bank change their assets (outputs) before the Act takes effect. Efficiency in 1990 was due to PTE* REG(speculative) Scale efficiency decline in 1993, none of the banks operated in DRS

RESULTS (2/13)

RESULTS (3/13)

RESULTS (4/13)
Table 3 examines average bank real estate loans and the potential gains reducing PTI, reducing scale inefficiency by operating at CRS and reducing RTI. Bank real estate portfolio is divided into: construction, farm loans, one-to-four family residential, multi-family residential, other loans (i.e. commercial)

Potential Real estate loan portfolio is when bank realize OTE=1 1/OTE measures maximum expansion of each category of assets(output) Measure of OTE doesnt require information on inputs and outputs prices(constant, but not for banking industry-expansion of RE loans to its potential: sell marginal output: reduce gain) Gains are independent from changes in real estate portfolio due to allocative inefficiencies in the mix of inputs and outputs

RESULTS (5/13)
Potential Real Estate loan portfolio=Mean of each RE categories/OTE Each actual real estate loan portfolio do not increase to the same factor, because each bank has a different OTE level and a different amount of each kind of RE loan
Actual Real Estate lending increase from 1990 to 1993 by 12% but potential real estate lending fell, because banks reallocated their loan portfolio

The potential gains in real estate lending from reducing all inefficiencies is 1/OTE and OTE=PTE*REG*SCALE
The authors measure Potential gains in real estate lending with PTE=1 REG=1 SCALE=1 RE=actual real estate lending

RESULTS (6/13)

REG=1 in 1990 is speculative because FDCIA take place in 1991so GAINreg depends in that year only on PTE, but although considering REG=1 it could be that constraints didnt have effects on real estate lending for the downturn in the business cycle. REG=1 GAINreg declines

From 1990 to 1993 the average bank of the sample grew from $2.5 billion to $2.8 billion(merger and normal grew) SCALE=1 GAINscale increased The LP method construct the best-practice technology and not the true unobserved technology, so it could be that the observed frontier of 1990 lies further from the true frontier and increasing bank size compensate declining in scale so that there was a positive GAINscale

RESULTS (7/13)
Figure 3 plots a cumulative distribution function to compare each component of OTE with the banks share of cumulate real estate. Vertical axis=efficiency score for each component Horizontal axis=individual bank real estate lending by all banks of the sample Figure suggest no significant concentration of real estate lending among few banks Shift in the vertical intercept in 1993 show that inefficient banks became more efficient in OTE, PTE, SCALE and REG Shift in the cumulate distribution function in the corner of the box show an increase in GAIN most pronounced for GAINreg

RESULTS (8/13)

RESULTS (9/13)
The authors examine the three alternatives that bank have to respect capital constraints regressing the log change in regulatory efficiency on(as in Peek and Rosengren): 1)log change in equity(E) 2)log change in total assets (A) 3)log change in real estate lending(RE) 4)log change in per capita disposable income (Y): to control business cycle

RESULTS (10/13)
Last part of the study they examine regional differences in bank efficiency disaggregated the sample by Federal Reserve District (FRD). This because credit crunch had different impact in US states: severe impact in New England, southwest and west-cost. They reported for each district, distinguished data collected in 1990 than in 1993, number of the bank observed, Overall Technical Efficiency and each of its components measured by geometrical mean and Gain in real estate loans(expectation of real estate lending if banks realize OTE=1). Non-parametric Wilcoxon signed-rank test is used to test significant differences across states

RESULTS (11/13)

RESULTS (12/13)

RESULTS (13/13)

VALUE ADDED RESPECT TO LITERATURE (1/1)

They give an empirical evidence of the theoretical research of Peak and Rosengren (1995): Credit Crunch is a supply-induced restriction. Is a originally and complex microeconomic study that investigate supply side behavior by banks. They find evidence that studying bank production function there are relation between bank crisis, bank efficiency, capital equipment, regulatory constraints, ALM and credit risk management. They were able to measure potential real estate lending efficiency overall and analyzing each component of the efficient production frontier.

IMPLICATIONS AND FURTHER DEVOLPMENT (1/1)

Estimated regression suggests that the decline in inefficiency due to RBC standards results from increase in bank equity capital and a slower growth in real estate lending.

The RBC standards constrained residential mortgage lending the most, but an active secondary market in residential mortgage allows bank to originate and then remove mortgage from the balance sheet. Moreover there was numerous non-bank sources of financing mortgage. Construction and small commercial real estate borrower are more bank-dependent so the RBC may have more impact in construction and commercial real estate. The research is dated, new studies have to compare the Credit Crunch period starting in 2007, and is important to introduce variables measuring the babble in real estate price and how it influence real estate lending policy.