BID® Daily Newsletter
Dec 7, 2006

BID® Daily Newsletter

Dec 7, 2006

A CANARY IN THE LOAN MINES


If you believe the mythology, somewhere around the year 1815, miners started to take canaries into mines to protect against Carbon Monoxide and Methane. In the presence of these gases, the bird, who was presumably singing like a canary up to that point, would get woozy and pass out. Miners would then safely high-tail-it-out-of-there and their lives would be saved. This is apropos because 2006 will mark one of the first years that independent banks began using a variety of systems to predict problems loans before they surfaced. One such methodology for monitoring CRE credit exposure is based on property valuation. Bankers inherently know that when property values go down, delinquencies go up. Therefore, in a down market, it is likely that both property incomes are falling and capitalization rates are increasing. Lower cashflow and deterioration of equity sets the stage for the borrower to walk away from their loan. In fact, when back-testing is performed, the correlation is so strong that delinquencies are more than 7x more likely to occur with properties that are falling in value vs. those that are rising. This correlation gives banks an opportunity to develop an early warning system for monitoring loan and risk exposures. Banks may want to consider setting up a formalized system to capture and track property improvements, income, capitalization and area comparables, in order to come up with a proxy for value. Bankers should note that our preliminary research finds that once values dip more than 8%, loan delinquencies increase. As we update our Loan Pricing Model ("LPM"), we are starting to notice a wide range of discrepancies in property values. Perhaps more foreboding, we have not seen this large a disparity since the early 1990's. At a minimum, this means we are in for more loan earnings volatility. By January, we will be releasing state-by-state information within the LPM and by April, we will be getting down to the metro/zip code level. As we collect data each month, we are starting to see some material changes in property values. To name a few areas and property types bankers should monitor (that have seen property values drop 9% to 25%) include multifamily in Indianapolis, Detroit and Charlotte; retail in New Mexico and Honolulu; offices in Dallas and Houston; and industrial property around San Francisco. Of course, the opposite is also true and in a majority of markets across the country, appreciation has risen. Specifically, Los Angeles and Atlanta office; San Diego, Seattle and Orlando retail; and San Francisco multifamily are up an average of 42%. For properties that are down more than 8%, banks can expect an approximate 8 to 18 month time lag before cashflow starts to get tight and delinquencies occur. During this time, banks can increase surveillance, try to restructure the loan (to lower risk or increase pricing), or look for refinance opportunities with other banks that don't have access to this data. As property values continue to change, we will continue to monitor the situation and provide access through LPM. This will give bankers an edge as they utilize property valuations as an early-warning problem indicator. Hopefully, with such early warning, banks will have time to shift risk if the singing suddenly stops.
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