Commercial Mortgage Loan Portfolios

U.S. bank regulators are now targeting commercial real estate lending as an area for special

scrutiny.1 One important dimension of risk in commercial mortgage loan portfolios is geographic

concentration. Except for the largest banks, most institutions have notable geographic

concentrations in their commercial mortgage loan portfolios. The regulators should encourage banks

to mitigate risk by boosting the geographic diversification of their commercial mortgage loan

portfolios. Here is one way that would allow banks to do so.

The approach has two steps. In the first step, a bank sheds risk on its existing portfolio. In the

second step, the bank acquires exposure to a geographically dispersed pool of commercial loans

originated by other banks.

In the first step, the bank "buys protection" on a mezzanine slice of its own commercial mortgage loan

portfolio. For example, the protection might cover losses that exceed 1.5% of the original balance of

the loans, up to a maximum of 5.0%. Think of it as a credit loss insurance policy with a deductible of

1.5% and a coverage amount of 3.5% (i.e., 5.0% - 1.5% = 3.5%). If the bank's commercial loan

portfolio is $1 billion, the swap might cover losses from $15 million to $50 million. However, instead

of taking the form of an insurance policy, the protection likely would be a credit default swap or

"CDS." In CDS jargon, the protection would have an "attachment point" of 1.5% and a "detachment

point" of 5.0%. The bank would purchase the CDS from a securities firm that deals in CDS. For

purposes of our example, we'll call the firm the "Swaps Dealer."

In purchasing credit protection through a CDS, a bank must balance competing considerations in

selecting the attachment and detachment points. The attachment point should be substantially higher

than the level of "expected losses" on the protected portfolio to keep the price of protection

reasonable. A bank naturally knows its own loan portfolio better than outsiders do — it faces less

uncertainty about the level of expected losses. Accordingly, each bank reasonably has the strongest

bid (i.e., ascribes the highest value) to the "first loss" exposure on its own loans. It usually cannot buy

"first loss protection" at a price that it would deem fair. Thus, for a bank to buy protection

economically through a CDS, the attachment point must be substantially higher than the level of

expected losses.

Likewise, the detachment point on a CDS should be high enough that it covers most plausibly

adverse scenarios (i.e., high levels of unexpected losses), but not so high that it covers extremely

unlikely "catastrophic" losses. Compared to third parties, a bank can better judge what is reasonable

for its own portfolio. By properly selecting attachment and detachment points, the CDS contract can

provide a bank with meaningful protection at a reasonable cost.