Monday, April 2, 2012

When looking for assets vulnerable to the next crisis, don't fight the last war

Here is an interesting chart from the Fed. It shows bank (all US chartered banks) charge-off rates for 3 different asset classes: commercial/industrial (corporate) loans, commercial real estate loans, and residential real estate loans. Charge-offs for all three spiked during the last recession. But the previous two recessions were quite different.

The "Gulf War-I" recession caused an increase in corporate and commercial real estate loans charge-offs, while residential loans remained relatively intact. The "Dot-com bust" recession however only hit the corporate loan asset class (Worldcom, Enron, Mirant, etc.). Real estate loans charge-offs remained immaterial.

What's interesting is that on a relative basis the largest dollar losses during this past recession came from residential loans followed by commercial property loans, with corporate loans producing the least amount of dollar losses. There isn't a sufficient data for a conclusive result, but one could postulate that risk appetite (looser lending standards) and ratings biases were driven by how assets behaved in earlier recessions. And the better the asset class performed in previous economic shocks, the more comfortable the lenders/investors became with the product. Risk managers and regulators in effect "fight the last war".

As an example of that effect consider the fact that sovereign debt did quite well during 08-09 and became the darling of European banks. Clearly these banks held sovereign debt before the 08 crisis, but the holdings increased considerably during 2009 and 2010. Just as with mortgage loans prior to the crisis (using securitization), both the regulators and the rating agencies made holding sovereign debt easy for banks.

The problem markets/asset classes for the next crisis may therefore be those that did well during the recent economic shocks. There are a few that come to mind, but that's a topic for another discussion.
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