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Real estate markets and bank distress

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  • Real estate markets and bank distress

    Michael Koetter(University of Groningen and Deutsche Bundesbank)

    Tigran Poghosyan(University of Groningen)

    Discussion PaperSeries 2: Banking and Financial StudiesNo 18/2008Discussion Papers represent the authors personal opinions and do not necessarily reflect the views of theDeutsche Bundesbank or its staff.

  • Editorial Board: Heinz Herrmann Thilo Liebig Karl-Heinz Tdter Deutsche Bundesbank, Wilhelm-Epstein-Strasse 14, 60431 Frankfurt am Main, Postfach 10 06 02, 60006 Frankfurt am Main Tel +49 69 9566-1 Telex within Germany 41227, telex from abroad 414431 Please address all orders in writing to: Deutsche Bundesbank, Press and Public Relations Division, at the above address or via fax +49 69 9566-3077

    Internet http://www.bundesbank.de

    Reproduction permitted only if source is stated.

    ISBN 978-3865584441 (Printversion) ISBN 978-3865584458 (Internetversion)

  • Abstract

    We investigate the relationship between real estate markets and bank distress amongGerman universal and specialized mortgage banks between 1995 and 2004. Higherhouse prices increase the value of collateral, which reduces the probability of bankdistress (PDs). But higher prices at given rents may also indicate excessive expec-tations regarding the present value of real estate assets, which can increase PDs.Increasing price-to-rent ratios are positively related to PDs and larger real estateexposures amplify this eect. Rising real estate price levels alone reduce bank PDs,but only for banks with large real estate market exposure. This suggests a positive,but relatively small 'collateral' eect for banks with more expertise in specializedmortgage lending. Likewise, lower price-to-rent ratios are estimated to reduce theriskiness of banks. The multilevel logit model used here further shows that realestate markets are regionally segmented and location-specic eects contribute sig-nicantly to predicted bank PDs.

    Keywords: Real estate; distress; universal vs. specialized banks; multilevel mixed-eect modelJEL: C25; G21; G3

  • Non-technical summary

    The detrimental eects of overheated real estate markets for nancial stabilityare obvious in light of the recent turmoil in international nancial systems. But therelation between real estate markets and bank distress is hardly analyzed for themajority of economies that do not show clear signs of overheating, such as Germany.The scarcity of empirical evidence on the relation between house prices and bankdistress relates to two measurement problems. First, comparable series on houseprices are often unavailable or mask important regional dierences that inuencebanking risks. Also, in addition to price levels, the ratio of rents generated fromreal estate assets relative to their price may be a more adequate determinant ofbank risk. But corresponding data on both property prices and rents is usuallyeven more dicult to obtain. Second, bank distress is usually not announced to thepublic. Failures are resolved within banking groups to reduce the risk of negativeexternalities, which complicates the measurement of bank's risk in most studies.

    We address both issues by combining information on bank distress collectedby the Deutsche Bundesbank with regional house price information collected by aprivate data provider, Bulwien AG. We suggest a novel multilevel hazard rate modelas to account more explicitly for the regional dierences of housing markets and therespective location of banks in dierent states of the Federal Republic of Germany.Within this framework, we provide empirical evidence on the relation between realestate price developments and bank distress for a large bank-based economy.

    Especially the regional aspect of house price developments has important impli-cations for bank distress. Random region-specic eects contribute signicantly tothe PD of banks. Approximately one third of predicted PDs of banks located in thenew federal states of Germany is due to this location eect. In contrast, the locationcontribution to PDs is relatively low and negative for banks headquartered in theold federal states.

    The level of real estate prices is of minor importance for bank distress, both sta-tistically and economically. Price-to-rent ratios that indicate the extent to whichcash ows are expected to be generated from property are in turn consistentlypositively related to bank PDs. Akin to the price-earnings ratio from the nanceliterature, higher prices per Euro of expected rent generated from real estate as-sets may therefore indicate deviations from fundamentals, thereby contributing to alarger probability of banks to face distress. Note, however, that in contrast to price-earnings ratios of liquid nancial assets, property rents do not adjust very often.This might limit the ability of our proxy to measure changes in the expectation ofthe value of real estate assets in the future perfectly.

  • Nichttechnische Zusammenfassung

    Die gegenwrtigen Turbulenzen in internationalen Finanzsystemen unterstrei-chen die negativen Auswirkungen berhitzter Immobilienmrkte fr die Finanzsta-bilitt entwickelter Volkswirtschaften. Viele Immobilienmrkte, z. B. in Deutschland,weisen jedoch keine Anzeichen derartiger Blasen auf. Theoretisch sind Immobilien-mrkte jedoch auch ohne oensichtliche berhitzung fr den Zustand des Bankwe-sens relevant, da Kreditinstitute Hypothekenkredite vergeben und Immobilien alsSicherheiten nutzen. Empirisch ist der Zusammenhang zwischen Immobilienmrk-ten und Bankstabilitt jedoch weitgehend unerforscht.

    Der Mangel an empirischer Evidenz ist vor allem auf Messprobleme von Haus-preisen und der Wahrscheinlichkeit einer Schieage bei Banken (PD) zurck zufhren. Vergleichbare Hauspreisindizes sind entweder nicht oder nur auf nationalemNiveau vorhanden. Dies vernachlssigt wichtige regionale Unterschiede von Immo-bilienmrkten, welche fr die Stabilitt lokaler Banken relevant sind. Korrespondie-rende Preis- und Mietzinsdaten sind ebenfalls selten vorhanden, was die Ermittlungentsprechender Quotienten in Analogie zu Kurs-Gewinn-Verhltnissen (KGV) an-derer Finanzanlagen verhindert. Diese sind jedoch zur Einschtzung von Bankrisikeneher geeignet. Bankrisiken selbst sind ebenfalls nur selten akkurat zu ermitteln, weilSchieagen meist innerhalb des Bankensystems gelst werden, um negative Exter-nalitten zu vermeiden.

    In der vorliegenden Studie nutzen wir die Ausfalldatenbank der Bundesbankund regional erhobene Immobilienmarktdaten des privaten Dienstleisters BulwienAG, um diese Probleme zu umgehen. Wir nutzen ein neues multilevel hazard model,um regionale Unterschiede des Banken- und Immobilienmarktes in der empirischenSchtzung von Bank PDs explizit zu bercksichtigen.

    Unsere Ergebnisse besttigen die Wichtigkeit regionaler Immobilienmarktentwick-lungen fr Bank PDs auch dann, wenn es keinerlei Anzeichen einer berhitzung vonImmobilienmrkten gibt. Das hier genutzte empirische Modell schtzt den Einussregionaler Eekte auf Bank PDs separat. Diese Eekte sind sowohl statistisch alsauch konomisch signikant. Etwa ein Drittel der Bank PD von Instituten in denneuen Bundeslndern ist auf diesen regionalen Eekt zurckzufhren. Regionale PDEekte fr Banken mit Sitz in den alten Bundeslndern sind hingegen negativ undwesentlich kleiner.

    Unsere Ergebnisse zeigen auch, dass allein das Niveau von Immobilienpreisenkeinen wirtschaftlich signikanten Einuss auf Bank PDs hat. Im Gegensatz dazuist das Verhltnis von Kaufpreisen zu Mietzinsen durchgehend signikant positiv.Insoweit dieser Quotient in Analogie zu KGVs die Hhe zu erwartender Ertrgeaus dem Erwerb von Immobilien misst, deutet dieses Ergebnis darauf hin, dassmglicherweise von Fundamentaldaten abweichende Erwartungen hhere PDs nachsich ziehen. Im Gegensatz zu KGVs gehandelter Finanzanlagen ist allerdings zubemerken, dass Mietzinsen sich nicht hug ndern sondern oftmals nur dann, wennes zu einem Mieterwechsel kommt. Mglicherweise schrnkt dies die Fhigkeit derVariable ein, die tatschlichen Anpassung von Erwartungen des zuknftigen Wertesvon Immobilien perfekt zu messen.

  • Contents

    1 Introduction 1

    2 Real estate prices and bank distress 3

    2.1 Real estate prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

    2.2 Exposure and distress . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

    3 Methodology 7

    3.1 Empirical model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

    3.2 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

    4 Results 11

    4.1 Specication . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

    4.2 Estimations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

    4.3 Robustness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

    4.4 PD predictions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

    5 Conclusion 17

  • Real estate markets and bank distress1

    1 Introduction

    Recent turbulence in international nancial systems originating from mortgage mar-kets highlights the close relationship between real estate price developments and thesoundness of the nancial sector. Real estate market problems are likely to precedenancial crises as shown from a theoretical angle in Allen and Gale (2000) and asconrmed by historical crises.2 Therefore, it is not surprising that policy makers alsoconsider property prices among other indicators in their nancial sector assessmentprograms (IMF, 2003).

    Most studies on the relation between house prices and nancial system sound-ness share two characteristics. First, they often focus on economies with overheatedhousing markets. But the vast majority of economies does not exhibit clear signs ofreal estate prices deviating excessiv

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