Major reasons for default risk on commercial real estate loans is a bubble economy. An often-quoted definition of “bubble” is the one given by Stiglitz as follows: ” If the reason for the price is high today is only because investors believe that the selling price will be higher tomorrow – when “fundamental” factors do not seem to justify such a price – then a bubble exists”.

The basic reason for the connection between a bubble and banking problems is over-expansion of bank credit fuelled by the build-up of real estate prices and increasing credit risks. The acceleration of economic growth and increased demand for real estate triggers “euphoria” as households and companies anticipate these further properties’ prices rise and increase their willingness to engage in debt-financed investment.

There is a special thing about real estate lending: as price increases create “an extra” collateral that can be used for additional borrowing.
Increases in the price of real estate property held by companies mean a rise in the value of this asset on their balance sheet. Such capital gains lead to easier access to bank loans, which may be used for new productive investments or more speculative real estate investments. For various reasons lenders may incorrectly rely on trend-based analyses, which assumes that current market conditions continue in the future.

Thus, increased real estate prices, when related to fundamental improvements in the economic outlook or declines in real interest rates, can lead to increased borrowing. Therefore bank lending may also be a source for upward pressure on real estate prices; especially, if banks relax lending policies. Thus, lenders may undertake extremely tolerant lending policies at the peak of the cycle and extremely conservative lending policies at the trough of the cycle.

At the peak of the cycle banks may have borrowers that are highly exposed to a sharp price decline. These borrowers are known as the latest entrants in the real estate markets and they are especially vulnerable, since they have borrowed when prices were close to the peak and possibly expected that the price rally and trend would continue. These borrowers would experience the largest capital losses and the largest risk of default. Once these borrowers stand face to face with the possibility of default, they are also likely to take increasing risk (moral hazard).

Once the peak of a cycle is being approached, real estate prices become increasingly cut off from their “fundamental values” and vulnerable compared to exogenous shocks. The shock can be an unanticipated change in the overall economic performance. This event damages market confidence and causes a capital flight away from the relevant assets. When real estate prices are so high that buyers do not want to buy anymore at this price level, and of course, sellers are not able to sell at his level, there will be market correction – a bubble crashes. The price collapse can be affected substantially by forced sales of properties. The difficulties experienced by borrowers are transmitted to banks. The bad loans of banks and capital adequacy problems may lead to tightening of lending standards and credit rationing.

The next situation was common in Japan at the end of 80′s: Land is the main problem in the non-performing loans held by the Japanese financial institutions. During the period of the bubble economy, banks competed with one another in offering a large amount of loans and accepting the pieces of land as collateral. The combination of low interest rate and abundant liquidity activated real estate investments and affected most sharply on the inelastic urban land supply to generate accelerating in increase of land prices. Increases in the market value of land (land as asset) held by corporations mean a rise in the value of this asset on their balance sheet.

There have been two links between increases in land values and banks’ credit in the Japanese financial environmental. First, banks gave
land-related loans directly to real estate companies or indirectly trough loans to subsidiary companies that are the main loan channels to real
estate companies in Japan. Such lending policies rose very sharply and accelerated joint land and equities asset prices. Secondly, banks in
Japan have traditionally relied on collateral rather than project quality and cash flows. The soaring value of land provided the collateral against which Japanese firms could borrow at home to buy assets abroad.

After the collapse of the bubble economy, however, those pieces of land could not be disposed of in order to reconstruct loans because the prices of the land fell significantly and banks have been obliged to retain the pieces of land with depreciated values. Liquidity was cut back because of restriction policies and the discount rate was raised five times from 2.5 percent to 6.0 percent by the end of 1990. The so-called bad-loan disposal, which is expected to continue for the next several years, is actually nothing, but a higher level of the reserve fund covering the losses of loans.

The reserve fund for loan losses is a fund prepared to cover the losses caused by default of borrowers and it gives favourable tax treatment for such funds. Non-performing loans have not been worked out directly, but reserve funds were raised. This means that the indirect “disposal” of bad loans is officially approved for taxation purposes and the disposal method used for the past several years has simply built reserve funds. In other words, non-performing loans are still recorded on the financial institution’s balance sheets and therefore the amount of bank loans has not been reduced. The real estate market is depressed with the illiquid lands kept idle by banks without being traded in the secondary market.

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