Loss given default, loan seasoning, and market fragility: Evidence from commercial real estate loans at failed banks

Commercial real estate (CRE) lending is important – it is a primary asset class at many small- and medium-sized banks, and it was a major contributor to bank failures in the recent financial crisis. Yet despite the recognized risks, losses on these types of loans are not well understood. While prior research has suggested a relationship between seasoning and the probability of default (PD) for certain types of loans and bonds, the effect of seasoning on loss given default (LGD) has received little attention. We provide new evidence of seasoning effects on LGD for CRE loans, using a newly available dataset on CRE loan losses. We show that these effects are distinct from other factors, such as loan amortization over time, asset price changes and loan vintage effects. Our data come from over 14,000 distressed CRE loans at 295 failed banks resolved by the FDIC using loss-share agreements between 2008 and 2013. We find that CRE loan seasoning is negatively related to both the probability and the severity of loss. This highlights a channel of risk for lenders with high CRE loan growth---even if the origination quality has not deteriorated---as the LGD on newer CRE loans will tend to be higher than for more seasoned loans in default. Loan seasoning may contribute to CRE credit cyclicality and market fragility, as aggregate losses may be worse after periods of expansion due to the changing composition of loan seasoning in the industry. In addition, we find several other unique results related to loss given default in times of distress.