The new CRE guidance specifically calls for greater sophistication in analyzing correlations between various CRE loan types.  The implication is that if a bank can demonstrate negative correlation between CRE loan sectors, then some of the riskiness in the CRE concentration might be mitigated. 

Different loan types have differing loss histories over time.  For example, a credit card loss rates far exceed loss rates on commercial loans.  This study evaluates historical loss rates for a broad range of loan types from the period 1994 to present based on statistics released by the FDIC and the Federal Reserve. 

Loss rates vary by loan category.  The highest loss rates occur in consumer loans and the lowest occur in commercial real estate loans (including construction, multifamily and Nonfarm/ Nonresidential).  C& I loans are in the middle.  Different loan types have differing loss histories and the cycles of losses are not always correlated.  In some cases, loss rates are actually negatively correlated as between CRE loans and C&I loans or CRE loans and consumer installment loans. 

Unfortunately, the three types of CRE loans - construction, multifamily and Nonfarm/ Nonresidential are extremely positively correlated.  Therefore, bankers must be vigilant in concentrating exclusively in these three areas. 

The implications of this for banking and in particular for portfolio management are significant.  If loan types are shown to have negative correlations in their loss histories, then bankers can demonstrate synergies from differing loan portfolio compositions.  In addition, differing loss histories that are negatively correlated tend to cancel one another out.  A bank that is well diversified between CRE loans, C&I loans and consumer loans will have lower overall losses in its portfolio than a bank that is not.

The above analysis is based on data for nearly 7,000 banks nationwide.  The results may differ for individual banks.  Each bank should track loss histories by loan type and for real estate loans by property type in order to establish a valid loss history database.  Findings for individual banks may actually show results that differ from the national averages. 

Findings:

Loss rates for CRE loans (Construction, Multifamily, Nonfarm) are least correlated (-1.00 being perfect negative correlation) with Commercial Loans and Consumer loans. 

Commercial Loans and	Construction	-0.07
	Multifamily	-0.27
	Nonfarm/nonresidential	-0.08
Consumer Installment loans and	Construction	-0.53
	Multifamily	-0.74
	Nonfarm/ nonresidential	-0.59

Loss rates within CRE loan categories have the highest correlations (1.00 is perfect correlation)

Construction and	Multifamily	+0.93
	Nonfarm/ Nonresidential	+0.96
Multifamily and	Nonfarm/ Nonresidential	+0.98