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Portfolio Analytics Quantify Benefits of Geographical Dispersion

In a recent examination of commercial mortgage portfolios, Boxwood quantified the impact of the geographical dispersion of loans on diversification benefits and economic capital. Lenders traditionally rate the credit quality of individual loans and then establish capital reserves for the stand-alone credit risk. What is more elusive is the quantification of portfolio risk. Portfolio risk not only reflects the risk or volatility of each single loan, but also the behavior of the loans in aggregate. By quantifying geographical diversification, discounts on capital set-asides can be realized.

Boxwood's study involved the simulation of thousands of prototypical apartment mortgage portfolios with various geographical distributions and concentrations. We then analyzed the geographical diversification effects employing forward-looking simulation models that carefully identify and preserve default covariances of the loan assets. The results indicate that substantial diversification benefits can be achieved through national and regional distribution of loans. Quantification of these diversification benefits, in turn, suggests that economic capital can be reduced by roughly 40% for geographically diversified portfolios. Moreover, optimized market selection can further increase the "diversification rebate" to nearly 60% with loan exposures in only a modest number of metropolitan areas. The study underscores the potential of portfolio analytics in shaping lender policies regarding portfolio strategy, risk management and cross-regional lending relationships.