Boxwood Means, Inc., the real estate research consulting firm, announced that its pioneering study on the impact of mortgage portfolio diversification on economic capital has been published in the September issue of The RMA Journal. Results indicated that substantial reductions in economic capital set-asides are possible through geographically diversified portfolios.

In its examination of commercial mortgage portfolios on behalf of an institutional client, 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 has been 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. The geographical diversification effects were then analyzed by employing forward-looking simulation models that carefully identify and preserve default co-variances of the loan assets. The results indicated 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 and risk management.

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