Comment by Nevermark

The problem is the bank didn’t leave a buffer to meet their requirements, so arbitrage between reality and official reality comes to the rescue.

If a bank only loaned 60% of a buildings value, it could be devalued, the operator would eat the shortfall, but the bank could reappraise, with the loan continuing as before.

[So a regulation setting a banks maximum loan percentage, at a percentage less than they are required to maintain, is an obvious regulatory fix.]

However, another way to look at this from a banks point of view is while they may loan 80%, they might have been happy to loan 100% but for regulations. So perversely, they may not be as concerned about this happening as it appears.

For them, the 80% max loan is already providing a buffer, in terms of the risk they would be happy to take. So if they can avoid acknowledging they have loans that have risen in percentage terms, it is in their business interest to encourage, facilitate, giving operators breathing room.

And in the meantime, inflation, property value growth, and future demand increases provide three statistically “expected” ways for the situation to self-correct over time.

For financial investment products, all value is “expected” value.

And the operator may not be losing money, so much as paying for the buildings accrued value growth. Which would be a wash, but avoids the practical problems of defaults. Not the best, but not losing (as much) money as it appears.

And for the bank, if the loan payments are made there is no problem.

So there are two hidden buffers: banks willingness to loan more than regulators want them to, and natural property value increases, lowering rent prices (i.e. inflation) over time.