MORTGAGE LENDING: CONDUITS

APARTMENT FINANCE TODAY • OCTOBER 2007

Capital Crisis Hits Conduit Lenders

By Bendix Anderson

New York City—Loans are still available from most conduit lenders. But interest rates are much higher and underwriting terms much tougher than they were just a few months ago—and according to experts, some of these changes will be permanent.

Broken promises and low loan originations After the market for subprime mortgage loans melted down in July, investors pulled back from bonds backed by real estate, sending the market for commercial mortgagebacked securities (CMBS) into crisis.

All of a sudden, conduit lenders couldn’t raise the money to fund the loans they’d already committed to make. Many lenders broke promises, pushing up interest rates for loans that had not yet closed even if the lender had already given the borrower a so-called “rate lock,” according to David Rosenberg, managing director of capital markets for Meridian Capital Group, LLC, a New York City-based mortgage broker.

Almost all conduit lenders are still accepting applications for loans, Rosenberg said. But the terms on offer are so uncompetitive that few are closing a significant volume of deals. The conduit lending arms of the largest commercial banks like JPMorgan Chase and Citibank are the most likely to be closing new loans. But even they have drastically diminished their conduit lending, and the volume of conduit loan originations in early September was just a quarter of what it had been before the crisis, according to Sally Gordon, vice president for bond-rating firm Moody’s Investors Service, based in Manhattan. Moody’s rates the CMBS backed by these loans. Gordon made her estimate based on the volume of loans in Moody’s pipeline to be rated.

For example, Centerline Capital Group’s conduit lending arm originated no loans in August or early September. Borrowers that might normally have chosen conduit financing used Centerline’s Fannie Mae and Freddie Mac financing instead, according to Larry Duggins, executive managing director and cohead of the commercial real estate group for Centerline.

The few conduit loans being made have higher interest rates. The rates on offer for 10-year, fixed-rate multifamily loans now often reach more than 200 basis points over the yield on the 10-year Treasury note. That’s a steep increase from a spread of 85 to 90 basis points just six months ago, said Rosenberg.

Higher conduit spreads aren’t as hard on borrowers as they might have been, because the yields on Treasury bonds have dropped by more than 80 basis points from their highs over the summer.

Still, the increase makes conduit financing relatively unattractive compared to much lower spreads for Fannie Mae and Freddie Mac loans, said Rosenberg. These loans are more competitive in part because bond investors are more willing to risk their money on bonds backed by these loans, which often come with a Fannie Mae or Freddie Mac guarantee on their value, according to Lisa Pendergast, managing director in RBS Greenwich Capital’s Real Estate Finance Research Department.

The same bond investors have largely abandoned CMBS. Even for AAA-rated CMBS, yields rose to 127 basis points over Treasuries as demand dropped in early September, compared to 70 to 80 basis points at the beginning of the year, experts said.

Other tranches—AA- and A-rated pieces—have been even more volatile. “Originators have loans on their books that they can’t sell,” said Pendergast. “Chances are, the only part of the deal that you’ll be able to sell are the AAA-rated bonds.”

Lenders are hesitant to originate new loans until they can unload the bonds from loans they have already closed.

Part of this logjam should begin to clear in late October and November, Pendergast said, as the high yields now available on CMBS bonds lure some investors back into the market. Prices will also become more stable once conduit lenders sell off their excess inventory of A- and AA-rated CMBS.

Leading B-piece buyer stays in the game

Centerline believes strongly enough in the value of CMBS to buy the riskiest tranches of CMBS bonds even as other investors back away from the market.

The company was preparing to close on two large purchases of Bpiece CMBS in September and three more in October and November. It expects to pay low prices for these bonds, enjoying the advantage of being one of the few B-piece CMBS investors left in the market.

Centerline believes that CMBS are good investments because the company believes in the quality of the loans that back the bonds.

“We have historically low levels of defaults,” said Greenwich’s Pendergast. As of early September, 0.77 percent of all apartment loans that back CMBS were delinquent by 30 days or more. Delinquency rates for other property types are even lower: 0.7 percent rate for hotels or even 0.13 percent for office loans, according to data from Trepp, LLC, a leading CMBS data provider.

Although apartment delinquencies are high compared to office and hotel loans, they’re still lower than two years ago. At that time, when CMBS investors couldn’t buy enough of the bonds and the issuance of CMBS was breaking records, the delinquency rate was more than 1 percent.

Plus, the foreclosure process for commercial properties can take six months to two years, giving borrowers plenty of time to structure workout plans. That means few of the loans that are 30 days late will actually reach foreclosure, said Duggins.

In comparison, the percentage of subprime home loans in much deeper trouble, with payments 90 days late or more, was more than 13 percent in June, according to a report by Michael Youngblood, an analyst at securities firm Friedman, Billings, Ramsey Group, Inc.

Centerline continues to favor CMBS loan pools made up of at least 25 percent apartment loans. That’s because apartments offer a consistent stream of income to pay debt service, an asset that will help prevent delinquencies from climbing much further, said Duggins.

Tighter underwriting

Centerline is also taking advantage of the lack of competition from other B-piece buyers to impose some tougher “common sense” underwriting.

That means kicking loans with lax underwriting out of loan pools.

“We are able to more aggressively remove deals that don’t pass the smell test,” said Duggins.

Moody’s also got tough on conduit borrowers by tightening its ratings standards for CMBS beginning in July, just before the capital crisis began.

Both Moody’s and Centerline now frown on borrowers that count potential increases in income as if they had already happened, and both encourage borrowers to fully recognize the probable cost of future expenses like increased taxes.

Interest-only loans, which allow borrowers to pay only the interest on the loan and not the principal, will likely be scarce for a while. Before the crisis, conduit lenders often offered interest-only periods that lasted the entire 10-year term of a loan.

And borrowers should get used to receiving lower proceeds on their loans, which are likely to cover only 70 percent to 80 percent of the value of an asset rather than 90 percent or more, said Duggins.

These underwriting changes are likely to be the lasting legacy of the capital markets crisis for the conduit lending world. The new, tougher underwriting standards will last much longer than the panic on the bond markets, Duggins said.