Commercial mortgage
Encyclopedia
A commercial mortgage is a mortgage loan
made using commercial real estate
as collateral
to secure repayment.
A commercial mortgage is similar to a residential mortgage
, except the collateral is a commercial building or other business real estate, not residential property. In addition, commercial mortgages are typically taken on by businesses instead of individual borrowers. The borrower may be a partnership, incorporated business, or limited company, so assessment of the creditworthiness of the business can be more complicated than is the case with residential mortgages.
Some commercial mortgages are nonrecourse
, that is, that in the event of default
in repayment, the creditor can only seize the collateral, but has no further claim against the borrower for any remaining deficiency. The general reason for this is twofold: many laws significantly prevent the creditor from going after the borrower for any deficiency, and mortgages structured for sale as bonds give a higher priority to constantly receiving some sort of income and therefore require a clause which allows the lender to take the property immediately, regardless of bankruptcy proceedings that the borrower might be going through.
Frequently, the mortgage is supplemented by a general obligation of the borrower or a personal guarantee from the owner(s), which makes the debt payable in full even if foreclosure on the mortgaged collateral does not satisfy the outstanding balance.
(a total payoff) after a lesser time frame. The borrower most likely will attempt at that time to refinance the loan or sell the property. Thus there are two elements generally to the term of a commercial mortgage loan: the length of time allowed until balloon payment (known simply as the term), and the amortization. The length of the loan can vary from a matter of days to 30 years. If a loan had a 30 year amortization schedule, but a 10 year term it would commonly be referred to as a 10 year balloon with a 30 year payment schedule.
As an example, assume a $15,000,000 loan at 8% interest with a 30 year amortization schedule and 10 year term (a 10/30 loan) with monthly payments. The payment amount would be $110,065 per month or $1,320,776 per year if it were on a typical 360 day accrual (in Excel: =PMT(8%/12,30*12,15000000,0)*12 ). The principal balance owed (to the mortgage bank) at the end of each of year would be:
At the end of the 10 year loan term, the borrower would have to pay the remaining balance (balloon payment) of $13,158,706. Note: If this table were continued, '$ owed to bank' would reach exactly $0 at year 30 since the loan type is 10/30.
Commercial premises are purchased for many reasons. One may require bigger premises to cope with expansion, or you may be buying property, whereby the property is directly linked to a business e.g. a hotel.
Commercial Mortgages are usually made with terms less than 10 years, but may be much longer than this. The Property itself is usually at risk if payments are not made on time.
Commercial Mortgages are often used for a variety of purposes::
The lender's decision will also depend on the business' current circumstances, a commercial lender will expect stability and profitability. They may ask to see a business plan
as well as long-term financial projections, to assure themselves that the business has, and will continue to have, the ability to make repayments on the loan. Some lenders impose restrictions on the uses of commercial premises and certain business concerns may be excluded altogether. The terms of a commercial mortgage depend largely on the type of business the type of premises or land to be bought.
"). In a normal residential mortgage, a lender would have a difficult time selling a property if the bankruptcy court case is still pending.
Lenders usually also require a minimum debt service coverage ratio
which typically ranges from 1.1 to 1.4; the ratio is net cash flow (the income the property produces) over the debt service (mortgage payment). As an example if the owner of a shopping mall receives $300,000 per month from tenants, pays $50,000 per month in expenses, a lender will typically not give a loan that requires monthly payments above $227,273 (($300,000-$50,000)/1.1)), a 1.1 debt cover.
Lenders also look at Loan to value
(LTV). LTV is a mathematical calculation which expresses the amount of a mortgage as a percentage of the total appraised value. For instance, if a borrower wants $6,000,000 to purchase an office worth $10,000,000, the LTV ratio is $6,000,000/$10,000,000 or 60%. Commercial mortgage LTV's are typically between 55% and 70%, unlike residential mortgages which are typically 80% or above.
The most common commercial mortgage is a fixed-rate loan, where the interest rate remains constant throughout the term. This must not be confused with the typical residential loan which uses the term to denote a 30 year term mortgage that comes with a rate fixed for 30 years. Most commercial loans have fixed periods between 3 and 10 years. The biggest for this is the source of funds. Many banks borrow their money to lend from the Federal Government with a wholesale cost and repackage the money for retail lending. Since the Fed Rate can change every 3 months or so, banks typically do not want to run the risk of their funds costs exceeding the income derived from interest through a loan made to consumer. These loans are typically based on the yields of treasuries, swaps, corporate bonds, or CMBS
rates. Loans can also be variable or capped. These rates are usually based on an index such as LIBOR.
A second commercial mortgage is an additional loan on a commercial property secured behind that of the first lien. The second mortgage is subordinated to the first mortgage and therefore carries a higher interest rate due to the higher risk of not being able to recover all losses should the loan default.
However if the commercial mortgage market for apartment buildings of 5 or more units, Fannie Mae and Freddie Mac do even more than this. Essentially they lend their own money and then securtize the bonds themselves, leaving banks to handle the servicing (ie. billing etc.) of the loan. They have come to dominate the market for apartment lending As of December 17, 2007 GSE's were reported to hold 34% of total debt outstanding for multifamily property. Given the recent liquidity crisis due to the sub prime crash of 2007 & 2008, these numbers are reported to be even higher by the Mortgage Bankers Association.
The financial institutions who work to obtain the loans for Freddie Mac or Fannie Mae are then primarily agents, and for this reason this area of lending is known as Agency Lending.
In 1970 the Federal Home Loan Mortgage Corporation, sometimes known as Freddie Mac, was established. This corporation is designed to promote the flow of capital into the housing market by establishing an active secondary market in mortgages. It may by law deal only with government-supervised lenders such as savings and loan associations, savings banks, and commercial banks; its programs cover conventional whole mortgage loans, participations in conventional loans, and FHAFHA
and VA loan
s.
Known in financial circles as Fannie Mae, this association was chartered as a government corporation in 1938, rechartered as a federal agency in 1954, and became a government-sponsored, stockholder-owned corporation in 1968. Fannie Mae, which has been described as "a private corporation with a public purpose", basically provides a secondary market for residential loans. It fulfills this function by buying, servicing, and selling loans that, since 1970, have included FHA-insured, VA-guaranteed, and conventional loans. However, purchases outrun sales by such a wide margin that some observers view this association as a lender with a permanent loan portfolio rather than a powerful secondary market corporation.
This association, which is often referred to as Ginnie Mae, operates within the Department of Housing and Urban Development. In addition to performing the special assistance, management, and liquidation functions that once belonged to Fannie Mae, Ginnie Mae has an important additional function — that of issuing guarantees of securities backed by government-insured or guaranteed mortgages. Such mortgage-backed securities are fully guaranteed by the U.S. government as to timely payment of both principal and interest..
in San Francisco to develop programs to convert commercial mortgages into bonds, primarily by making new commercial mortgage loans with clauses and structures which make them more like what bond investors want to invest in. The main thing that bond investors did not like about mortgages is that the borrower could repay the loan at any time (which was usually done when interest rates went lower, causing the bond investor to lose out on their high rate bond and having then to reinvest in new low rate bonds). While the government did not like restrictions on prepayment penalties being required of regular home owners, Nomura and other investment banks began to structure commercial mortgages that absolutely forbid prepayment, in exchange for dramatically lower interest rates (and also allowing new buyers of the property to take over the existing loans, in other words, making them assumable). The loans that were especially designed to be turned into bonds became known as "conduit loans". Because of the rule against prepayment, for a borrower to prepay a conduit loan, the borrower will have to buy enough government bonds (treasuries) to provide the investors with the same amount of income as they would have had if the loan was still in place. This is known as a defeasance
. When a property defeases, the bond it is in will increase in value since the higher risk real estate collateral is being replaced with lower risk US treasuries.
Conduit loans have been part of a trend in the Investment Banking industry to become more "vertically integrated". That is, instead of helping banks and other lenders to provide fix rate products and replenish funds by selling off loans as bonds, investment banks have taken to making the loans themselves, and then selling the bonds themselves. In fact, many times the Investment Banks make little or no money on the loan itself, and only make money by the selling and trading of bonds. For this reason, these forms of loans are usually at a better interest rate than is possible through other forms of Bank lending.
Like most residential mortgage loans that are sold as bonds to bond investors, investment banks usually create multiple classes (known as 'tranches') of bonds based on the same pool of mortgages. The tranches might be ranked so that the 1st class takes all of the losses on the mortgage loans up to a certain point in exchange for having a higher interest rate paid to them. The second class may only take losses when the losses reach a certain point for the first class of bondholders, in exchange for a lower interest rate. In this way one set of mortgages could be used to create bonds that appeal to a wide range on investors.
With the subprime mortgage crisis
, investors have stopped buying the majority of classes of commercial mortgage backed securities, and therefore, most conduit loans are no longer available at good interest rates. This is due to a few factors: while there is concern that the residential mortgage crisis will have an adverse effect on commercial real estate, the biggest issue is that both subprime mortgage bonds as well as commercial mortgage bonds have been arguably constructed incorrectly, with the investment banks underestimating the losses that might occur for each tranche and under compensating the tranches as a result (and also underpricing the original loan). It is not clear at this time whether new commercial mortgage backed securities will again begin to be issued in an orderly fashion, and if so whether the tranche system might be changed fundamentally. However this is an issue for the commercial real estate market in general as other lender (banks, Fannie Mae/Freddie Mac, life insurance companies) will be able to make up for the lost conduit loan availability.
s must compete for deposits. Consumer lending institutions compete for loanable funds
not only among themselves but also with the federal government
and private corporation
s. Called disintermediation
, this process involves the movement of dollars from savings accounts into direct market instruments: U.S. Treasury obligations, agency securities, and corporate debt. One of the greatest factors in recent years in the movement of deposits was the tremendous growth of money market funds whose higher interest rates attracted consumer deposits.
To compete for deposits, savings institutions offer many different types of plans:
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
made using commercial real estate
Real estate
In general use, esp. North American, 'real estate' is taken to mean "Property consisting of land and the buildings on it, along with its natural resources such as crops, minerals, or water; immovable property of this nature; an interest vested in this; an item of real property; buildings or...
as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
to secure repayment.
A commercial mortgage is similar to a residential mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
, except the collateral is a commercial building or other business real estate, not residential property. In addition, commercial mortgages are typically taken on by businesses instead of individual borrowers. The borrower may be a partnership, incorporated business, or limited company, so assessment of the creditworthiness of the business can be more complicated than is the case with residential mortgages.
Some commercial mortgages are nonrecourse
Nonrecourse debt
Non-recourse debt or a non-recourse loan is a secured loan that is secured by a pledge of collateral, typically real property, but for which the borrower is not personally liable. If the borrower defaults, the lender/issuer can seize the collateral, but the lender's recovery is limited to the...
, that is, that in the event of default
Event of default
Event of default is a term used in commercial loan documentation. It refers to the occurrence of an event which allows the lender to demand repayment of the loan in advance of its normal due date...
in repayment, the creditor can only seize the collateral, but has no further claim against the borrower for any remaining deficiency. The general reason for this is twofold: many laws significantly prevent the creditor from going after the borrower for any deficiency, and mortgages structured for sale as bonds give a higher priority to constantly receiving some sort of income and therefore require a clause which allows the lender to take the property immediately, regardless of bankruptcy proceedings that the borrower might be going through.
Frequently, the mortgage is supplemented by a general obligation of the borrower or a personal guarantee from the owner(s), which makes the debt payable in full even if foreclosure on the mortgaged collateral does not satisfy the outstanding balance.
Terms of a commercial mortgage
The majority of Commercial Mortgages in the United States, while requiring the borrower to simply make a monthly payment small enough to pay off the loan over a 20 to 30 year time frame, require a balloon paymentBalloon payment
When a debt is repaid in payments of varying amounts there are some colourful jargon terms used to describe the different loan structures. The term balloon payment arises because if you hold back most of a debt and pay it only towards the end of the agreement, both those last payments and the total...
(a total payoff) after a lesser time frame. The borrower most likely will attempt at that time to refinance the loan or sell the property. Thus there are two elements generally to the term of a commercial mortgage loan: the length of time allowed until balloon payment (known simply as the term), and the amortization. The length of the loan can vary from a matter of days to 30 years. If a loan had a 30 year amortization schedule, but a 10 year term it would commonly be referred to as a 10 year balloon with a 30 year payment schedule.
As an example, assume a $15,000,000 loan at 8% interest with a 30 year amortization schedule and 10 year term (a 10/30 loan) with monthly payments. The payment amount would be $110,065 per month or $1,320,776 per year if it were on a typical 360 day accrual (in Excel: =PMT(8%/12,30*12,15000000,0)*12 ). The principal balance owed (to the mortgage bank) at the end of each of year would be:
| Year | $ Balance | $ Paid During year |
|---|---|---|
| 0 | $15,000,000 | $1,320,776 |
| 1 | $14,874,695 | $1,320,776 |
| 2 | $14,738,991 | $1,320,776 |
| 3 | $14,592,022 | $1,320,776 |
| 4 | $14,432,856 | $1,320,776 |
| 5 | $14,260,479 | $1,320,776 |
| 6 | $14,073,794 | $1,320,776 |
| 7 | $13,871,615 | $1,320,776 |
| 8 | $13,652,655 | $1,320,776 |
| 9 | $13,415,521 | $1,320,776 |
| 10 | $13,158,706 | $1,320,776 |
At the end of the 10 year loan term, the borrower would have to pay the remaining balance (balloon payment) of $13,158,706. Note: If this table were continued, '$ owed to bank' would reach exactly $0 at year 30 since the loan type is 10/30.
Applications of commercial mortgage loans
Common applications of commercial mortgage loans include acquiring land or commercial properties, expanding existing facilities or refinancing existing debt. Common commercial properties are zoned for office, retail, & industrial purposes.Commercial premises are purchased for many reasons. One may require bigger premises to cope with expansion, or you may be buying property, whereby the property is directly linked to a business e.g. a hotel.
Commercial Mortgages are usually made with terms less than 10 years, but may be much longer than this. The Property itself is usually at risk if payments are not made on time.
Commercial Mortgages are often used for a variety of purposes::
- To purchase the premises of the business.
- For the extension of existing premises.
- Residential and commercial investment.
- Developing the property in other manners.
Lenders' criteria
Most banks and building societies offer commercial mortgages, but applicants must satisfy the lenders' criteria for qualification. The primary criterion is the debt service coverage ratio or the ratio of cash available to the required loan payments. Some lenders may accept applications where there is an adverse credit history, but most require a positive personal credit rating and clear evidence that the business is creditworthy. Most will apply a loan-to-value ratio and will expect the business to invest a proportion of its own money into the purchase.The lender's decision will also depend on the business' current circumstances, a commercial lender will expect stability and profitability. They may ask to see a business plan
Business plan
A business plan is a formal statement of a set of business goals, the reasons why they are believed attainable, and the plan for reaching those goals. It may also contain background information about the organization or team attempting to reach those goals....
as well as long-term financial projections, to assure themselves that the business has, and will continue to have, the ability to make repayments on the loan. Some lenders impose restrictions on the uses of commercial premises and certain business concerns may be excluded altogether. The terms of a commercial mortgage depend largely on the type of business the type of premises or land to be bought.
Underwriting standards
Commercial Mortgage loans are almost always designed to be underwritten based entirely on the attributes of the property being mortgaged, as opposed to the credit attributes of the borrower. To facilitate this, many times lenders require the property to be owned by a single asset entity such as a corporation or an LLC created specifically to own just the subject property. This allows the lender to foreclose on the property in the event of default even if the borrower went into bankruptcy (the entity is known as "bankruptcy remoteBankruptcy remote
Bankruptcy remote is a term that describes the relative position of one company as it relates to bankruptcy vis-a-vis others within a corporate group, whereby the insolvency of the bankruptcy remote entity has as little economic impact as possible on other entities within the group...
"). In a normal residential mortgage, a lender would have a difficult time selling a property if the bankruptcy court case is still pending.
Lenders usually also require a minimum debt service coverage ratio
Debt service coverage ratio
The debt service coverage ratio , also known as "debt coverage ratio," is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt payments...
which typically ranges from 1.1 to 1.4; the ratio is net cash flow (the income the property produces) over the debt service (mortgage payment). As an example if the owner of a shopping mall receives $300,000 per month from tenants, pays $50,000 per month in expenses, a lender will typically not give a loan that requires monthly payments above $227,273 (($300,000-$50,000)/1.1)), a 1.1 debt cover.
Lenders also look at Loan to value
Loan to value
The loan-to-value ratio expresses the amount of a first mortgage lien as a percentage of the total appraised value of real property. For instance, if a borrower borrows $130,000 to purchase a house worth $150,000, the LTV ratio is $130,000/$150,000 or 87%.Loan to value is one of the key risk...
(LTV). LTV is a mathematical calculation which expresses the amount of a mortgage as a percentage of the total appraised value. For instance, if a borrower wants $6,000,000 to purchase an office worth $10,000,000, the LTV ratio is $6,000,000/$10,000,000 or 60%. Commercial mortgage LTV's are typically between 55% and 70%, unlike residential mortgages which are typically 80% or above.
Interest rates
Interest rates for commercial mortgages are usually higher than those for residential mortgages.The most common commercial mortgage is a fixed-rate loan, where the interest rate remains constant throughout the term. This must not be confused with the typical residential loan which uses the term to denote a 30 year term mortgage that comes with a rate fixed for 30 years. Most commercial loans have fixed periods between 3 and 10 years. The biggest for this is the source of funds. Many banks borrow their money to lend from the Federal Government with a wholesale cost and repackage the money for retail lending. Since the Fed Rate can change every 3 months or so, banks typically do not want to run the risk of their funds costs exceeding the income derived from interest through a loan made to consumer. These loans are typically based on the yields of treasuries, swaps, corporate bonds, or CMBS
Commercial mortgage-backed security
Commercial mortgage-backed securities are a type of mortgage-backed security backed by mortgages on commercial rather than residential real estate....
rates. Loans can also be variable or capped. These rates are usually based on an index such as LIBOR.
A second commercial mortgage is an additional loan on a commercial property secured behind that of the first lien. The second mortgage is subordinated to the first mortgage and therefore carries a higher interest rate due to the higher risk of not being able to recover all losses should the loan default.
Agency mortgages
In residential lending in the United States, the market evolved from one where banks extended loans to borrowers, to one where banks extended loans but those loans were securitized and sold off as bonds. The government sponsored enterprises Fannie Mae and Freddie Mac were created to assist banks in doing this, by stamping the bonds with a guarantee of timely payment, even if the homeowner was late on their payment.However if the commercial mortgage market for apartment buildings of 5 or more units, Fannie Mae and Freddie Mac do even more than this. Essentially they lend their own money and then securtize the bonds themselves, leaving banks to handle the servicing (ie. billing etc.) of the loan. They have come to dominate the market for apartment lending As of December 17, 2007 GSE's were reported to hold 34% of total debt outstanding for multifamily property. Given the recent liquidity crisis due to the sub prime crash of 2007 & 2008, these numbers are reported to be even higher by the Mortgage Bankers Association.
The financial institutions who work to obtain the loans for Freddie Mac or Fannie Mae are then primarily agents, and for this reason this area of lending is known as Agency Lending.
Second-layer lenders
A group called second-layer lenders became an important force in the residential mortgage market in the latter half of the 1960s. These federal credit agencies, which include the Federal Home Loan Mortgage Corp., the Federal National Mortgage Association, and the Government National Mortgage Association, conduct secondary market activities in the buying and selling of loans and provide credit to primary lenders in the form of borrowed money. They do not have direct contact with the individual consumer.Federal Home Loan Mortgage Corporation
Main article: Federal Home Loan Mortgage CorporationFederal Home Loan Mortgage Corporation
The Federal Home Loan Mortgage Corporation , known as Freddie Mac , is a public government sponsored enterprise , headquartered in the Tyson's Corner CDP in unincorporated Fairfax County, Virginia....
In 1970 the Federal Home Loan Mortgage Corporation, sometimes known as Freddie Mac, was established. This corporation is designed to promote the flow of capital into the housing market by establishing an active secondary market in mortgages. It may by law deal only with government-supervised lenders such as savings and loan associations, savings banks, and commercial banks; its programs cover conventional whole mortgage loans, participations in conventional loans, and FHAFHA
FHA loan
An FHA insured loan is a Federal Housing Administration mortgage insurance backed mortgage loan which is provided by a FHA-approved lender. FHA insured loans are a type of federal assistance and have historically allowed lower income Americans to borrow money for the purchase of a home that they...
and VA loan
VA loan
A VA loan is a mortgage loan in the United States guaranteed by the U.S. Department of Veterans Affairs . The loan may be issued by qualified lenders....
s.
Federal National Mortgage Association
Main article: Federal National Mortgage AssociationFederal National Mortgage Association
The Federal National Mortgage Association , commonly known as Fannie Mae, was founded in 1938 during the Great Depression as part of the New Deal. It is a government-sponsored enterprise , though it has been a publicly traded company since 1968...
Known in financial circles as Fannie Mae, this association was chartered as a government corporation in 1938, rechartered as a federal agency in 1954, and became a government-sponsored, stockholder-owned corporation in 1968. Fannie Mae, which has been described as "a private corporation with a public purpose", basically provides a secondary market for residential loans. It fulfills this function by buying, servicing, and selling loans that, since 1970, have included FHA-insured, VA-guaranteed, and conventional loans. However, purchases outrun sales by such a wide margin that some observers view this association as a lender with a permanent loan portfolio rather than a powerful secondary market corporation.
Government National Mortgage Association
Main article: Government National Mortgage AssociationGovernment National Mortgage Association
The Government National Mortgage Association , or Ginnie Mae, was established in the United States in 1968 to promote home ownership. As a wholly owned government corporation within the Department of Housing and Urban Development , Ginnie Mae’s mission is to expand affordable housing in the U.S. by...
This association, which is often referred to as Ginnie Mae, operates within the Department of Housing and Urban Development. In addition to performing the special assistance, management, and liquidation functions that once belonged to Fannie Mae, Ginnie Mae has an important additional function — that of issuing guarantees of securities backed by government-insured or guaranteed mortgages. Such mortgage-backed securities are fully guaranteed by the U.S. government as to timely payment of both principal and interest..
Conduit mortgages
In the early 1980s, Investment Banks such as Salomon Brothers worked with banks and the government sponsored entities Fannie Mae and Freddie Mac to develop ways for banks to be able to sell their home mortgage loans as bonds into the bond market. By doing this, banks would free up funds to continue to make more loans, as well as earn fees upon the sale of the loans while leaving little or no of their own money at risk. However, similar developments in commercial mortgages were slow in appearing. The first movement in this area came with the savings and loan failures: the government set up a company known as the "resolution trust company" which would buy commercial mortgages from failed savings and loans and then turn them into bonds. In the early to mid nineties this led the staff of the Japanese Investment Bank NomuraNomura
Nomura Nomura Nomura (野村 (field village), 埜村 (wilderness field) is a Japanese surname. It can refer to:-Finance:*Nomura Holdings, part of the Nomura Group (also including Nomura Securities Co.)-People:*Don Nomura (born 1957), Japanese-American baseball agent...
in San Francisco to develop programs to convert commercial mortgages into bonds, primarily by making new commercial mortgage loans with clauses and structures which make them more like what bond investors want to invest in. The main thing that bond investors did not like about mortgages is that the borrower could repay the loan at any time (which was usually done when interest rates went lower, causing the bond investor to lose out on their high rate bond and having then to reinvest in new low rate bonds). While the government did not like restrictions on prepayment penalties being required of regular home owners, Nomura and other investment banks began to structure commercial mortgages that absolutely forbid prepayment, in exchange for dramatically lower interest rates (and also allowing new buyers of the property to take over the existing loans, in other words, making them assumable). The loans that were especially designed to be turned into bonds became known as "conduit loans". Because of the rule against prepayment, for a borrower to prepay a conduit loan, the borrower will have to buy enough government bonds (treasuries) to provide the investors with the same amount of income as they would have had if the loan was still in place. This is known as a defeasance
Defeasance
-Defeasance of a Securitized Commercial Mortgage Loan:Defeasance of a securitized commercial mortgage is a process in commercial real estate finance by which a borrower substitutes other income-producing collateral for a piece of real property to facilitate the removal of an existing lien without...
. When a property defeases, the bond it is in will increase in value since the higher risk real estate collateral is being replaced with lower risk US treasuries.
Conduit loans have been part of a trend in the Investment Banking industry to become more "vertically integrated". That is, instead of helping banks and other lenders to provide fix rate products and replenish funds by selling off loans as bonds, investment banks have taken to making the loans themselves, and then selling the bonds themselves. In fact, many times the Investment Banks make little or no money on the loan itself, and only make money by the selling and trading of bonds. For this reason, these forms of loans are usually at a better interest rate than is possible through other forms of Bank lending.
Like most residential mortgage loans that are sold as bonds to bond investors, investment banks usually create multiple classes (known as 'tranches') of bonds based on the same pool of mortgages. The tranches might be ranked so that the 1st class takes all of the losses on the mortgage loans up to a certain point in exchange for having a higher interest rate paid to them. The second class may only take losses when the losses reach a certain point for the first class of bondholders, in exchange for a lower interest rate. In this way one set of mortgages could be used to create bonds that appeal to a wide range on investors.
With the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
, investors have stopped buying the majority of classes of commercial mortgage backed securities, and therefore, most conduit loans are no longer available at good interest rates. This is due to a few factors: while there is concern that the residential mortgage crisis will have an adverse effect on commercial real estate, the biggest issue is that both subprime mortgage bonds as well as commercial mortgage bonds have been arguably constructed incorrectly, with the investment banks underestimating the losses that might occur for each tranche and under compensating the tranches as a result (and also underpricing the original loan). It is not clear at this time whether new commercial mortgage backed securities will again begin to be issued in an orderly fashion, and if so whether the tranche system might be changed fundamentally. However this is an issue for the commercial real estate market in general as other lender (banks, Fannie Mae/Freddie Mac, life insurance companies) will be able to make up for the lost conduit loan availability.
Competition among lenders for loanable funds
To be able to provide homebuyers and builders with the funds needed, financial institutionFinancial institution
In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...
s must compete for deposits. Consumer lending institutions compete for loanable funds
Loanable funds
In economics, the loanable funds market is a hypothetical market that brings savers and borrowers together, also bringing together the money available in commercial banks and lending institutions available for firms and households to finance expenditures, either investments or consumption...
not only among themselves but also with the federal government
Federal government
The federal government is the common government of a federation. The structure of federal governments varies from institution to institution. Based on a broad definition of a basic federal political system, there are two or more levels of government that exist within an established territory and...
and private corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
s. Called disintermediation
Disintermediation
In economics, disintermediation is the removal of intermediaries in a supply chain: "cutting out the middleman". Instead of going through traditional distribution channels, which had some type of intermediate , companies may now deal with every customer directly, for example via the Internet...
, this process involves the movement of dollars from savings accounts into direct market instruments: U.S. Treasury obligations, agency securities, and corporate debt. One of the greatest factors in recent years in the movement of deposits was the tremendous growth of money market funds whose higher interest rates attracted consumer deposits.
To compete for deposits, savings institutions offer many different types of plans:
- PassbookPassbookA passbook or bankbook is a paper book used to record bank transactions on a deposit account. Depending on the country or the financial institution, it can be of the dimensions of a chequebook or a passport....
or ordinary accounts — permit any amount to be added to or withdrawn from the account at any time. - NOW and Super NOW accounts — function like checking accounts but earn interest. A minimum balance may be required on Super NOW accounts.
- Money market accounts — carry a monthly limit of preauthorized transfers to other accounts or persons and may require a minimum or average balance.
- Certificate accounts — subject to loss of some or all interest on withdrawals before maturity.
- Notice accounts — the equivalent of certificate accounts with an indefinite term. Savers agree to notify the institution a specified time before withdrawal.
- Individual retirement accountIndividual Retirement AccountAn individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
s (IRAs) and Keogh accounts—a form of retirement savings in which the funds deposited and interest earned are exempt from income tax until after withdrawal. - Checking accounts — offered by some institutions under definite restrictions.
- Club accounts and other savings accountSavings accountSavings accounts are accounts maintained by retail financial institutions that pay interest but cannot be used directly as money . These accounts let customers set aside a portion of their liquid assets while earning a monetary return...
s—designed to help people save regularly to meet certain goals.
See also
- Credit (finance)Credit (finance)Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
- LoanLoanA loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
- Mortgage loanMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
- Annual percentage rateAnnual percentage rateThe term annual percentage rate , also called nominal APR, and the term effective APR, also called EAR, describe the interest rate for a whole year , rather than just a monthly fee/rate, as applied on a loan, mortgage loan, credit card, etc. It is a finance charge expressed as an annual rate...
- Debt service coverage ratioDebt service coverage ratioThe debt service coverage ratio , also known as "debt coverage ratio," is the ratio of cash available for debt servicing to interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt payments...
External links
- FHA loans (Department of Housing and Urban Development)
- FSA Consumer page UK regulator mortgage information.
- ABC's of Mortgages, Financial Consumer Agency of CanadaFinancial Consumer Agency of CanadaThe Financial Consumer Agency of Canada is an independent government agency of the Government of Canada. FCAC provides consumer information and oversees financial institutions to ensure that they comply with federal consumer protection measures. Created in 2001, the Agency investigates cases of...