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Movements in commercial mortgage securitization.

The securitization of commercial mortgages continues to be pursued for both its potential economic merits and other practical applications. While the academic discussions persist, currently there is insufficient investor interest to expect securitization to become commonplace. There are, however, signs that certain types of transactions with a specific niche to fill will get funding. This, by no means, should be seena s the smoke that precedes the fire. But it does bear out a belief held by many in the industry--that securitization makes good sense for both buyers and sellers in specific instances.

The two circumstances in the market currently that hold the greatest promise for furthering commercial securitization are the emergence of conduit programs and the volume of commercial mortgages held by the Resolution Trust Corporation (RTC). While only tangentially related, these two issues offer the most clear indication that the lethargic commercial mortgage market is beginning to rouse itself.

Covering old ground about the whys and why nots of securitization will not be the focus of this article, yet one thing remains true about future progress for this market--no securitization will happen at all unless investors for these securities step forward in great numbers. Without investors, securitization is just another fancy restaurant without customers.

The formation of commercial mortgage conduits clearly fills the void left by undercapitalized thrifts, retreating banks and insurance companies. But what is a conduit and what kind of role can it play? A conduit is simply defined as a channel or pipe, which is exactly how it is used in the mortgage origination and capital markets. It is the channel or pipe that connects those who need to borrow money and those who want to invest in mortgage securities. This conduit is an enterprising entity that acts as teh "middle man" between the parties. A conduit is nothing more than a mortgage investor that does not plan on holding the loans in portfolio. In fact, the conduit does not want to own the mortgage at all. If it has to take ownership, it will do so for as short a time as possible.

Conduit programs have been successfully implemented in the single-family mortgage-backed security (MBS) market, but to date, they have only been whispered about in commercial mortgage securitization circles. There have been a couple of private placements issued and several programs in the development cycle, but the application has been quite limited.

A typical conduit raises proceeds from the capital markets by issuing bonds or pass-through certificates. It will, in turn, originate mortgage loans either through an existing network of thrifts, banks or insurance companies, or they will originate the loans themselves. The pricing for the mortgage loans must be high enough to allow for the cost of the conduit and issuance fees, and it must allow for some profit.

One of the major items on the expense side of the equation for a conduit is getting a warehouse loan. This warehouse line allows it to make new mortgages while pooling the existing mortgages in order to form and issue the security. This can be quite expensive. Alternatively, the conduit could imultaneously close both the originated mortgages and the securities offered. While feasible, this requires significant coordination. In order for conduits to effectively operate, there are numerous parties who must be comfortable with this arrangement. They include the borrowers, originating network institutions, the conduit's equity holders and the security investors. It is important to assess each of these parties for both their incentives and alternatives to determine if the conduit arrangement makes economic and practical sense.


With the persisting credit crunch, borrowers are facing a very ominous future as refinancing dates approach for existing loans. With the substantial volume of five-, seven- and ten-year balloons or partially amortizing mortgages originated in the 1980s, there will be huge amounts of mortgages needing refinancing with limited sources of takeout financing available. For borrowers, who have until recently enjoyed the pleasure of seeking the least expensive financing alternative, there will not be many avenues open. The question will not be how expensive is financing, but rather, is there any available at all?

Because of the credit crunch, the conduit, as a source of financing, is in an ideal position to increase rates on mortgages so that the spread (difference in interest rates between the conduit's borrowing costs and its lending rate) is sufficient to cover necessary costs. Borrowers will have to pay the added costs in the form of higher interest rates to secure this financing. While higher interest rates are certainly not attractive, the more pertinent issue is: what viable alternative is available?

A conduit is not a panacea for all borrowers. Because this type of financing seeks capital-market execution, conduit underwriting will be more conservative in terms of the debt-service coverages (read this, effectively more expensive) than borrowers have grown used to. Cash flow from the property may not be sufficient to meet these required, debt-service coverages. Conversely, in order to meet the required coverages, the new loan may be less than the level of debt to be refinanced. Well-capitalized borrowers will be able to survive; however, those marginal borrowers will still face potential, ultimate foreclosure.


These entities are the traditional lending sources that can no longer afford to be involved in real estate finance. Because many of these entities have the origination capacity to make mortgage loans, they are a vital link in the conduit concept. It is a rare conduit program that would be able to act as the originator for all these mortgages. The network of originators provides the access to borrowers and the diversity of mortgages to create less risky mortgage pools. The originators benefit from such a program because they are able to service their existing customer base, roll over existing loans (if they meet underwriting guidelines), generate origination and servicing income and keep the loans of their balance sheets.

The exact mechanics of keeping the loans off the blaance sheet clearly will be more questionable if the originator is required to keep some form of subordination, or recourse, in the process of participating in the conduit program. These institutions can also use the program to reduce the size of their existing loan portfolios if they are able to restructure the loans and sell them into the conduit. In this way, their overall mortgage exposure will further decline. With such an avenue available to an originator, the painful process of exiting from commercial mortgage lending is somewhat abated.

The conduit

Those parties putting up the equity capital for the conduit must have the financial wherewithal and "stomach" to live through the origination and pooling cycle. Their risk/return analysis must factor in a number of issues. Primarily, these issues are: costs to develop the program and attract and educate participants; interest costs to warehouse the loans while the pool is being formed; and the cost to issue securities in the capital markets as well as provide the necessary credit enhancement to get the security rated or get the discount, if sold as a whole loan.

In the program-development cycle, the conduit will neet to establish a firm and definitive set of underwriting guidelines. The guidelines will spell out the type of properties financeable under the program, specific underwriting steps, coverage levels and due-diligence procedures. Additionally, a standard form of mortgage, loan agreement, appraisal and environmental and engineering reports will have to be drafted. The conduit would then bring this package to potential originators who would receive a turn-key lending program with the promise that, if the loans are originated according to the guidelines, they will be purchased by the conduit.

Unfortunately, this development cycle can be both expensive and time-consuming. Alternatively, the conduit could seek to simply avoid the entire program-development cycle and choose to buy existing mortgage product from originators with whom it is comfortable. While theoretically possible, this approach has many drawbacks. It would require less efficient reunderwriting, less standardization and a more difficult sell cycle and rating process.

As mentioned earlier, the warehouse line is another pitfall and expensive proposition. The conduit, which would not have the proceeds from the securities offering until after the loans had been purchased and pooled, would need to fund the acquisition of the mortgages by borrowing from another entity. It would then acquire the loans, pool and form the security and then repay the warehouse loan with the proceeds from the sale of the securities.

The problem has been that few institutions are interested in providing this type of financing, and those that would consider it are not cheap. If the conduit is able to arrange this warehouse line, or if it raises additional equity funds, there is still certain interest-rate risk. Without an appropriate hedging policy, the conduit faces the risk that interest rates may move upward between the time the mortgages are purchased and the securities are priced. Obviously, if rates decline, it is a windfall. However, this type of interest-rate roulette should not be part of the conduit's business charter.

Potentially, the conduit could simultaneously close on the purchase of the newly originated mortgages at the same time that it issues the securities in the marketplace. This would require not only careful scheduling, but also a borrower who can wait until the securities are cleared. This creates uncertainty about when funds will be available and at what price, because the borrower will not know the interest rate until the securities are priced. This uncertainty can again be covered through a hedging mechanism, but the bottom line is that, in either case, the timing between the origination and securities issuance creates additional expense.

In order to attract buyers for the securities, almost certainly a rating will be needed on the securities, a substantial credit enhancement or both. Credit enhancement or both. Credit enhancement is normally in the form of a cash reserve, subordination or overcollateralization. Either one of these forms is tantamount to buying the mortgages for something less than 100 cents on the dollar. A higher rating (and, therefore, larger credit enhancement), will bring down the borrowing costs to the conduit. It will also mean less available proceeds to originate mortgages.

If, for example, the conduit anticipates purchasing $100 in mortgages, it may only be able to raise $80 in rated securities, at the rating it desires. In this case, there must be more money brought into the transaction, or the loans must be purchased at a discount. If the securities issued are to be considered less risky, someone has to assume the costs of mortgage losses. The conduit must measure the tradeoff between higher borrowing costs and less mortgage originations.

The level of credit enhancement needed is geared to either the rating desired on the securities or investor confidence. This credit enhancement is expected to cover the losses incurred when certain mortgages default aad are foreclosed upon. This expected loss on the mortgage pool means that the conduit must either charge that much more for its loans, or effectively purchase the mortgages from originators at a discount. The originators of the mortgages must then make an economic decision as to the pricing of the mortgage to the borrower and a capital decision as to the treatment of that less-than-face-value sale to the conduit on their balance sheet.

If the mortgage is sold at a discount it will mean a loss. It could, however, take the form of the partial recourse, holding a piece of the conduit's subordination or an equity position in the conduit. The originator could, as an alternative, write the loan in a first and second mortgage format. The first, and more conservatively underwritten, mortgage would be sold to the conduit, while the second mortgage would be retained by the originator.

While this does not completely eliminate the loss assumptions for the first mortgage pool, it will certainly reduce the level of credit enhancement to a great extent. Developing, pricing and practically implementing the protection for the credit-loss expectations for the mortgage pool will be the largest economic hurdle for the conduit.

The conduit could also potentially purchase mortgage loans from a variety of originators not subject to a prearranged underwriting program. The conduit could then reunderwrite the loans or merely pass along the underwriting of the originator. While this would initially be less of an administrative burden for the conduit, it does pose more credit risk. This means less perceived value to the investors, thereby raising the borrowing cost for everyone.


As with most financial arrangements, nothing will happen unless those with the money show up. In other words, the conduit program is a great idea, but if investors are not inclined to purchase the conduit's securities, then there is no program. While investors could potentially be large equity players (if the rates charged on the morthages are high enough), expectations are that the securities issued by the conduits will be either pass-throughs or collateralized mortgage obligations (CMOs). Investors for these securities will obviously have a number of concerns, as do all commercial mortgage investors these days.

However, the conduit program does offer some redeeming qualities for potential securities buyers. To begin with, the loans will be underwritten in a uniform manner. This level of standardization, in and of itself, gives greater cofort that individual accommodations are not made to borrowers. This reduces the risk that, on a loan-by-loan basis, such accommodations will create problems in the future. Investors will be able to more easily predict cash flow, prepayments and ultimate yield. It also streamlines the investor's level of due diligence.

Additionally, there will be a large number of third parties participating in the process, effectively increasing the number of times the loans and/or the program are underwritten. The level of information on all loan originations will be current, accurate and consistent. This will give investors the chance to quickly decide if they are comfortable with the underwriting and to efficiently price their purchases. Without standardized underwriting and current information, the investor's decision-making process is less efficient and, therefore, more expensive.

Clearly these programs are not without risk to the investors. Those originating the loans will not be holding the mortgage in portfolio. Although they are originating in accord with the underwriting guidelines, one needs to question their incentives and their commitment to detailed scrutiny.

The conduit itself is not holding the loan in portfolio either. Therefore, its attention to program compliance by the originator network must be considered in light of generated volume. One must always possess a "healthy skepticism" when dealing with fee-based participants. Obviously an investor will not participate in the program again if the originators and conduit are not operating in a consistent and scrupulous manner. It is essential for the investor to gain a comfort level with the participants in the program or any third parties reviewing the transaction.

Conduit programs, while certainly no stranger to single-family mortgage securitization, are a untested idea when applied for commercial mortgages. Given the current, diminished appetite for real estate lending by major institutions, and the potential for this downside in the lending cycle lasting for some time, conduit securitization has great appeal. It is only a matter of time before this approach will have economic necessity and practical application on a full-scale basis.

RTC opportunities

Besides the emergence of conduit programs, the other major movement currently in commercial mortgage securitization is the participation of the RTC. The RTC, by many accounts, controls the largest inventory of commercial mortgage loans and properties. The potential for securitization on a large and frequent scale is enormous. However, the RTC has many challenges and hurdles before it. Many of these may be more perceived than real. There are many real estate and mortgage investors who assume merely because the RTC is in possession of a mortgage loan originated by a now-defunct institution, that the mortgage is of poor credit quality. Indeed, many institutions are now defunct due to poor asset quality, but that in itself does not mean all assets from that institution are inferior.

On the other hand, there is no lack of war stories detailing poor underwriting, lack of adequate documentation and, in some cases, lack of any collateral. The point is, the RTC's commercial mortgage loans must be scrutinized so that the more-creditworthy ones are identified and securitized. By offering the entire basket of mortgage loans from one institution, the good loans are unfairly tainted by the weaker credits. In order to identify the good from the bad, one needs to examine exactly what information is available and how current and accurate it is.

These are major issues working against the RTC. Assuming for a second that with a certain level of due diligence (that level could be massive), accurate and current information could be obtained. The the debt-service coverages, property condition, market conditions and delinquency status could be ascertained.

Once the general loan quality is judged, then the pools could be arranged in a manner to mitigate as much risk as possible. The individual loan quality is a given, not much can be done to change that fact. However, with the inventory of loans the RTC holds, there is ample opportunity to select the highest quality loans and securitize them. Cherry picking for securitization as many loans as possible will reduce some risk. Additionally, with this supply of loans originated around the country, the RTC can assemble securitized pools that offer the greatest geographic, property type and borrower diversification of any commercial mortgage pool to date. However, it appears that the RTC is choosing to securitize/dispose on a regional basis or an institution-by-institution basis. This would not appear to be the best way to mitigate risk.

The RTC could securitize in two ways. First, it could directly securitize its portfolio. Secondly, it could sell on a whole-loan basis to another institution, which would then securitize the purchased portfolio. By securitizing on its own, the RTC avoids the more problematic issue of selling off the subordinate piece of these pools, (if it can hold it, itself). This could be more of an administrative burden than it would like to undertake. A cash reserve would supplant this option. By selling on a whole-loan basis to another institution, the transaction could be executed more quickly, but the RTC may not get the most efficient pricing. The buyer will most likely exploit the risk of potentially adverse loan losses as a way to put significant pressure on the offered price.

Again, the key to any of the options is getting good information to the marketplace. The real and/or perceived problems with RTC loans will never completely go away. This stigma will keep prices down. However, with certain loan selectivity and planning for assembling more diversified pools, the RTC improves its chances of getting top dollar for its loan balances.

No discussion of the RTC's impact on the commercial mortgage market would be complete without discussing its real estate owned (REO). One segment of these assets are properties requiring a tremendous amount of attention. The remainder is a class of property that should never have been built, much less lent upon. Unfortunately, both happened.

In order to sell off the properties needing attention, sophisticated buyers must be attracted. These buyers must have a definitive business plan in place that will reposition the asset, by providing intensive marketing, leasing and management activities. In this way, the properties can be brought in line with current market effective rentals and vacancies. With the abundance of property for sale in all markets, the RTC real-estate owned will have to be priced at a deep enough discount to entice someone to take the chance of turning these properties around.

Compared with other opportunities, these properties must offer a significant risk/return incentive. Additionally, there are very few buyers out there who have the inclination, financial staying power and expertise to work these properties through the cycle. This limited buyer universe will further depress prices.

Commercial mortgage securitization clearly has many opportunities for growth ahead. While there is certain appeal to the notion that conduits will be the source of commercial mortgage lending in the future, it will take time for this process to gain a foothold. In the short term, the RTC product coming into the market will compete for investor dollars, thereby reducing capital available for mortgage lending. As with the current outlook for real estate's supply/demand, the short term is far less sanguine than the later half of the 1990s.

By the later half of the decade, the lending cycle will have returned to the point where traditional lenders are back in the market. However, their participation is more likely to be in the form of capital market executions rather than lending for their own portfolios. For those borrowers with maturities after 1995, there is hope. For those with maturities before 1995, it is time to look for equity dollars.

The investors for commercial mortgage securities will dictate which transactions get done and which do not. The golden rule, which says, "Those with the gold make the rules," is never more true than for the market for commercial mortgage securitizations. Price and quality will be the issue that color their decisions. The moral of the story here is that anyone contemplating accessing the capital markets for commercial mortgage money had best identify and secure an investor before bothering to pen a term sheet.

Joseph C. Franzetti is senior vice president of real estate finance, for Standard & Poor's Ratings Group in New York.
COPYRIGHT 1991 Mortgage Bankers Association of America
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:events which may attract investors to commercial mortgage securities
Author:Franzetti, Joseph C.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
Previous Article:The rise of the banker/developer.
Next Article:Commercial Real Estate Workouts.

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