James Ruiz recently wrote a piece, published in the Texas Lawyer, summarizing the February 10, 2010 report (“Commercial Real Estate Loses and the Risk to Financial Stability”) issued by the Congressional Oversight Panel. (continue reading link below). It is a good summary of the Panel’s perspective of the credit problems in commercial real estate, and addresses the REMIC issues inherent in modifications of CMBS loans and the impact of two new accounting standards (Statement of Financial Standards 166 & 167).

Earlier, I posted a summary of the report, and commented that if financial reform is going to occur, the window is narrow given the August start of the mid-term Congressional re-election campaign season. As you might know, I’have been blogging\following the Restoring American Financial Stability Act of 2010 [link] as it makes its way through the Congressional process. 

It’s time to step back and ask the all-important questions: so what does all this mean? What is the big-picture? Where is this going?

Here’s my list of some of the answers to those important questions:

1. The Good: ‘Return’ of the unregulated CRE lenderr. in the near future, unregulated lenders will play a very important role in CRE finance. This will mean new opportunity from a new source.
2. The Bad: ‘Extend and Pretend’ and More Defaults. This will mean continuing opportunity for special servicing and asset management - but the RTC is not the model.
3. The Uncertain CMBS 2.0: Practical and important structural challenges abound before the new CMBS (“CMBS 2.0”) will include pools of loans from multiple borrowers, in amounts that will have a meaningful impact on the CRE finance market.
4. The Not Now For Covered Bonds: the current focus is on CMBS 2.0, although covered bond legislation was introduced by members of the House Financial Services Committee – Capital Markets Subcommittee. Why isn't’t this legislation getting more attention?

Based on this list, the next 2-4 years will look like this: CRE finance = Good+Bad.

Yes, we’ll have good and bad at the same time (with more of the later in the near-term).

Let me briefly explain:

#1. “Unregulated Lenders” Will Play An Important Role In CRE Financee: By this phrase, I mean lenders who are not banks, savings and loans, credit unions, insurance companies or government sponsored entities (such as Fannie Mae). In addition, these lenders will be different from “hard money” or “hot money” commercial lenders, who as lenders of last resort offer loan terms that resemble predatory lending.

Instead, these lenders will be mortgage REITS and other lenders whose base or core sources of funds are not the Federal Reserve, insurance premiums or Federal Government sponsorship (which I call the “traditional sources of CRE finance”). The pricing and terms will be more favorable to the borrower than offered by the "hard money" or "hot money" lenders, and more expensive than terms than offered by traditional sources of CRE finance. In my description of this middle-tier CRE finance group, I’m thinking of mortgage REITs such as CreXus and of mortgage finance companies like the former Lomas & Nettleton.

What leads me to this conclusion?

• One study reports that traditional sources of CRE finance only offer @ $200Bill of funds annually for CRE lending (based upon a recent three year average of loan originations by this group).
• The same study shows that CRE lending needs for maturing debt will exceed this amount by a total of $500Bill in 2010, 2011 & 2012.
• This “funding gap” doesn't’t take into account funding for defaulted CRE loans (by way of financing purchases of notes and REO from lenders and servicers). So, the gap really is larger than $500Bill
  
  What will be the source of funding to “fill” this gap?
   
• CMBS 2.0 will not fill this funding gap any time soon. True, banks and life companies are forming CMBS 2.0 programs – and we’re working on several of them. However, at the CMSA January conference, in an informal poll of investors, 58% of the investors believed that “CMBS 1.0” style multi-borrower, fixed rate pools will be return no sooner than 2012 (or even later); and 69% of the investors believed that annual new CMBS issuances would not exceed $100bill until 2013. (click on this link to my blogs from the conference for more information; and\or search TTFL blog using the term “CMSA” for more information.)  The message is simple: CMBS 2.0 probably is not a near term reality for multi-borrower loan pools in an amount necessary to close this gap  – which also is why the new CMBS 2.0 programs will be underwriting loans as if they were going to hold them on their books – and not sell them in a securitization.
• Bank CRE lending will not fill the gap for several reasons:
  -  Banks credit allocations for CRE will decrease for the near term (my guess: 3-5 years). Recently, the US Controller of the Currency spoke at the annual convention of the Independent Community Bankers of America, and called on policymakers to devote special attention to the CRE lending concentrations at banks. He then suggested a lengthy list of options, all of which would reduce lending risks AND result in less capital available for CRE lending.  Regional and community banks have high CRE loan concentrations.  For example, I've been told that the CRE lending concentration for banks governed by the Dallas Federal Reserve Bank is @ 26%. Simply too, too much CRE loans on the bank portfolios.
  -  The Wall Street Journal reported on March 15Th that in the coming weeks, the Financial Accounting Standards Board is likely to propose that banks expand their use of market values for financial assets such as loans (called “mark-to-market”). If these accounting rules are implemented, then this will be another pressure on banks to make less capital available for CRE lending.
• Insurance company CRE lending will not fill the gap. Recently the Capital Adequacy Working Group of the National Association of Insurance Commissioners (“NAIC") voted to release for comment a proposal that might result in a large increase to the risk-based capital (“RBC”) charges for life company holdings of CRE mortgages.   If passed, this could significantly restrict the ability of some life companies to make capital available for CRE lending.

All of this points to opportunity for a new niche CRE lender.

#2. Extend and Pretend AND More Defaults:  as noted in our postings on the October 31, 2009 bank regulatory announcement, and at the CMSA January conference, the regulatory plan clearly is to avoid taking back CRE collateral if it has some reasonable basis for keeping the loan current. Many people, myself included, called for a quick RTC style take over of failed banks, with a quick disposition of the assets. Clearly, absent a change in the mark-to-market rules (described above), the perspective of the administration is that the current CRE crisis is NOT attributable to over building. Instead, it is a credit crisis unrelated to CRE. So, the plan seems to be extend until the fundamentals for the broader economic recovery firm up as evidenced by: increases in employment; improvement in consumer confidence and spending; etc.  In other words, treat the source of the problem, and not the symptoms.

However, default rates on CRE mortgages continue to climb (see my earlier posting).

So, unless and until we clear much of the over-leveraged CRE from the market (my “sub-prime commercial” product type), if you have expertise in distressed CRE, then you should be busy.

And, if your company can handle both the good AND the bad, then you’ll really be busy.

In the near future, I’ll cover #3 and #4.

If you have any questions, comments or suggestions, please post your comments below.

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