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   ARTICLE   |   From Scotsman Guide Residential Edition   |   August 2013

A Tale of Two Markets

Commercial financing may be more flexible than today’s residential loans

Many mortgage originators tend to think of the commercial and residential mortgage markets as separate worlds, and they are different in several respects. The two markets do interact and affect each other, however, and as the economic recovery continues to take hold, some residential mortgage originators may be taking a closer look at the commercial side of life — and for good reason.

"Several high-profile financial scandals in recent years have slowed down residential lending "

In many ways, commercial loans have become more flexible financing vehicles than their residential counterparts, particularly since the credit crisis. Subsequent to the tightening of financial markets and the consolidation of numerous banks and investment companies, government-guaranteed loans — those backed by the Federal Housing Administration, the U.S. Department of Veterans Affairs and the U.S. Department of Agriculture — and loans backed by the government-sponsored enterprises (GSEs) have accounted for the majority of residential loans. In fact, in 2009, nearly 97 percent of all residential loans were either government insured or guaranteed by way of the GSEs. 

Although this government support helped stabilize the market, it also led to stricter underwriting. Traditionally, private money or banking sources that do not need to sell their loans to the secondary markets as much tend to be more flexible when it comes to underwriting and approving loans than lenders who must follow more stringent governmental guidelines.

For residential mortgage originators considering adding commercial loans to their mix of products, here is a look at the how commercial loans are structured, as well as the factors influencing the commercial — and residential — mortgage markets today.

Commercial terms

Commercial real estate loans typically have shorter fixed terms than residential properties. With commercial loans, many banks will borrow the money wholesale and sell it to the borrower retail. The commercial bank or mortgage banker must be fairly comfortable that they are pricing the mortgage loan’s margin above the pegged cost of funds’ benchmark index for a decent anticipated profit margin spread.

If a commercial banker prices the commercial loan too low for a three-, five-, seven- or 10-year fixed loan and the underlying index goes in the wrong direction in the near term, then the banker may actually lose money on the loan.

Many commercial loans may have early prepayment penalties or “defeasance,” “lockout” or “interest guarantee” penalties for terms of between one and five years or more. Many of these loans will be securitized, so the early prepayment penalty fees protect the secondary market investors as well. Should the borrower pay off the mortgage too soon, then the lenders or investors will try to recapture some of their early payoff losses by way of some type of an exit fee. These fees may equate to a small percentage of the outstanding loan balance or several years of mortgage-interest payments.

Some borrowers want longer-term fixed rates for the perceived stability of the loan, but many bankers want to make short term loans to minimize their risk. There are some portfolio commercial lenders, however, who will lend out their own money at longer-fixed rate terms — at higher interest rates, however. Still, many types of commercial loans may be fixed for as much as 15 or 20 years. Other loans may be fully amortized over 25 or 30 years, which provides the borrower with much lower monthly payments.

Typically, however, commercial loans are fixed for shorter five-, seven- and 10-year terms, so they must be refinanced or paid off more often than residential loans.

The Libor scandal

Several high-profile financial scandals in recent years have slowed down residential lending further, including the Libor (London Interbank Offered Rate) scandal. The Libor rate is tied to between $350 trillion and $800 trillion in assets worldwide, and some consider the scandal that erupted in July 2012 to be the largest financial insider-trading scandal in history.

Libor is a benchmark interest rate that is supposed to measure the average interest rate that banks charge when they lend to each other. Libor is also used for many other rates that impact fees associated with residential and commercial mortgage loans, credit cards, derivatives (i.e., credit default swaps) and hundreds of other financial vehicles worldwide. The Libor scandal allegedly involved the rigging and manipulation of the Libor rate by banks to benefit their investment positions. Of course, the Libor rate also is used by many big banks to speculate on the future directions of interest rates by way of complex derivatives.

The Libor scandal is so important because many of the biggest banks allegedly knew what the next day’s benchmark interest rates would be because they had insider information on the future directions of the interest rates. Many of the largest U.S. investment banks actually earn much of their revenues from investing in the derivatives markets, so this alleged manipulation either earned them — or cost them — significant money. 

The Libor scandal also affected some borrowers, as they ended up paying higher rates than actual market prices at the time. Many of these same borrowers later ended up filing suits against their banks if their mortgage rates were slightly higher (i.e., 4.5 percent instead of 4.125 percent) than what the true market rates should have been at the time. Also, many banks sued other banks for charging them more for their money than what the true market rates should have been at the time. 

The MERS scandal

Yet another case of inappropriate conduct by several of the large banks affected the residential real estate market negatively. The MERS (Mortgage Electronic Registration Systems) and robosigning scandals were contributing factors for many banks to slow down significantly on foreclosures — as well as residential lending.
MERS functions as a centralized electronic registry of mortgages and tracks ownership, as well. MERS allows mortgage ownership to change hands quickly and also was created to function as a substitute for local land records.

In many cases, however, MERS actually did not have original promissory notes in its mortgage files. Many savvy homeowners fought their personal foreclosures by alleging that without the evidence of valid original promissory notes — which should include the note’s interest rate, loan terms and other important items — then these mortgage loans owned or serviced by MERS may not be legal instruments of mortgage debt.

With the robosigning scandal, there also were claims of forged signatures on behalf of the borrowers, lenders and notaries that may have invalidated many of their notes and deeds. Several courts sided with homeowners, and many foreclosures were stopped. In some cases, these mortgage loans may have been sold five or six times to other investors, so there were also potential liabilities for every investor in these questionable mortgage securities.

As such, there are serious chain-of-title implications with the ongoing MERS scandal that may affect millions of mortgage loans. Chain-of-title concerns affect the ability of banks to unload potentially millions of properties. This is a major reason why some of the largest banks have sold thousands of their real estate owned (REO) properties to large investment funds, hedge funds or other investors without ever listing these homes for sale.

Commercial’s upside

Because these scandals have cast a spotlight on the residential mortgage industry, credit has been tight and underwriting strict — and regulations have increased. On the commercial side, however, there is a higher percentage of nongovernmental money available for commercial real estate properties than for residential properties today. In addition, more commercial properties are being approved for better loan terms sooner than residential ones.

Historically, commercial property price appreciations on an upward economic swing tend to follow residential property’s price increasing trends by about 12 to 18 months, so commercial values may begin to increase soon. Increasing values combined with more flexible capital may mean now is the right time to explore the commercial side of the mortgage industry.


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