Commercial Magazine

Lessons Must Be Learned

After the recent bank failures, mortgage lenders should seek new risk management strategies

By David Eichenblatt

The commercial real estate landscape often reflects many of the same issues that affect the national economy, including movements in interest rates, which have been steadily rising. Even after the Federal Reserve raised the benchmark interest rate in July 2023 to between 5.25% and 5.5%, there may be more rate hikes to come before the central bank hits its target number of 2% inflation.

While inflation may be abating, the capital markets are in a period of discovery. Many commercial mortgage lenders have significantly pulled back in the wake of the Silicon Valley Bank, First Republic Bank and Signature Bank failures earlier this year. What made these collapses unique was the speed at which their deposit runs occurred. Now, unsurprisingly, there are growing concerns from regulators that are exploring new and better ways of monitoring lender balance sheets and liquidity.

As an example, the Fed is now considering the implementation of “reverse stress testing.” This approach would evaluate the conditions needed to break a financial institution, rather than creating an artificial stress scenario and its projected impact. Institutions with assets of $100 billion or more already receive more scrutiny and are under more regulatory obligations at the federal level. While these banks tend to make the most loans tied to commercial real estate, they also have fewer effective options for loan risk management or balance-sheet optimization. Recently, many of these lenders have looked to the insurance industry for a possible solution.

Similar in concept to private mortgage insurance on residential loans to consumers, commercial property loan insurance (CPLI) is an investment grade-rated loan guarantee product designed to serve as an effective risk transfer and mitigation strategy. By leveraging this option to insure the most risky portion of a commercial mortgage, lenders can gain significantly better access to liquidity, balance-sheet optimization and risk management when financing a real estate project. It’s something that mortgage brokers and borrowers should understand as they work with lenders to structure safe and cost-effective financing.

Prudent approach

The Federal Reserve requires banks with more than $250 billion in assets to be stress tested each year. (Institutions with at least $100 billion in assets are evaluated in even-numbered years.) Importantly, these rules now cover a large portion of prime commercial real estate lenders.

The enhanced scrutiny impacts these institutions’ balance sheets and liquidity. Although a lender could possibly raise more debt or equity to address this, doing so is expensive and dilutive. Another option is to curtail commercial real estate lending activities, and many institutions have already met (or are exceeding) their concentration limits, meaning that they’ll receive additional regulatory scrutiny. Many lenders are even selling their commercial mortgage notes, especially for certain office and retail properties, at significant discounts.

Regardless of size, focus or geography, all commercial real estate lenders need to ensure they are employing best practices when it comes to risk management. The recent and relatively quick collapses of the three previously respected banks are harsh reminders of what can happen if these measures fall short.

Constant due diligence is a requirement for all types of risk — and not only for an institution’s loan exposure. The banks that failed this year had some things in common: Their loan portfolios were reasonably solid and up to date, but they improperly managed interest rate and deposit risks. These events also serve as reminders that the industry-ingrained stance of “waiting until others go first” has proven to be a faulty if not fatal approach.

Insurance basics

The unexpected deposit runs and rapid interest rate increases that felled these banks can have significant impacts on any lender’s balance sheet. In addition to liquidity issues, these can also affect capital requirements, concentration levels and loan-to-value regulatory parameters, which can put an institution at risk by severely hindering its operations and profitability.

Just as regulators are exploring new methods of stress testing, many commercial real estate lenders are seeking new approaches to optimize their balance sheets. Commercial property loan insurance has emerged an alternative. Other available options (including credit-linked notes, credit-risk transfers and credit derivatives) tend to offer mixed success at best, since they can be costly or unreliable.

There are two main strategies for lenders to employ in regard to CPLI. It can be used alone or in conjunction with a fixed-income collateral agreement. Either of these strategies can be highly scalable. Commercial mortgage lenders can quickly compare these paths by identifying the risk weighting for a specific loan amount, then reviewing the costs of each option using market percentages of first-loss protection.

For example, on a loan pool of $1.13 billion with a conservative overnight rate and spread of 12.5%, the cost to leverage loan insurance (with or without a collateral agreement) can be roughly 40% to 60% lower than using credit-linked notes or credit-risk transfers. This also provides more capital, operational efficiency and scalability for the lender.

Using CPLI on its own is an effective option, but commercial real estate lenders can also leverage it in conjunction with additional cash, or cash-equivalent collateral, for added risk-weighted benefits. Regulators are likely to view this collateral as having a zero risk weighting, which means a much lower impact on a lender’s overall capital requirements — and likely its concentration requirements.

Creating an agreement for pledged collateral that serves as a credit enhancement for a commercial mortgage is a fairly straightforward process, with the collateral remaining liquid and held in an escrow or equivalent custodial account. An investment grade-rated CPLI policy would then be purchased, either by the lender or the borrower, to remove the need for a personal guarantee. This places the insurer in the first-loss position ahead of other parties while protecting the collateral at hand.

Urgent action

This year’s bank collapses gave all lenders a sobering reminder of the consequences of a risk management failure. These events not only highlighted how difficult it can be to predict and plan for unexpected events — the purpose of any insurance product — but more importantly, why adhering to the status quo related to due-diligence strategies could be a costly or fatal move.

Banks are likely to be further scrutinized in the months ahead. As regulators broaden their methods of assessment, the commercial mortgage lenders that have traditionally taken a wait-and-see approach may quickly find themselves in a difficult position.

Additionally, as underwriting continues to be impacted by current pre-recessionary market conditions, and as nonbank lenders rush to fill the gaps left by many banks moving away from commercial real estate, the cost of borrowing is likely to continue to rise. Lenders that start to explore their options now rather than waiting until they are forced to react are likely to increase their risk mitigation capabilities. They could capture a significant competitive advantage in the marketplace or possibly even regain lost market share.

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With commercial mortgages representing the largest portion of assets in the portfolios of many community and regional lenders, the impact of failing to act could be devastating. As other areas of the capital markets explore alternatives to optimize balance sheets and lessen risk, the implementation of commercial property loan insurance can offer lenders an immediate and cost-effective solution. This can provide the regulatory relief and better risk management they need to thrive, regardless of anticipated market cycles or unexpected events. ●

Author

  • David Eichenblatt

    David Eichenblatt is president and founder of LGIS Group in Atlanta. He has more than three decades of experience as a commercial real estate investor and developer. He is a graduate of Harvard Business School, holds degrees from Georgia State University and Florida State University, and holds the designation of Certified Commercial Investment Member. To learn more, visit lgisgroup.com.

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