As more CMBS loans are dropped from initial pools, non-bank loan sellers are contributing significantly more than their share. Al Barbarino speaks to experts to find out why.
In recent months, ratings agencies have grown increasingly concerned about the number of dropped loans – or ‘drops’ – in CMBS loan pools that don’t make the cut from an initial proposal (or tape) to final securitisation.
Kroll Bond Rating Agency (KBRA) analysed its drop data in an eight-page, 3,600-word report released on April 15. The data shows that, not only are drops becoming more prevalent, but that non-bank lenders are introducing more than their share compared with banks.
There were 41 transactions with 35 loan sellers rated in 2015; of those 35 sellers, there were 18 banks and 17 non-banks. KBRA found that 23.6 percent of bank loans were dropped compared with 37.1 percent of those from non-banks.
At the extremes, a staggering discrepancy: the seller with the most drops dropped 36 loans, representing 67 percent of its original $694.6 million balance, but the seller with the least drops (a bank) had only 12 loan drops, just 9.5 percent of its original $581.1 million balance (see table below).
In part, the discrepancy could be owing to banks having more established relationships and securitisation programmes, as well as lower costs of funds, which helps to originate higher quality loans, KBRA says in the report.
Yee Cent Wong, a KBRA managing director and one of the report’s authors, tells Real Estate Capital that increased competition could be creating a sense of urgency for the non-banks to get loans off of their balance sheets as quickly as possible.
The report found that loans with balances less than $50 million dropped two times more frequently than larger loans; there were more drops on loans secured by properties in tertiary markets; and unfunded loans were two times as likely as funded loans to exit the pool.
More often than not, these criteria match the profiles of non-bank loans as opposed to those from the banks, and non-banks are likely to cause more drops due to the intricate relationships between themselves, the banks, and the B-piece buyers, several non-bank CMBS originators and CMBS experts tell Real Estate Capital.
First off, the non-banks are more likely to write transitional and often riskier loans than would a large bank – and at higher loan-to-values. It’s the unique position in the market they’ve chosen, sources explain.
Indeed, the KBRA study shows that the dropped non-bank loans had a 108.1 percent loan-to-value compared to the banks’ 106.5 percent, and a 1.47 to 1.56 debt service coverage, respectively.
“Generally the non-banks play with spicier collateral and are more driven by returns,” says the head of one non-bank CMBS originator, noting that the non-bank loans also experience higher delinquency and default rates. “We often deal with tougher collateral and non-institutional partners who are more challenging to deal with.”
The B-piece buyers buy the non-investment grade CMBS bonds in the deal, which have the greatest risk of significant loss. To manage their risk, the B-piece investors focus heavily on the real estate supporting the CMBS and may kick out loans they don’t deem creditworthy.
“Those [non-bank] guys aren’t realistically competing with the institutional quality loans the banks are doing and are usually doing non-traditional, high LTV stuff that causes the B-piece buyers more angst,” says one CMBS investor and originator.
The large bank issuing the deal wants to keep as many of its own loans as possible, which are often the largest, likely funded, and thus unlikely to get dropped or kicked out by the B-piece buyer.
“For marketing purposes, the larger loans get a lot of focus, so the metrics are going to look a lot better because they get way more scrutiny than anything else,” says an executive with a different non-bank CMBS originator.
The non-bank originators, generally much smaller than their larger banking counterparts who are issuing the securitisations, have higher costs of capital associated with their loans in large part due to fees and their reliance on the bigger banks for warehouse financing.
“They are inherently at a disadvantage for going after those bigger loans, and the banks want to do those loans themselves,” says the CMBS investor and originator.
He says that 80-90 percent of the money going into his firm’s CMBS loan originations is obtained through warehouse lines with the issuing banks.
“It’s really about capital efficiency; we borrow that capital from the banks at very cheap rates so we aren’t holding idle cash around the securitisation timeline,” he says.
As Fitch Ratings noted in an emailed memo late last year warning about the increasing prevalence of loan drops, in some instances the smaller lenders could be using the B-piece buyers and rating agencies as initial providers of credit feedback.
“Fitch is concerned that the numerous loan drops could indicate a lack of lender due diligence prior to sending the initial loan information to rating agencies and/or B-piece buyers,” that ratings agency wrote.
But there seem to be varying degrees to which the non-bank lenders are doing this. One of the non-bank CMBS originators says his company will never include a loan on an initial tape that’s sent out to the ratings agency or B-piece buyer if the borrower hasn’t at least initiated the application process.
But, he adds: “There are people that will think that they have a deal and they’ll put it on the tape, just because, thinking ‘maybe it will work.’
“It’s not as thoughtful of an approach to the business but people do it just because they are motivated by volume and profit,” he says. “Not that anyone in this business isn’t focused on profit, but they are getting as much through as they can and aren’t as focused on the stress it’s putting on the system.”
Even after the application process with the borrower is underway, a long list of factors could go wrong during the underwriting and due diligence process which could lead to the lender not closing the loan: from engineering reports, to appraisals, site inspections, credit checks and other legal documents and deliberations.
It’s important to note dropped loans are part of the natural process, due in part to the “shaping” of the loan pool to provide better property, geographic and originator diversity. A property may also experience last minute tenancy changes and often a loan is dropped from one pool only to reappear in a subsequent pool as the cause for the drop is worked out, ratings agencies have noted.
KBRA declined to provide a list of the loan sellers ranked based on their loan drop performance, citing the sensitivity of the relationships. Fitch did provide a list (see chart right) of all originators who contributed to Fitch-rated CMBS deals in 2015, 36 in all, which “encompasses the vast majority of the [CMBS] universe as a whole.”
In the end, much of the burden of increasing drops falls on the ratings agencies, which must then re-analyse new loans introduced into the pool. Additional resources and time are required, several ratings agency sources said.
But the issuers have been “fairly flexible in allowing more time,” says Robert Grenda, a senior vice president of CMBS at Morningstar, noting that “we aren’t going to provide feedback if we feel that we don’t have adequate time to do the analysis.
“In a perfect world it would be great if there were no drops whatsoever,” he adds. “But it’s not a perfect world.”