Thursday, May 05, 2005

"Leverage Going Way Up" In Commercial RE

The National RE Investor web site lets us in on a disturbing trend; interest-only loans for commercial property. "As of January 1, 55.8% of all fixed-rate conduit loans featured IO periods—up from 5.9% at the beginning of 2002. And 35.6% of these loans are IO for the full term, according to an analysis by Moody’s Investors Service."

"A few IO loans wouldn’t be a problem, but frothy loan underwriting has swelled the total dollar volume to $800 billion of the total $1.7 trillion in commercial mortgage debt at year-end 2004. Here’s another factoid for your catalog: That $1.7 trillion is a staggering 14.4% of U.S. gross domestic product. The last time that commercial mortgages accounted for more than 14.4% of the economy was during the late 1980's, and everyone knows how that ended."

Who in their right minds would finance commercial deals this way? "'What does the guy originating the loan really care?' says a source from one of the largest loan servicers in the nation. 'The borrower needs the interest-only loan to make their returns work, and it may not really be a problem for years. This is an extremely competitive business.'" A quote to remember.


At 8:30 AM, Blogger Greenlander said...

Ben, your blog rules.

At 8:46 AM, Anonymous arealbang said...

Over 50% of Calif home loans in 2005 were interest-only ARMs. Buyers have to place the future at risk in order to afford today's prices.

One of the biggest benefits of home ownership is the ability to build equity. With an I/O, there is no chance of building equity except through asset appreciation---which is what I guess all these buyers are counting on.

The Rude Awakening (service of has a good piece on it today:

One ad agency exec interviewed for the LA Times story refers to Orange County's conspicuous consumption as "affluenza." The effects of the disease are showing up in the county's housing market, where the median home price has doubled over the past five years to a whopping $660,000.

If this manic home price appreciation were powered by a corresponding income growth, we might have little cause for concern...But it is not.

Instead, home prices are booming on the back of a related boom in high-risk mortgage lending, especially interest-only (IOs) mortgage lending. Interest-only loans in California were virtually non-existent four years ago, but comprised nearly
half of all mortgage originations last year. Orange County, itself, has witnessed a similar surge of IO financing, as has the entire nation.

 "Measured as a percentage of [nationwide] jumbo-loan originations," James Grant recently observed, "IOs have climbed to 70% at year-end 2004 from less than 20% in early 2002."

The most worrisome aspect of the current home-price boom, therefore, is that it relies mostly on easy access to innovative – read: risky – mortgages, rather than incomes.

To be sure, some Orange County residents require no mortgage lender to finance their home purchases. Bond fund king, Bill Gross, for example, who operates his multi-billion dollar operation from Newport Beach, does not require an exotic, IO loan to underwrite his lifestyle. But most OC residents carry a smaller billfold than Bill Gross. If they are to live the OC dream, therefore, they must secure the necessary funding from somewhere other than their weekly paychecks.

"The work-and-spend treadmill is particularly intense in 'pleasure domes' such as Orange County," Haris reports. "Daily life here is a constant reminder of things you don't have - yet."

Enter the mortgage-banker, like a new-age Mephistopheles, to offer a seductive proposition:  Borrow a bundle of money, spend most of it on earthly delights, and don't worry about repaying the debt...until later.

During the early years of an interest-only mortgage, the borrower pays only interest on the loan and none of the principal. Unfortunately, this delightful arrangement comes to an end eventually, in which case the borrower's monthly payments rise dramatically.

"Three to five years down the road," explains William Batz, executive vice president of Federal Home Loan Bank of Pittsburgh, "when the principal payments kick in, and keeping in mind that now you're looking at amortizing the principal over 25 years rather than 30 years, you get a real bang at that point."

Now that IOs have become mainstream, the future days of reckoning loom large. What happens when millions of homeowners find themselves in a pay-or-quit situation? What happens when millions of homeowners must begin making much larger monthly mortgage payments or lose their homes?

We would guess that two consequences, at least, will
result: Consumption will slow dramatically and home prices will fall...perhaps dramatically.

"Even as [many] mortgage executives celebrate the
industry's use of innovative products aimed at getting more people into homes," MarketWatch relates, "they express concern that some home buyers are using adjustable-rate mortgages, interest-only loans and other products without fully understanding the inherent risks."

"'One of the things we don't feel good about right now as we look into this marketplace," Thomas Lund, senior vice president at Fannie Mae, tells MarketWatch, "is more home buyers being put into programs that have more risk...Does it make sense for borrowers to take on risk they may not be
aware of? Are we setting them up for failure?"

No, and yes, would be our respective guesses.

"To the extent that credit conditions are driving home
price trends," FDIC economists Cynthia Angell and Norman Williams placidly observe, "the implication would be that a reversal in mortgage market conditions - where interest rates rise and lenders tighten their standards - could contribute to the end of the housing boom."

At 9:03 AM, Anonymous Anonymous said...

"The work-and-spend treadmill is particularly intense in 'pleasure domes' such as Orange County," Haris reports. "Daily life here is a constant reminder of things you don't have - yet."

arealbang - thanks for that excellent post. This will be a nice counter to the OC trolls that we have lurking around here that insist OC is "different" and is such a "special" and "desirable" place that couldn't possibly be in a housing bubble.

Bottom line people: the massive appreciation in the last several years hasn't been accompanied by an associated amount of income growth.

At 10:51 AM, Anonymous Anonymous said...

Some commercial madness for you... How is $6481.48 per square foot for basically a pizza parlor?:

And re residential... a lower Manhattan apt complex, built for lower-income and middle class tenants, is apparently being converted into co-ops:

At 11:37 AM, Blogger Sunny said...

Seems like the focus these days is on residential real estate. But commercial real estate has gone nuts, too. Sometimes it is even more nuts than residential, especially for the small to medium properties. Also, it is much more likely to have a bubble in the commercial market because its not "something to live in" and people are more likely to not be emotionally attached.

Waiting to Pounce in Central Fla.


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