“The worst is yet to come. Typically there’s a lag between when the economy softens and when the defaults actually occur.”
-Steven Kandarian, MetLife Inc. Chief Investment Officer
Ahhhhh, its nice to see that sophisticated professionals make the same mistakes that Mom & Pop did during the credit bubble: Interest-Only Mortgages:
“Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping malls are bracing for more loan defaults through 2010 as Bank of America Merrill Lynch says landlords’ monthly payments may jump 20 percent or more.
Principal is coming due on the so-called partial interest- only loans as an 18-month-old recession saps demand for commercial real estate. About $179 billion of such loans were written between 2005 and 2007 and bundled into bonds, according to data from Bank of America Merrill Lynch.
With soaring vacancies and falling rents, some cash- strapped borrowers will fail to cover the higher costs, said Andy Day, a commercial mortgage-backed securities analyst at Morgan Stanley in New York. About 87 percent of mortgages sold as securities in 2007 allowed owners to put off paying principal for several years or until maturity, compared with 48 percent in 2004, Morgan Stanley data show.”
When you make a purchase via financing, there are two basic costs: The item you are purchasing (land, malls, hotels, apartment buildings, etc.) and the cost of financing. The item purchased/financed/leased is paid for with borrowed capital, and the costs of that financing is the interest the borrower pays on it.
Its one thing to use I/O on a short term bridge loans, or any temporary financing. But these 2 and 3 year commercial I/O lending packages at the tail end of a giant RE book are inherently problematic. Almost by definition, when a borrower users I/O financing, it suggests they cannot afford to make the actual purchase, and were unable to arrange other forms of financing. Otherwise, the buyer would have arranged for to a less risky structure that is not dependent upon subsequent credit availability. Note that I do not refer to the 10 or 15 year I/O funded projects that have an exit strategy — a sale or merger in the not-too-distant future, rather than an ongoing hunt for financing.
One of the regular data points of the 1929 market crash and Great Depression is that 20% of homes were foreclosed upon. Back then, the mortgages were typically 3 year, interest-only, with a balloon at the end. If the mortgagee could not arrange a new loan at the end of the term, they lost their house.
Unless credit frees up significantly, we could see similar issues with CRE (but nowhere near 20%).
UPDATE: June 11, 2008 9:03am
After I posted this, I spoke to friend — a senior CRE attorney at Shearman & Sterling with 3 decades plus doing large commercial transactions.
He noted that while I/O financing has been around “forever,” it was only in the last cycle where it became prevalent — especially in the 3 to 5 year term. “The mindset was more leverage meant more profits, and since the next firm was generating 25% a year, you had to also.”
Bondholders Face Commercial Mortgage Losses as Principal Is Due
Bloomberg, June 11 2009
Automaker bankruptcies may cause land pileup
Orlando Business Journal, June 5, 2009