Developing Secondary Markets for Small-Balance Commercial Real Estate Loans
There are two major secondary market outlets for credit unions needing to sell the commercial real estate loans they originate. The most widely used outlet is a well-developed credit union market for nonmember loan participations. The second outlet is the Small Business Administration, which has a number of programs designed to help small businesses. These programs have the secondary effect of partially protecting lenders from defaults.
In 2006, 356 credit unions purchased nearly $2 billion of nonmember business loan participations from other credit unions and MBL CUSOs. This represents a 38 percent increase from 2005, although much of the increase can be attributed to the entry of a couple of large buyers. The average nonmember MBL participation purchase in 2006 was around $650,000.
The loan participation market has been around for many years. Ten years ago there were a handful of large originators who each developed their own network of credit union participation buyers. With few credit unions originating MBLs themselves, as well as an established track record of little or no losses and a strong demand for additional earning assets, these loans were extremely attractive to buyers and the market was highly liquid. Things have changed a little as more credit unions now originate their own MBLs. Many want to keep the capacity under their MBL cap for their own member needs. Loan-to-share ratios are also moving higher as credit unions increase their originations of indirect auto and residential mortgage loans. This has also dampened, but definitely not eliminated, the appetite for MBL participations.
MBL participation sales are still highly concentrated in a small number of sellers; however, buyers are becoming more selective and demanding in terms of quality and yield. In 2006, 26 credit unions sold more than $10 million in loans while only seven credit unions sold more than $100 million. Until recently, corporates were not a big factor in the MBL participation market because we were not really needed. As liquidity and the scope of distribution capabilities becomes more important, corporates (including WesCorp) are now actively positioning themselves to add liquidity and help bring new credit union buyers to the market.
Increasing Use of SBA Programs
In 2006, 153 credit unions had SBA loans on their books. This number has increased from 110 in 2005 and 88 at the end of 2004; balances more than doubled last year from $229 million at the end of 2005 to $483 million at the end of 2006. Balances, however, are a little misleading since most credit unions sell off the SBA guaranteed portion of 7a loans and only retain the non-guaranteed portion on their books.
Since 7a loans are still a large part of credit union SBA lending activities, the actual value of originations is much higher. Since the SBA programs and documentation are quite complex and lenders must first be approved by the SBA, a good proportion of this business is handled through specialized MBL CUSOs. WesCorp is actively partnering with originators to bring liquidity to the non-guaranteed portion of SBA 504 loans through securitization.
The securitization of MBLs, apart from the SBA programs, has not yet become a reality for most credit unions. First and foremost, most credit unions do not have the scale required to overcome the fixed costs associated with the securitization process. These primarily comprise underwriting, legal, and accounting fees. Second, there has been little standardization in terms of underwriting, documentation and servicing practices, which makes it difficult to pool together loans from different credit union originators. Finally, the Commercial Mortgage Backed Securities (CMBS) markets have been largely the province of large real estate developers and investors. The majority of credit union originations do not fit neatly into the large conduit CMBS deals. The securitization process is most efficient when the underlying collateral is fairly homogeneous. Adding small balance loans without prepayment penalties would make the securities less attractive and increase the yield required by potential investors. In the securitization world everything moves to the lowest common denominator. It is only recently that the securitization of the types of loans that most credit unions make has become commonplace.
The Evolution of Small Balance Commercial Real Estate Loan Securitization
For many years, small balance commercial real estate loans have been securitized separately from the large â€œconduitâ€ deals. This securitization activity, however, has greatly increased in the last couple of years, creating a ready market for the typical credit union loan. In 2006, there were at least 15 deals brought to market totaling some $4.5 billion. Below is a list of the most common issuers of these securities.
The Rating Agencies tend to cut off balances on this type of loan at $3.5 million. The underwriting characteristics of these loans tend to combine both traditional commercial loans and underwriting practices with those found in the residential mortgage market, (e.g., the use of FICO scores to analyze the borrowerâ€™s ability and propensity to keep the loan current and repay the principal). Other differences include less extensive third-party reports (appraisals, environmental and engineering reports, etc.), the absence of reserves for real estate taxes, insurance, and capital expenditures, the lack of lockboxes, and the waiving of the stipulation that a borrower must obtain terrorism coverage. Loan structures are also more flexible with a wide range of amortization terms being offered. Probably the biggest difference comes in the lack of structuring borrowers in a bankruptcy remote SPE. While lockouts are not common, prepayment penalties are normally in place retaining the attraction and pricing advantage of fairly predictable cash flows. Figure 1 shows examples of the type of prepayment penalties that are commonly utilized.
The really positive news for credit unions is that a new outlet for typical credit union small commercial real estate loans is rapidly developing. Additionally, the economies of scale for these deals are not too daunting. Figures 2 and 3 show the collateral characteristics and structure of a smaller deal done for $166 million in 2006. WesCorp actually owns a piece of one of the AAA-rated tranches in its investment portfolio.WesCorp formally recognized the differences between large â€œconduitâ€ CMBS and Small-Balance CMBS back in November 2006 when we adjusted our Investment Policy to reflect the very different collateral characteristics of these markets and established separate investment limits for each sector.
Looking to the Future
While most credit unions can probably grow their member business lending activities without the need for asset securitization, the development of this market is certainly an extremely positive factor. If activity continues to grow rapidly, we will eventually have to sell excess production outside the system. There are several credit unions, CUSOs and third-party vendors currently looking at developing capabilities to securitize credit union-originated commercial real estate loans, WesCorp included. In addition to looking at the development of secondary market conduits for both loan participations and whole loans, WesCorp is also planning to assist credit unions in underwriting and originating these loans. To learn more about these initiatives as well as delving into the mechanics of the securitization process, be sure to pick-up the next edition of WesCorpâ€™s InsideRISK magazine.