The “Unintended” Emergence of Private Lending
Where We are Now. Due to extensive efforts by U.S. banks to comply with both new international and domestic banking standards, we are seeing a rise in demand for private lending for situational loans, such as commercial bridge loans.
Basel III—a global regulatory standard on bank capital requirements, leverage ratios, and liquidity requirements—has driven banks to “deleverage” their balance sheets by being more selective with their commercial financing. In addition, the newly created Consumer Financial Protection Bureau (“CFPB”) released its mortgage lending guidelines for residential loans under the Dodd Frank Wall Street Reform Act. These guidelines outline a plethora of new lending requirements rightfully designed to protect the consumer.
In light of these tighter regulatory standards, banks have generally been on the sidelines when it comes to funding non-conventional, higher risk loans. A deeper analysis of the circumstances surrounding the financial industry reveals a number of legitimate obstacles interfering with a banks’ ability to lend and, as a result, we believe private lenders with access to capital and flexible underwriting standards will continue to fill the so-called funding gap, particularly for opportunistic and complex real estate projects.
A Brief History Lesson. The Dodd Frank Wall Street Reform Act was signed into law on July 21, 2010, as a response to regulate the unorthodox lending practices that led to the U.S. Subprime Mortgage Crisis. It is widely regarded as the most significant change in financial regulation in the United States since the regulatory reforms that followed the Great Depression. In January 2013, the CFPB, under the Dodd Frank Act, issued its new residential mortgage lending guidelines, otherwise known as the “Qualified Mortgage Rule,” which aims primarily to ensure that banks verify a borrower’s ability to repay a home loan and to restrict predatory lending practices.
On June 7, 2012 the Federal Reserve Board, FDIC, and Office of the Comptroller of the Currency issued new capital rules with the objective of conforming U.S. capital standards to international capital standards recommended by the Basel Commission. Basel III represents the recommendations from regulators worldwide in reaction to the recent global economic crisis. The two major implications of Basel III are:
1. Mortgage servicing rights (“MSRs”) not deducted from capital will be risk-weighted 250% compared with 100% under existing rules
2. An existing limit on MSRs as a percent of Tier 1 capital: 100% for savings and loans and 5% for commercial banks;
Basel III dramatically increased the amount of capital banks are required to hold against servicing rights. These new requirements, for instance, have made it much more expensive to service delinquent loans and as a result, returns for banks in the servicing market have been reduced to such low levels that many players have exited the business.
The Unintended Consequences. At first glance, it is easy to see these regulations as nothing more than a good faith effort by the CFPB and the drafters of Basel III to prevent the type of questionable mortgaging practices that led to the housing crisis of 2008. However, many institutional lenders believe that both the Dodd Frank Act and Basel III have contributed to artificially tight credit conditions, higher pricing and a more rigid, “box checking” process for loan underwriting. In their view, these regulations, while aiming to help the consumer, may severely curtail their access to capital and possibly even stifle much-needed investment, particularly for distressed assets.
Alternatively, as most private lenders are not directly impacted by these new capital standards, they have the ability to employ what we call “common sense” underwriting to better serve their borrowers’ individual financing needs—whether it be a fixed funding date, non-recourse loan or limited access to information. In fact, over the last two years, we have seen a growing number of opportunistic real estate investors in South Florida turn to private lenders for timely liquidity on projects that would otherwise fall “outside the box” of traditional lenders’ underwriting criteria (see display above).
Over the last five years, the Great Recession has prompted a global response centered on new forms of financial regulation and major procedural changes to loan origination and underwriting. This has in turn produced various forms of legislation that have collectively impacted how institutional lenders can operate, as they are forced to adapt to these new credit and capital standards. As such, we believe private lending will continue to be a valuable source of liquidity in a market characterized by restricted supply of traditional financing and growing demand for non-conventional financing, fueled by the recent recovery in the US housing market.