02 Jan Why Banks Do Not Lend on Conservative Loans
Ever wonder why banks shy away from loans that appear to be relatively conservative?
There are numerous reasons banks avoid making loans that are likely to be paid back. During the mortgage crisis almost a decade ago, one thread seemed to run through all of the bad loans: late payments on even the smallest of items, such as a department store credit card. This led banks to steer away from otherwise good borrowers. Thus, a borrower who never missed a mortgage payment but may have been late on a small credit card was seen as a bigger risk for a future default.
Banks are not in the business of taking over property and do not want to be viewed as predatory lenders. Even if a borrower has a good story, it’s not enough reason for the bank to entertain the request. Banks are very cash-flow oriented. They do not want to lend to borrowers when there may be a question of how a mortgage will be serviced.
In commercial real estate loans, banks use a ratio called Debt Service Coverage Ratio (DSCR). The DSCR is a measure of the borrower’s available cash flow to pay current debt obligations (principal and interest in cases of a mortgage). It shows the ability to produce enough cash to cover the mortgage payment. Before 2007, most banks required a DSCR of at least 1.1.
For example, if the mortgage payment (including principal and interest) was $10,000 per month, the net cash flow after paying normal expenses and before the mortgage needed to be at least $11,000 per month. This was not usually an undue burden, as most real estate investors would have expected a break-even cash flow after paying the mortgage. However, after 2007, almost every bank in the nation tightened their standards and insisted on a DSCR of at least 1.25 and as high as 1.35. Although this may not seem excessive, the extra 15 to 25 basis-point requirement severely restricted the borrower’s ability to borrow. The investor would have to 12 provide a much larger down payment (but require a smaller loan). Many real estate investors did not possess the mandated down payment and found they could not qualify for the higher DSCR.
Another aspect that impacted banks’ ability to make loans to less than stellar borrowers is that they are similar to corporations that rely on their good ratings (from S&P and Moody’s, for example) in attracting deposits or floating paper (through Wall Street’s ability to attract bond financing). From a deposit standpoint, although deposits are FDIC insured up to $250,000, many banks that have lower than AAA ratings pay higher yields to depositors to attract money. From a bond offering standpoint, the higher the rating, the lower the rate the banks have to pay their bondholders. If a bank makes loans that appear questionable, they risk receiving a lower rating. They find it better to avoid loans that may blemish their reputation, even though they would have earned a higher yield on the mortgage.
Due to competition, most banks work off of a fairly slim arbitrage, so it is not worth having riskier loans in their portfolio. When a loan moves onto a watch list or into default, more of the bank’s resources are tied up and not available for new loans. Watch list loans are those in which the loan to value is not as strong as the bank had originally determined. Although the borrower may not be late on any mortgage payments, the value of the property may have declined to a level of potential default.
For example, if the bank made a loan on a property two years ago for $100,000 on a property that had a value of $150,000 (67%), the bank would set aside a certain amount of reserves as prescribed by the FDIC. However, if the property declined in value to $117,000, the $100,000 loan (presuming the loan was interest only) now stands at over 85% LTV (loan to value). Under this scenario, the bank would be required to set aside more reserves. This creates a problem for the bank: Less money for the bank to lend out. If the loan actually progresses into default, substantially more reserves are needed. After the mortgage crisis, stringent guidelines were handed down to banks, as the federal government did not want to bail out more banks. Thus, most banks found it was just not worth using resources for potentially non-income earning activity.
There is a lot of activity in the lending arena as the economy has strengthened, and interest rates are still attractively low. With the numerous requests for loans, many banks do not need to attract borrowers. They do not want to explain to auditors (or even bank board members) why certain loans are initiated when they have many slam-dunk loans. Banks cannot justify the extra time, expense, and risk to make a typical non-bank loan.
An alternative to conventional financing can be found with private lending companies. Private lending companies do not have the same reserve requirements and will generally provide loans more expediently with much less hassle. These private lending companies are more interested in equity-based lending, meaning how much equity is in the property at the time they make the loan. This provides the private lending companies an opportunity to fill a gap where the banks have left off: Loans that are not generally considered risky but still need funding. However, the price of capital is higher because the private companies do not have the same access to capital that banks do. They cannot provide FDIC insurance to their capital resources; thus, they have to pay a higher rate than depositors of banks.
In conjunction with higher access to capital costs, these private lending companies must charge the borrowers a higher rate for the money. The benefit to the borrower is the access to otherwise unavailable capital; in addition, the borrower usually does not have to jump through as many hoops as with a conventional bank and will almost certainly be able to borrow in a shorter time window. Many borrowers find borrowing from private lenders worth the extra cost.
Of course, if time is not of the essence, a borrower should first attempt to obtain funding from a conventional lender. However, borrowers should not be dismayed if they are turned down. Alternative sources of capital are available. Many mortgage brokers also know private lenders and can assist the borrower with pricing and reputable companies.
In bringing a deal to a private lender, the borrower should be careful not to attempt a shotgun approach (seeking many lenders at the same time for the best deal), which may hurt the borrower in the long run. This may force competition, but many times, it backfires on the borrower, as some brokers broker to other brokers. This means a chain of brokers may be involved, all adding their fee onto the loan. A two-point deal may turn into a four-point deal because, by the time the loan reaches the final funding, many brokers can claim they had a hand in the deal and all want to get paid. The borrower may find that a better plan of action is to find one good broker who is well connected with an array of lenders. Many times, this broker will know ahead of time what terms the borrower can expect and communicate this with the borrower to avoid surprises. Some brokers specialize in construction loans (as do some lenders); some will not touch personal residence loans due to the Dodd-Frank regulations. It is best for a borrower to seek out a broker who is well versed in the type of loan that the borrower seeks.