By Edward Brown
Ever wonder why banks shy away from loans that appear to be relatively conservative?
There are numerous reasons banks avoid making loans that, in general, one would think have a high likelihood of paying back. According to a banker who works for a well known bank, during the mortgage crisis of almost a decade ago, one thread seem to run through all of the bad loans on the bank’s books; late payments on even the smallest of items, such as a department store credit card. This type of information led banks to steer away from otherwise good borrowers [after the mortgage meltdown], since the banks did not want to have borrowers who tended to be late or default on mortgages. 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 on a mortgage should there be instability in the economy.
Banks are not in the business of taking over property and do not want to be seen as predatory lenders. Even if a borrower has a “good story”, banks would rather not even entertain a loan, which, on its surface, appeared to be more likely to fall into default. Banks are very cash flow oriented. They do not want to lend to borrowers where there may be a question of how a mortgage will be serviced. In commercial real estate loans, banks use a ratio called DSCR [Debt Service Coverage Ratio]. The DSCR is a measure of the cash flow available 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. In previous years [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 to have at least a break even cash flow after paying the mortgage. However, after 2007, almost every bank in the nation tightened up their standards to where they 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 one’s ability to borrow. The investor found would have to put down a much larger down payment [thereby a lower loan needed] on the property in order to satisfy a much higher DSCR. Many real estate investors did not possess the mandated down payment and found they could not qualify for the new higher DSCR.
Another aspect that impacted banks’ ability to make loans to less than stellar borrowers is that they are similar to corporations in that they rely on their good ratings [from S&P and Moody’s for example] in attracting either deposits or floating paper themselves [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 find they have to pay higher yields to depositors in order to attract money. From a bond offering standpoint, the higher the rating, the lower rate the banks have to pay their bond holders. If a bank makes loans that appear “questionable”, they risk having their rating lowered and it ends up costing them in the long run. They find it better to avoid loans that may potentially give the bank a blemish, even though they would have earned a higher yield on the mortgage being provided to the borrower who appears to be below triple A in terms of ability to repay.
Most banks work off of a fairly slim arbitrage [due to competition], so it is not worth having loans in their portfolio that appear riskier. When a loan goes onto a “watch list” or goes into default, more of the bank’s resources are tied up and not available to be deployed into new loans. Loans that are put onto the “watch list” would be those loans 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 where bank auditors have determined that there is a more than likely 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 at the time the loan was made [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 stood 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 in that this means less money for the bank to lend out, as the extra reserves ties up more of the bank’s capital and less is available to make loans. If the loan actually goes into default, substantially more reserves are needed to be set aside. After the mortgage crisis, stringent guidelines were handed down to banks, as the Federal Government did not want to bail more banks out. Thus, most banks found it was just not worth using their 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 are finding that they do not need to attract borrowers. They do not want to spend time having to explain to auditors [or even bank board members] why certain loans are being made when they have many “slam dunk” loans that are “cookie cutter”. Banks are finding that they cannot charge enough to the borrower to 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 with much less hassle and more expediently. These private lending companies are more interested in “equity based” lending, meaning that they are more interested in how much equity is in the property at the time they make the loan as compared to the DSCR or credit issues of the borrower. 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 [than bank] 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 applying 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 by banks. Alternative sources of capital are available for funding requested loans. One only need to do a little research. Many mortgage brokers, who deal with banks, also know of private lenders. If the borrower is able to go direct with a private lender, there may possibly be a cost saving to the borrower as there is one less mouth to feed; however, many times, the mortgage broker can assist the borrower with expertise as to the pricing of private loans and which companies are reputable and which are not.
In bring a deal to a private lender, the borrower should be careful not to do a shotgun approach, which is to say that it may hurt the borrower in the long run to try many brokers at the same time for the same request. One may think this is the best way to obtain financing at the best price due to attempting to force competition, but, many times, it backfires on the borrower, as some brokers broker to other brokers. What often happens in this scenario is that there may be a chain of brokers involved, all adding their fee into the loan. A two point deal may turn into a four point deal because, by the time the loan reaches the final funding so many brokers 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, so there are no surprises. Some brokers specialize in construction loans [as due 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.
Edward Brown currently hosts two radio shows, The Best of Investing and Sports Econ 101. He is also in the Investor Relations department for Pacific Private Money, a private real estate lending company. Edward has published many articles in various financial magazines as well as been an expert on CNN, in addition to appearing as an expert witness and consultant in cases involving investments and analysis of financial statements and tax returns.