Mortgage Metamorphosis: Secondary Market Develops for Commercial Loans

What's sauce for the goose is supposed to be sauce for the gander.

So last month, goosed by real estate and mortgage industry lobbyists, President Bill Clinton signed the Community Development and Regulatory Improvement Act of 1994.

The bill is meant to serve up a sauce for commercial and industrial realty interests enjoyed since the 1980s by their residential counterparts: a secondary mortgage market.

In the residential secondary-mortgage market, loans are sold to one of several government agencies or to investment bankers, who then pool and repackage them as securities. Shares in such pools are then sold to investors who are paid out of the interest and principal.

Real estate thus becomes a liquid investment and lenders, relieved of risk, are encouraged to write new loans.

CDRI comes as commercial real estate nationally inches out of a credit crunch that slowed commercial activity to a crawl from 1988 to 1992.

During the same period, residential real estate slowed, too, but remained healthy by comparison.

Even developers admit that the commercial crunch was partly the result of overbuilding encouraged by early 1980s tax laws and an overly free flow of savings and loan money.

But many also complain that while the commercial building and investment climate has improved, the lending climate has not.

"It's eased," concedes Douglas Burkhardt, owner of First Realty Co., "but just a little. I don't know of any players willing to give money on the local market."

Banks, he complains, are unwilling to lend money to any but the top rank of investors or to projects with triple-A, national tenants.

"If you're Max Farash or Stephen Natapow, or you've got Wal-Mart for a tenant, you're all set. If you're just some schmo with a solid, local tenant and $5 million, forget it."

Michael Haymes, president of Re/Max Realty Group concurs.

Re/Max handles commercial and industrial properties and runs a residential mortgage brokerage subsidiary, Prime Mortgage Corp.

"In commercial lending, the banks are more aggressive than they used to be, but it's still tight," he says.

In the residential arena, lenders have been more forthcoming, thanks in part, Haymes believes, to its stronger secondary mortgage market.

A commercial secondary-mortgage market of sorts has existed for some five years, says Martin DePoy, a lobbyist for the National Association of Realtors.

And spurred by the dearth of conventional financing, Wall Street investment bankers are creating alternate financing routes called "conduits" that make real estate into a pass-through security functionally the same as secondary-market mortgage pools, says Rochester-based real estate investment banker Howard Taylor, of Howard Taylor & Co.

To create the so-called conduits, several of the largest firms put up money to back projects such as hotels and shopping malls, and then sell shares to investors.

DePoy says such avenues have indeed loosened capital, but that the commercial secondary market is as yet in a germinal state.

Regulatory roadblocks have been part of what has kept the market small and scattered, he says, but the market also has been stymied by the private side.

In both the public and private sectors, much of the problem has been lack of standardized product, DePoy says.

In the private arena, for example, mortgage writers such as insurance companies and banks sometimes define acceptable risk differently than investors such as pension funds, thus making mortgage sales difficult.

On the public side, rules governing such transactions vary among states, discouraging even the biggest players from moving widely on a national front.

In a cooperative effort to address private-sector barriers, representatives of the NAR, lenders and potential secondary-market investors have formed a group called the Capital Consortium that is trying to hammer out a set of mutually acceptable risk standards, DePoy says.

The group also is compiling a secondary-mortgage-market data base listing potential mortgage buyers nationwide.

On the regulatory front, the recently signed CDRI bill removes several legal hurdles.

A key provision extends the Secondary Mortgage Market Enhancement Act of 1984 to commercial loans.

The act created federal standards under which banks and insurance companies can invest in the residential secondary-mortgage market, and granted states the option of letting the federal regulations preempt their own.

DePoy says that some 32 states including New York have done so.

The federal regulations are in some cases tougher than the rules they preempt, DePoy says, but the benefits of standardization outweigh any downsides.

Other provisions include: loosened margin and credit restrictions for mortgage buyers, and provisions to allow thrifts and federal credit unions to invest in commercial-mortgage securities.

In addition, the 1994 act eases up on rules covering banks' offset reserves for mortgage loans.

Now, banks are required to set aside 8 percent of the total loaned on mortgages, and to keep the amount in reserve until the mortgage is discharged, even if the loan itself is sold.

Under the new act, banks will continue to make the same set-aside, but will be allowed to reduce the reserve as they sell off mortgages.

The reduction will not be dollar for dollar, but, DePoy says, any reduction will free new capital for commercial-mortgage lending.

Another measure NAR campaigned for but did not get would have changed the Employment Retirement Income Security Act to make it easier for private pension funds to invest in commercial-mortgage securities.

Congress saw the ERISA changes as too politically volatile, DePoy says. Lobbyists, nevertheless, are getting a "surprisingly positive" response from Department of Labor officials on such changes.

Meanwhile, the changes that are approved are as much as a year away from implementation. Details are being worked out by the Office of the Comptroller of Currency.

A best-case scenario would see the regulations rolling out in some five months. Whenever they hit the street, they will free new capital for a far wider range of projects, DePoy believes.

Local experts concur.

"Anything's better than what's going on now," says Burkhardt of First Realty Corp.

Taylor, of Howard Taylor & Co, and Re/Max's Haymes concur.

But Taylor further notes that the bill fails to address creation of a commercial counterpart to the government's Federal National Mortgage Association.

Known as Fannie Mae, the agency buys mortgages and sells them as government-backed securities.

A commercial-mortgage equivalent has been widely discussed, Taylor says.

None is in the cards, DePoy says. But not to worry.

"There is no political drive for it on the Hill, nor do I think we need it," he says. "We think the private market will take care of itself."

A smaller-scale version of such an agency is under discussion at the state level, says Lee Webb, acting president of the New York State Job Development Authority. The idea would be to use the JDA's bonding authority to raise money to buy up loans from county industrial development authorities. Such a move would free the IDAs to lend more, but would not have the scope of a federal agency.

Like DePoy, Taylor says he hopes the private market will suffice. But, he adds, he will reserve judgment on the bill until he sees the rules.

Burkhardt is likewise cautious.

The changes sound good and are surely needed, he says, but implementation could be an issue.

"Lawyers write the rules," Burkhardt says, "and usually, they're the only ones who can understand them."