Five Things You Need to Know: There’s no Such Thing as a Bad Loan
In banking, as in life, it's all about the risk
During a stint at Minyanville, a financial news and education media company, I was fortunate to work under the tutelage of a talented editor named Kevin Depew. Depew is now the deputy chief economist at consulting firm RSM, and wrote prolifically during the Great Financial Crisis, brilliantly capturing the mood of America during that trying time. His "Five Things You Need to Know" was required reading every week, and covered topics from high finance to macroeconomics to social trends. This series is an homage to "Pep," who once quipped "I majored in philosophy, but since none of the big philosophy firms were hiring, I went into finance."
1) There’s no such thing as a bad loan
My first job out of college landed me in a nondescript mid-block office tower in Midtown Manhattan, in an even less descript corner of mortgage finance called “correspondent warehouse lending.” This was 2002, years before the world started to google “subprime” and wonder what all the fuss was about.
Our little company issued credit lines to mortgage bankers who used our “cash” to fund home loans, and then packaged and sold those loans in bundles to a bunch of Wall Street banks that don't exist anymore. I use the term “cash” lightly here, since our firm had precious little of its own skin in the game, borrowing heavily to make loans to companies who made loans to individuals who were, in some cases, buying homes with no money down.
We know how that story ended, so my own is another for another day.
An early mentor of mine at the warehouse bank taught me how to read a mortgage application, how to spot inconsistencies and even fraud. He also taught me the methodology for evaluating a loan, how think about risk and price. I barely grasped what our company actually did or how that opaque market functioned, but he took the time to teach me lessons about lending that would serve as the foundation for a future, and moderately successful, career in real estate investment.
Chief among these lessons was that "there is no such thing as a bad loan.” Which seems like an odd and perhaps ominous message in the early 2000s, but his point does hold.
I have since expanded on the turn of phrase to add “… only a mis-priced one,” implying that at the right price, even a high leverage loan to a questionable borrower can be a good loan - for both lender and borrower. As a corollary, a low leverage loan to a reputable borrower can blow up a bank (ask First Republic).
The saying holds because lending boils down to a simple concept: pricing risk.
A lender’s only job is to assess how likely a loan is to be paid back in full, and price it accordingly. That’s not to say that every loan should be approved, but that loans which get approved are not good or bad on their face, only when evaluated against their price.
In most cases, the price can be interpreted as an interest rate, although things like fees, loan to value and other terms can also be considered in the broader notion of price.
In theory, loan pricing is simple: banks (or buyers of mortgages) are willing to accept a lower interest rate for a less risky loan, and demand a high rate of return for loans with a greater risk of default.
Loan pricing is actually not unlike life: we are constantly placing small bets, weighing trade offs and upside against the risks we are taking. This can be as weighty as starting a business or proposing marriage, or as pedestrian as choosing an exotic sounding meal over a familiar one.
There are three primary legs of the loan evaluation (or underwriting) stool: credit, income and assets.
2) Credit: What’s in a number?
In residential mortgage lending, “credit” is a borrower's history of paying loans on time, and can be thought of as "willingness to pay." In practice of course many people end up with bad credit not because of an unwillingness to pay but due to circumstances that make them unable to pay, but for loan underwriting, credit is the volition part of the equation.
Banks tend to have credit score minimums, as do apartment landlords and other providers of goods and services who evaluate the likelihood of someone making payments for an extended period of time.
In commercial deals, credit is more than a FICO score and a background check: Credit is your track record and reputation. Lenders want to see that an investor has experience not only deploying capital, but round-tripping deals and making sure lenders get made whole.
3) Income: Acronym Soup
Lenders understandably want to make sure that a borrower has enough money coming to make his or her loan payments every month. Income is the “ability to pay” side of things.
Banks use ratios like DTI, or debt-to-income, to determine what portion of a borrower's income is left to pay a mortgage obligation after other living expenses are covered. Banks tend to have DTI maximums at around 30-35%, but higher ratios are possible with the purchase of mortgage insurance (sidebar: the Federal Housing Agency, or FHA, allows lenders to go as high as a 57% DTI, which is all one needs to know about how the US government weighs encouraging low income Americans to get themselves into massive mortgage debt against spurring fee generation for the country’s mortgage banking and real estate brokerage industries).
Lenders also evaluate the source of a borrower’s income, valuing surety over absolute amount, as anyone who is self-employed or gets paid on commission can attest.
On the commercial side of things, income is all about the property. The analogue to the DTI is DSCR, or debt service coverage ratio. DSCR is calculated by taking net rental income and backing out operating expenses like property taxes, insurance, repairs and maintenance utilities, property management and other property-related, recurring costs, to calculate Net Operating Income, or NOI.
DSCR is the ratio of NOI over debt service. So if a property nets $14,000 per month after operating expenses and has a monthly loan payment of $10,000, the DTI is 1.4x (14,000 / 10,000 = 1.4). Lenders generally require a minimum DSCR of 1.2-1.4x, depending on the property type, location and tenant profile.
Lenders also use Debt Yield to measure a property's income relative to the loan amount irrespective of borrowing costs. For example, with an annual NOI of $300,000 and a loan amount of $3,000,000, the Debt Yield would be 10%. Debt yield minimums vary, but since the yield itself is interest-rate independent, lender minimums for Debt Yield are closely tied to fluctuations in borrowing costs.
4) Assets: The buffer the better
The third leg of the loan underwriting stool is assets, which has two parts: assets and equity (no, not that kind).
Banks understandably prefer to lend $1 million to someone with a million dollars in the bank than a couple thousand under their mattress. But as noted above, that is not say that good million dollar loans cannot be made to people with small balance sheets.
It's also window dressing: In all but the most extreme cases, a lender cannot legally chase down cash in your bank account if you don't make your loan payments. Disclosing your brokerage statement doesn’t change the fact that it's still your money - you are free to spend or invest it immediately after your loan is approved.
In commercial lending, banks often require borrowers to have some percentage of the loan amount in total assets, often as high as 100%, with another smaller percentage of those assets liquid (perhaps 10%). These requirements vary widely by lender and loan type, and play an important role in keeping novice investors out of the market for commercial assets. (It's debatable whether this aspect of the commercial lending market is a feature or a bug, but that's a question for another time.)
Banks also pay a lot of attention of the asset backing their loan, which is ultimately more important than the assets sitting on the borrower's balance sheet.
Loan-to-value, or LTV, is perhaps the most important metric in lending, which measures the loan amount against the value of the property. In a purchase transaction the market value is determined simply enough, the purchase price, but in a refinance that value has to be estimated - usually by an appraisal.
The difference between the loan amount and the purchase price is the borrower's down payment, or equity, and represents a lender’s buffer in the event that the investment goes sideways.
Putting these three legs altogether, it's not hard to see how lenders get into trouble when real estate markets go south.
Imagine an apartment building investment made in 2021 with the following characteristics:
$20,000 monthly rent roll
$240,000 annual rent roll
$156,000 net operating income (NOI) (35% operating expense ratio)
$2,600,000 value at a 6% capitalization rate ($156,000 / 0.06) = $2,600,000
A lender could make a very reasonable 70% LTV loan ($1,820,000) with a rate of 4.0% and a monthly payment of around $8,700, which equates to a 1.50x DSCR - plenty of room to get approved without raising any eyebrows inside the bank. With that high of a DSCR and a moderate LTV, even a borrower with less than stellar credit or a limited track record could get approved.
Fast forward two years and a couple things have happened.
Suppose rents have slipped 10% from 2021, which makes the lender a bit nervous with a DSCR now down to 1.35x, but still above the threshold of 1.2x they probably had back in 2022. No sweat, the market will recover.
However, if the investor’s business plan called for a quick sale or reposition, the borrower likely took out a loan which adjusted to prevailing rates in three years and may have even pushed for interest only payments for the first three years to maximize cash flow. In 2024 with rates having spiked higher, the loan will reset at, say 6.5%.
Now we have a problem.
The property is operating fine with no issue covering operating costs. But the new monthly payment of $11,500 (6.5% rate on a $1,820,000 loan) is a hair below the monthly NOI of $11,700 and well inside the bank's minimum debt coverage ratios - which have since risen to 1.4x from 1.2x, as risk managers are battening down the hatches.
10% is a relatively minor drop in rents, but the bank is backed into a corner because with the borrower in technical default on the loan (dropping below its debt coverage covenants), the lender has to start provisioning for losses, impairing its balance sheet and putting regulators on notice. The bank could extend the loan at the original rate but, as we'll see in a moment, that might be even worse.
5) What happens now?
Mortgages are a type of bond, and bond prices move inversely to interest rates.
And if there is a simpler phrase with a more profound an impact on capital markets, I am not aware of it.
Imagine a bond, or mortgage, purchased in 2021 with a face (or par) value of $100,000 and a coupon of 4.0%. The buyer bond can expect $4,000 per year in coupon payments until the bond matures. Now jump to 2024 where prevailing rates for that same bond are 6.5%.
A bond buyer could buy a new $100,000 bond (or mortgage) and expect $6,500 in annual payments at prevailing 6.5% rates. That purchase back in 2021 isn’t looking great in hindsight.
And what if that original bond (or mortgage) buyer wanted to sell, or value, the 4% coupon bond bought back in 2021 which is yielding $4,000 per year? Doing the math, a buyer should be willing to pay just $61,538 for the bond, because in today's market he or she expects to be paid 6.5% ($61,538 x 6.5% = $4,000).
Ouch.
Using our example above, that $1,820,000 mortgage with a 4% coupon is worth only $1,120,000 today, since a buyer of that mortgage should expect that 4% coupon to return 6.5% on the investment (meaning the investment itself needs to be far lower than the original $1,840,000).
Multiply that by hundreds (thousands) of loans banks made during the post-pandemic boom and it's easy to see why even Treasury Secretary Janet Yellen is conceding that the banking sector is not in tremendous shape.
And while there are accounting rules which let banks defer write-downs for certain loans held on their books if they don’t plan to sell them, balance sheets - especially in the regional banking sector - remain bullet-ridden.