During the crucial early loan application stage, when a loan officer sits a borrower down to size up a mortgage, it is imperative that the borrower receives clear counsel about the differences between a conduit loan and a general portfolio loan.
Borrowers have claimed that loan officers often fail to adequately explain what happens to a conduit loan after the ink dries on the closing documents and champagne bottles are thrown out.
Other borrowers say they don't care about what happens to a loan after it closes — what matters most are the terms of the. The prevailing interest rate, loan-to-value ratio, waived lender fees, and maximum loan proceeds often top a borrower's list of immediate concerns.
However, as a property investor's real estate management needs and development skills expand, the nature of the loans that investor buys into begins to take on new meaning.
And what the borrower can or cannot do with that loan or the property after the deal closes can spell the difference between taking advantage of a lucrative exit opportunity, or having one's feet held to the fire of conduit agony for a fixed-loan period.
Conduit lenders and Wall Street loan buyers rarely keep these mortgages on their balance sheets, unlike portfolio lenders, who make and hold onto loans. Instead, the conduit loan is almost always immediately transferred to a master trust and pooled with others for bond issuance.
It is estimated that Wall Street issued almost $200 billion domesticin 2006, well ahead of the $167 billion issued in 2005. The developments that follow the closing of a conduit loan can instantly add a new dimension to the business strategy and asset operations of a borrower, and dictate constraints on the real estate itself.
Almost every securitized conduit loan has a period in which it cannot be prepaid without incurring a stiff penalty, and borrowers often have difficulty accepting these constraints. Bondholders — who are often large financial institutions — receive interest payments against the mortgage(s) in a securitization issue. Prepayment disrupts that highly structured interest income stream.
The constraints that a borrower encounters after a conduit loan closes are strictly governed by an iron-clad legal document called a pooling and servicing agreement (PSA). The PSA levies severe restrictions and financial penalties on the borrower who prepays a mortgage. It is not unusual for a loan to carry a prepayment penalty equal to 12 months or more of interest payments.
Yield maintenance is another measure securities issuers and conduit lenders take to protect the buyers of their bonds from a rogue borrower who wishes to prepay a securitized loan. The PSA requires that a certain minimum level of interest income be received from a mortgage before it can even be considered for prepayment and the accompanying penalties.
That minimum yield maintenance period is referred to as a loan lock-out period. During this time, a yield maintenance premium is required to cure the bondholders in the event of a prepayment request.
Agony of conduit servicing
Primary conduit servicer shops are designed to administer loans with absolutely minimal human intervention, and that can spell agony for the uninformed borrower. In many instances, a borrower may call a primary or master loan servicer to make a routine request or lodge a customer complaint, and fail to even get a live person with whom that request or complaint can even be registered. These are the post-closing issues that give angst to servicing managers, borrowers, and the trustees who oversee the operations of securitized pools of mortgages.
In the event a borrower urgently wants to exit a loan — for reasons ranging from a can't-miss sale opportunity, to a major financial development in the property's operations — there is one final expensive remedy: loan defeasance. This exit strategy is a plan by which the borrower substitutes cash or an income-streaming investment — such as equally yielding U.S. treasury bonds — into a securitized loan pool in exchange for pulling his or her loan out of that pool.
In fact, the loan defeasance business dissolved 12.4% of all conduit loans to date by the beginning of 2006, when $29.7 billion, or 2,090 conduit loans, were defeased.
Some investment bankers estimate that these numbers were easily topped in 2006, showing the lengths to which property investors have gone to undo the constraints of those conduit loans that seemed so attractive in the beginning.
W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.