Wednesday, March 18, 2009

The CRE Credit Crunch, Hard Money, and Loan Sharking

It is very difficult to find financing for retail, industrial, and office properties (multifamily properties still have Fannie Mae and Freddie Mac). What effect is this having? An interesting post at Cheap Talk, “Credit Rationing and Loan Sharking,” helps explain what is happening.

Interest rate spreads increase:

The market for credit is like any other market with supply and demand and a price.  The price is the interest rate.  The problem with the credit market is that the price often cannot serve its usual market-clearing purpose.  When the supply of credit goes down, the interest rate should rise to clear the market.  Clearing the market means reducing demand to bring it back in line with the low supply.

Borrowers with good quality projects are sitting on the sidelines:

The problem is that high interest rates reduce demand by disproportionately driving away borrowers who are good credit risks and leaving a pool of borrowers who are now more risky on average.  This makes lending even more costly, reducing supply, driving the price up again…The effect is that there may be no way to clear the market by raising interest rates.  Instead credit must be rationed.

Borrowers with riskier deals turn to hard money sources:

One way to improve rationing is to increase collateral requirements. But borrowers who are already excessively leveraged (the other part of the credit crisis story) will not have additional collateral to compete for the rationed loans.  Here is where the loan shark comes in.  Loan sharks use a form of collateral that banks do not have access to:  kneecaps.  Highly leveraged borrowers who are rationed out of the credit market cannot post collateral to service their debt so they turn to loan sharks.

I see this going on at my day job. High quality lending opportunities have virtually disappeared, leaving the dreck. On the other hand, there are a lot of deals looking for hard money (for background, here’s an article on CRE hard money). The article erroneously suggests my employer offers a hard money program (I was talking about Fannie’s mezzanine program), but my phone rang off the hook for days.

The conclusion is the CRE credit crunch is resulting in lower volumes as borrowers with high quality deals sit on the sidelines, and the business which is getting done tends to be riskier deals with onerous terms.