Conduit Mortgages
In the early 1980s, investment banks, such as Salomon Brothers, worked with banks and the government sponsored entities Fannie Mae and Freddie Mac to develop ways for banks to be able to sell their home mortgage loans as bonds into the bond market. By doing this, banks would free up funds to continue to make more loans, as well as earn fees upon the sale of the loans while leaving little or no of their own money at risk. However, similar developments in commercial mortgages were slow in appearing. The first movement in this area came with the savings and loan failures: the government set up a company known as the "resolution trust company" which would buy commercial mortgages from failed savings and loans and then turn them into bonds. In the early to mid nineties this led the staff of the Japanese Investment Bank Nomura in San Francisco to develop programs to convert commercial mortgages into bonds, primarily by making new commercial mortgage loans with clauses and structures which make them more like what bond investors want to invest in. The main thing that bond investors did not like about mortgages is that the borrower could repay the loan at any time (which was usually done when interest rates went lower, causing the bond investor to lose out on their high rate bond and having then to reinvest in new low rate bonds). While the government did not like restrictions on prepayment penalties being required of regular home owners, Nomura and other investment banks began to structure commercial mortgages that absolutely forbid prepayment, in exchange for dramatically lower interest rates (and also allowing new buyers of the property to take over the existing loans, in other words, making them assumable). The loans that were especially designed to be turned into bonds became known as "conduit loans". Because of the rule against prepayment, for a borrower to prepay a conduit loan, the borrower will have to buy enough government bonds (treasuries) to provide the investors with the same amount of income as they would have had if the loan was still in place. This is known as a defeasance. When a property defeases, the bond it is in will increase in value since the higher risk real estate collateral is being replaced with lower risk US treasuries.
Conduit loans have been part of a trend in the Investment Banking industry to become more "vertically integrated". That is, instead of helping banks and other lenders to provide fix rate products and replenish funds by selling off loans as bonds, investment banks have taken to making the loans themselves, and then selling the bonds themselves. In fact, many times the Investment Banks make little or no money on the loan itself, and only make money by the selling and trading of bonds. For this reason, these forms of loans are usually at a better interest rate than is possible through other forms of Bank lending.
Like most residential mortgage loans that are sold as bonds to bond investors, investment banks usually create multiple classes (known as 'tranches') of bonds based on the same pool of mortgages. The tranches might be ranked so that the 1st class takes all of the losses on the mortgage loans up to a certain point in exchange for having a higher interest rate paid to them. The second class may only take losses when the losses reach a certain point for the first class of bondholders, in exchange for a lower interest rate. In this way one set of mortgages could be used to create bonds that appeal to a wide range on investors.
With the subprime mortgage crisis, investors have stopped buying the majority of classes of commercial mortgage backed securities, and therefore, most conduit loans are no longer available at good interest rates. This is due to a few factors: while there is concern that the residential mortgage crisis will have an adverse effect on commercial real estate, the biggest issue is that both subprime mortgage bonds as well as commercial mortgage bonds have been arguably constructed incorrectly, with the investment banks underestimating the losses that might occur for each tranche and under compensating the tranches as a result (and also underpricing the original loan). It is not clear at this time whether new commercial mortgage backed securities will again begin to be issued in an orderly fashion, and if so whether the tranche system might be changed fundamentally. However this is an issue for the commercial real estate market in general as other lender (banks, Fannie Mae/Freddie Mac, life insurance companies) will be able to make up for the lost conduit loan availability.
Read more about this topic: Commercial Mortgage