While interest-only mortgages have almost disappeared in the residential space (thanks in part to the Consumer Financial Protect Bureau’s efforts), they are growing again in the unregulated commercial space.
(Bloomberg) – Commercial mortgage bonds are getting stuffed with the lowest-quality loans since the financial crisis by one measure, according to Moody’s Investors Service, a warning sign that the $517 billion market may be headed for harder times. More than 75 percent of the loans backing the bonds a re interest-only mortgages, a similar level to late 2006 and early 2007, Moody’s said. Those loans are riskier because borrowers don’t pay any principal early in the debt’s life. When that period expires, the property owners are on the hook for much higher payments.
The percentage of interest-only loans in a commercial mortgage bond is an “important bellwether” for the industry, according to Moody’s analysts, because the loans are more likely to default and to bring bigger losses to lenders when they do. Underwriters aren’t taking steps to fully offset the rising risks, the ratings firm said.
The riskier debt getting packaged into commercial mortgage bonds mirrors a trend that’s infiltrated many corners of the credit markets, fromleveraged loans to residential mortgage securities: As investors have flocked to debt investments that seem safe, underwriters have been emboldened to make the instruments riskier and keep yields relatively high by removing or watering down protections.
Moody’s said fierce competition in lending has allowed “the vast majority” of borrowers with good properties to get the loosest kind of interest-only loans, and even debt tied to “lower-quality properties in secondary markets” now often has the borrower-friendly terms.
The growing percentage of interest-only loans is “a significant negative credit trend, as well as an important warning sign of deteriorating underwriting standards,” analysts led by Kevin Fagan wrote in a note this week.
In the first three months of the year, more than 75 percent of loans in commercial mortgage bonds with multiple borrowers were interest-only, the highest share since late 2006. On average, a borrower can wait nearly six years before paying principal, up from 2.2 years four years ago. Almost half of the pools of loans backing bonds included “full-term” interest-only debt, which doesn’t require principal payments until the full loan is due.
The heavily regulated residential mortgage space where interest-only loans are pretty rare (though government mortgage entities are seemingly engaged in a “race to the bottom” in terms of low down payment loans), the relatively unregulated commercial space is seeing a growing trend in interest-only loans.
Let’s see how well the interest-only loans perform as The Fed continues to raise its benchmark rate and unwind their balance sheet.