Or perhaps Prometheus had it right in its original form. “Whom the Gods would destroy they first make mad.” Look at what we are doing to construction lending in the name of our seemingly endless safety and soundness crusade.
Under the new regulatory capital rules, we have a new asset class; HVCRE or High Volatility Commercial Real Estate. HVCRE includes acquisition, developments and construction loans. These loans are assigned a risk rating of 150% of the basic risk rating for commercial real estate. Now, to be fair there are limitations and exceptions to the type of loans that attract this higher regulatory capital requirement, but those are somewhat at odds with the realities of the market. Just by way of a few examples, to avoid HVCRE status the borrower must have 15% cash equity. The rules about what is and what is not cash equity are artificially restrictive and not in all respects in accord with the market practice. So-called soft costs count but appreciation in the value of the real estate is disregarded; only cash paid at acquisition counts. As a property is held for longer and longer, this makes increasingly little sense. Why is land value equity any less real than cash invested for so-called soft costs? I have never met a developer without a fabulist view of what should be counted as soft costs. Please, I’ll take real live equity in the dirt any time. Also, for reasons which are entirely obscure, one cannot count the borrowers’ other free and clear assets, letters of credit, cash or unencumbered readily marketable securities held on account of the borrower. Also neither preferred equity nor subordinated debt counts.
The rule is full of other fine and often inexplicable distinctions about what is and what is not good equity, how to calculate that equity and otherwise determine what is or is not a HVCRE asset. Moreover, this is another Hotel California experience. A bank, once it has an HVCRE asset, can never escape the higher capital treatment of that asset even if the loan remains in place after construction is done and the income stream from the tenancies-in-place is robust. How does that make any sense?
My point here not so much to try to summarize the mind numbing complexities of the rule, but to make some observations about yet another victory for the government’s favorite law: the Law of Unintended Consequences. Ok, construction loans are riskier than loans secured by stabilized properties. That certainly qualifies for a “no duh” moment. Shockingly, banks get this and have always understood this. Construction loans have traditionally been underwritten with lower attachment points, more structural credit enhancement features and attract a higher yield. There is risk, but the banks are contractually obtaining structural protection and are getting paid for the risk. If the regulators are suggesting that we simply put more capital against these loans because the borrowers don’t “trust” the banks to do business intelligently (and isn’t that trope getting a tad old by now?), should we then structure them as fully stabilized loans and simply rely on the extra capital cushion to protect the banks? Apples and apples anyone?
I have heard estimates from reliable sources that this new capital structure will require between 40-80 bps increase in yield to pay for the additional capital. And these loans are going to attract massive amount of regulatory compliance costs and generally give the regulators an opportunity to criticize the bank 24/7, day in and day out. I could hear the conversation amongst the regulators: “Hey, since we don’t have a lot to do for the next month or so, how about we just hoover up everything in the construction book? That should be fun and enlightening.”
So what is all this going to mean for the marketplace? It is going to push a lot of construction lending in the shadow banking market. How in the world is moving a major core function of the US banking system into the shadow banking system achieving a societal good? This again is another example of our regulators attempting to do by regulatory fiat that which could be more efficiently and in a more focused way done by principal based, regulatory rigor (if indeed more was necessary) around existing rules regarding the credit and underwriting processes that the regulated banks use in approving construction loans.
I gotta think the regulators know better, I really hope they do – I really hope they are in on the joke. Maybe, maybe politicians involved in this process do not. They at least have gotten awfully good at pretending not to. So what do we get? Another banking sector scalp hung on the wall, another notch in the handle of the regulatory pistol, another AG closer to being a governor, but to what end? Stomping on perceived high-risk lending sector with the jack boots of higher capital charges may make good political theater, but I don’t believe it will increase credit quality, reduce losses, improve the safety and soundness of our banks, but I know with an absolute certainty it will reduce the availability of capital to an important sector of the real estate market and when that capital is provided it would be provided outside the regulator purview of our banking regulators.
Why do we keep doing this? Shouldn’t the political class and the enabling apparatchik simply declare victory on this going on eight year long jihad against the banking sector and let the regulators and the market go back to implementing and enforcing principal based regulations which really deliver safety and soundness without throttling an industry on which our economy is based.