The way the new Basel III High Volatility Commercial Real Estate Lending Rule (HVCRE) was crafted, and is being enforced, is insane. We’ve written about this before. This is one of the purest examples of the regulatory apparatchik’s mule-headed refusal to look at data or engage with the banking establishment to develop thoughtful and effective rules. I think I saw a thoughtful and effective rule once. My last missive on this was a cri de coeur for the inanity of the whole thing, but I’m moving on.
HVCRE includes any loan for the acquisition, development or construction of commercial real estate (“ADC”) that fails to meet numerous detailed and complex “scope out” criteria. Beginning January of this year, the HVCRE Rule extended from a small group of the largest banks in the country to all banks. While some institutions may be so well capitalized that RBC considerations are not vital, many, and most of our smaller banks, who earn their daily bread in the acquisition, development and construction financing market do care, and care a lot. If a loan is deemed HVCRE, substantially higher capital requirements are triggered. That means that either loans as currently priced will be uneconomic, or the pricing will have to increase a lot.
The scope criteria seemed actually designed to make it hard if not impossible for your average acquisition, development or construction loan to avoid the HVCRE label. I wish I found that shocking. I promised I wouldn’t belabor the philosophic inanity of this Rule, and I’ll move on in a second, but the regulators have boundless safety and soundness regulatory tools in their toolbox. Moreover, the banks actually get that these are riskier loans and have always used underwriting structural safeguards to address this enhanced risk. HVCRE seems like a very blunt tool to address the types of risks that bank regulators already can manage. But perhaps only blunt objects get street cred within the populist narrative about the evils of Wall Street and our bankers. Presumably, that’s intentional.
The marquee criteria to scope out a HVCRE includes:
- The borrower must contribute cash (or marketable securities) to the project equal to at least 15% of the appraised as completed value of the project.
- All of the borrowers’ capital is contractually obliged to remain in the project until the loan is repaid (or converts to a permanent facility, but the Rule makes that very hard indeed to do).
The Rule contains mind numbing details about how it is applied, what constitutes equity for purpose of this test and what does not. Curiously, the Rule has very little to say about what is an ADC and what is not. Sort of important that, wouldn’t you say?
The cost of meeting the higher capital requirements of the Rule has been estimated at somewhere between 50 and 100 bps of spread. But remember, as the Clintons taught us, it’s not just the capital, stupid. Think of the regulatory and administrative headaches of dealing with a regulatory apparatchiki pawing through your CRE book, making clumsy determinations of what is and what is not HVCRE. We understand that the banking community is tying itself in knots trying to figure out where lies the boundaries of HVCRE, with banks reporting wildly disparate proportions of their book being HVCRE. The regulatory burden alone will probably add materially to the break-even cost of playing in the whole CRE market.
The industry needs to do something. We need a healthy and robust supply of construction lending. There is currently almost $13 billion dollars of outstanding construction loans open today, and if you look out the window in most places in America, you realize we would be a sad place if that flow of construction funds began to tail off.
What do we do? Suck it up? Charge more for loans? That’s clearly part of the answer but it seems insufficient. Moreover, I’m betting as the regulators fill in the blanks in the Rule over the next year-or-so, it’s not going to make this easier, but more difficult, more expensive. Just for example: many, perhaps most, think a loan with 15% hold back for TIs and CapEx is not HVCRE. Want to bet what happens after a year of bank examiners beavering away?
So, again, what do we do? The obvious answer is that some of this lending must move from the bank’s books and into the non-bank market. But it’s really the banks that have the expertise, skill and the balance sheet to fund construction lending, so what do we do?
Here’s my plan: The banks can step back into a wholesale banking capacity to fund this business through warehouses and securitized, non-consolidated structures.
There’s no suggestion in the Rule that a warehouse financing a pool of HVCRE loans is itself HVCRE, and that makes good logical sense. Provided the regulators don’t wildly expand their writ to drag even this into the HVCRE bucket, here’s an opportunity. So the business moves to a non-bank, fund or permanent capital vehicle, the traditional banks provide warehouse funds and actually service the loans on behalf of those funds. Obviously, paying the piper for a fund investment in the construction lending is going to be costly, but that may simply be a cost of doing business in our new regulated world. The RBC offset from the banks is valuable and can partially offset the increased yield to be required in the shadow banking world.
While the CRE securitization market hasn’t seen any material construction lending, ever (well, there was one deal in 1997 following the passage of the never lamented Fasit rules, but that wasn’t a happy thing), it’s time to revisit securitized construction lending. It’s time to create lending vehicles funded by pass-through, rated debt, which can be largely held by the very same banks which ought to be in the construction lending business in the first instance. Rated, investment grade debt is going to carry much lower capital charges and get the banks entirely out of the regulator’s HVCRE bear hug. The bank can buy the investment grade debt on such a vehicle and then provide leverage to fund vehicles that acquire the lower rated tranches of the capital stack. These newly-minted lending entities can, in turn, retain one or more banks to service and actually manage the construction lending—because that’s their expertise. Perhaps not the most efficient or elegant structure in the world, and funding the lower rated tranches of the pass-through debt would require a considerably higher coupon than traditional bank lending, but with 100+ bps of pricing offset for the capital charge savings, this might all work.
Well, if this doesn’t work, something else will or should. This is no time to give up. The economy actually needs a robust construction lending sector that is priced at a place driven by the market, not by the most recent, reflexive regulatory effort to ostensibly show how much the government hates the banks. This is all the same skein of good politics but bad policy. We’re stuck with it. It’s not going to go away, but it’s not time to surrender.