If you're in the commercial loan business, the history of our industry is important to you. Commercial real estate finance ("CREF") tends to repeat certain cycles. Mark Twain said it best, "History doesn't repeat itself, but it does rhyme." How commercial lenders reacted to periods of soaring interest rates, periods of declining interest rates, and periods when commercial real estate plummeted by 45% is a strong indicator of how they will structure their commercial loans in the future.
We will start our six-part journey in the 1960's, at a time when the United States was still on the gold standard, and inflation was close to zero. Back then there was no organized secondary market for commercial loans. If a bank or life insurance company ("life company") made a commercial loan, it was a portfolio loan.
A portfolio loan was a commercial loan that the lender intended to keep in its own portfolio for the entire term. Portfolio lending was liberating. When a commercial lender made a portfolio loan, it was lending its own dough. The commercial lender didn't have to meet any rigid, outside underwriting criteria. For example, if a bank felt comfortable making a third mortgage on a land lessor's interest in a shopping center site, the bank was free to make the commercial loan.
How could a third mortgage on land ever be prudent? Suppose a former land owner leased his unsubordinated land (there were no mortgages in front of it) to a shopping center developer for a 99-year term at $10,000 per month. The developer then built a $10 million shopping center on the land. If the developer ever failed to make his $10,000 per month land lease payment, the land lessor could "foreclose" on his lease and own the $10 million shopping center free and clear!
The problem with commercial lending back in the 1960's was that commercial real estate lenders only had a limited appetite for commercial loans. There were just three major types of commercial real estate lenders back in the 1960's - life companies, commercial banks, and savings and loan associations (known as "S&L's" or "thrifts").
A savings and loan association was a special type of bank that was only allowed to make real estate loans. They did not offer checking accounts. They could only offer savings accounts. S&L's were not allowed to make business loans, car loans, personal loans, or credit card loans. Instead, thrifts just made long-term real estate loans. Interest rates on deposits were regulated back then (Regulation Q). A giant bank like Bank of America could not offer higher CD rates than a local one-horse, small-town bank. However, thrifts were allowed to offer certificates of deposit that were 25 basis points (one-quarter of a percent) higher than commercial banks. The idea here was to encourage savers to keep their long-term savings in savings and loan associations, which would then use these deposits to make long-term real estate loans.
Back in the 1960's, there were several thousand S&L's, thousands of commercial banks, and about 300 life insurance companies. Nevertheless, the appetite of these commercial lenders was extremely limited. Why? Because there was no way to sell off a commercial loan in the event of a liquidity crisis. If depositors suddenly started lining up to withdraw their deposits (aka: bank run), a bank or thrift could quickly sell off its home loans to Fannie Mae or Freddie Mac to meet the run. Their commercial loans, however, could NOT be easily sold off because there was no organized secondary market for commercial loans.
So in the beginning, every commercial loan was a portfolio loan, and commercial lenders could only risk having a handful of commercial real estate loans in their portfolios.
