“The worst is yet to come. Typically there’s a lag between when the economy softens and when the defaults actually occur.”

-Steven Kandarian, MetLife Inc. Chief Investment Officer


Ahhhhh, its nice to see that sophisticated professionals make the same mistakes that Mom & Pop did during the credit bubble: Interest-Only Mortgages:

“Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping malls are bracing for more loan defaults through 2010 as Bank of America Merrill Lynch says landlords’ monthly payments may jump 20 percent or more.

Principal is coming due on the so-called partial interest- only loans as an 18-month-old recession saps demand for commercial real estate. About $179 billion of such loans were written between 2005 and 2007 and bundled into bonds, according to data from Bank of America Merrill Lynch.

With soaring vacancies and falling rents, some cash- strapped borrowers will fail to cover the higher costs, said Andy Day, a commercial mortgage-backed securities analyst at Morgan Stanley in New York. About 87 percent of mortgages sold as securities in 2007 allowed owners to put off paying principal for several years or until maturity, compared with 48 percent in 2004, Morgan Stanley data show.”

When you make a purchase via financing, there are two basic costs: The item you are purchasing (land, malls, hotels, apartment buildings, etc.)  and the cost of financing. The item purchased/financed/leased is paid for with borrowed capital, and the costs of that financing is the interest the borrower pays on it.

Its one thing to use I/O on a short term bridge loans, or any temporary financing. But these 2 and 3 year commercial I/O lending packages at the tail end of a giant RE book are inherently problematic. Almost by definition, when a borrower users I/O financing, it suggests they cannot afford to make the actual purchase, and were unable to arrange other forms of financing.  Otherwise, the buyer would have arranged for to a less risky structure that is not dependent upon subsequent credit availability. Note that I do not refer to the 10 or 15 year I/O funded projects that have an exit strategy — a  sale or merger in the not-too-distant future, rather than an ongoing hunt for financing.

One of the regular data points of the 1929 market crash and Great Depression is that 20% of homes were foreclosed upon. Back then, the mortgages were typically 3 year, interest-only, with a balloon at the end. If the mortgagee could not arrange a new loan at the end of the term, they lost their house.

Unless credit frees up significantly, we could see similar issues with CRE (but nowhere near 20%).


UPDATE: June 11, 2008  9:03am

After I posted this, I spoke to friend — a senior CRE attorney at Shearman & Sterling with 3 decades plus doing large commercial transactions.

He noted that while I/O financing has been around “forever,” it was only in the last cycle where it became prevalent — especially in the 3 to 5 year term. “The mindset was more leverage meant more profits, and since the next firm was generating 25% a year, you had to also.”


Bondholders Face Commercial Mortgage Losses as Principal Is Due
Sarah Mulholland
Bloomberg, June 11 2009


See also
Automaker bankruptcies may cause land pileup
Anjali Fluker
Orlando Business Journal, June 5, 2009


Category: Credit, Real Estate

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

11 Responses to “I/O Mortgages Hit Commercial Real Estate”

  1. [...] Jump to Comments Is this serious? These jokers took out interest-rate mortgages for CRE. Guess where this is going: “Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping [...]

  2. danm says:

    From St Louis Fed:

    Lending terms varied widely across lenders. Although mortgages
    made by savings and loan associations (S&Ls) were usually fully
    amortizing, thosemade by life insurance companies and commercial
    banks often included no, or only partial, repayment of principal
    over the life of the loan and were usually for shorter terms than
    those made by S&Ls. SeeMorton (1956) for more information about
    the mortgage market and loan characteristics during the 1920s.

    The largest difference between then and now is the balloon payment. When the loan came due, the borrower could not find a lender. That’s why FRE and FNM were created.

    Canada stuck with the balloon loans, amortizing over 25 years but renegotiated every 3-5 years. Our answer to that depression issues was CMHC insured loans. So the banks aren’t stuck with a fixed rate for 25-30 years. And it<s much tougher for homeowners to refi because our terms are much lower.

  3. [...] Original post: I/O Mortgages Hit Commercial Real Estate | The Big Picture [...]

  4. VennData says:

    This is what the TALF has been adjusted to assist, CMBS. So the government money will go a long way to helping banks renegotiate the debt coming due. Money’s fungible, but I’d like to see how many of these loans get re-fied by TARP recipients vs ex-TARP, since the rest may be eligible for TALF.

    Is Wells not paying the TARP most likely because they are the leader in commercial real estate loans with $103 Billion…


    “…$594 million of commercial mortgages, including those inherited from Wachovia, were no longer collecting interest, or about 0.6 percent of its loans…”

    Hmm… under one percent. And they’ve made allowances for that 1 percent, and say they will earn there way out of this. They must know what they’ve got.

    While the negative talking heads complain that “Anybody can make money if the gov’t gives you money at zero percent” the Chinese are doing this as a matter of policy to many of their domestic and international businesses. It’s good to see the Treasury is doing the same with TALF.

    Will Larry Kudlow say dropping rents are like a corporate tax cut? Or complain about how Obama is rough-housing with distressed debt investors an capitalism is dead?

  5. Bruce in Tn says:


    retail sales…flat except for big jump in gasoline sales…


  6. hrux says:

    I was curious if any of you have ever looked into the Harry Browne permanent portfolio strategy? I have been searching for a portfolio strategy that is well diversified, low drawdown ratios, lower market volatility and offers appreciation potential after inflation for quite some time and have been suffering from paralysis analysis big time. Recently, I have become more interested by a variation of Harry Browne’s permanent portfolio theory. This strategy consists of 25% gold, 25% short term treasuries (1-3 yr. such as SHY), 25% long term treasuries (20+ yr. such as TLT) and 25% equity (could be 25% total US stock market, or a blend of 12.5% Total us stock market and 12.5% total international market). This portfolio has proven to hold up during inflation, deflation, prosperity and recessions. Since 1972 it has had 2 losing years and those had minimal drawdown (-3.9% in 1981 and -2.5% in 1994). In 2008 it was UP 1.9%. This portfolio has generated a 10.0% average annual return versus a 11.1% return for an all equity (US) portfolio with much less volatility. Needless to say I agree in that the typical 60/40 portfolio is not well diversified however Harry Browne’s portfolio has 4 distinct asset classes that create one heck of a lazy portfolio.

    the following blog is dedicated to the HB permanent portfolio strategy:

    I would appreciate everyone’s thoughts on this approach?

  7. Greed has to be one of the most puzzling of all human foibles. You have people who will never need another penny in their lives if they never worked again ‘betting’ their fortunes to get more of what they will never be able to spend. We know they aren’t doing it for their offspring. It is a giant ego trip. It is also that nasty spirit called greed and it is curious but incredibly sad to watch. I hope I am not that way if I ever get to those income levels

  8. KevinKleen says:

    Good post, but I think you incorrectly describe the motivation for these deals. The interest only period was not about maximizing the leverage or affordability – even though the actual payments were interest only, the loans were sized as though they were amortizing. The IO period was about goosing the return in the early years of the deal. With an amortizing loan the first year ROI in a typical deal was in the 3% range, which looked bad. Eliminating amortization in the first year boosted the ROI into the 6% range, which was much more palatable. I go through the math at the link below.


  9. danm says:


    Maximizing leverage implies boosting ROI.

  10. [...] CRE: BR on ‘Interest Only Mortgages” in CRE Posted in June 11th, 2009 by Mark in News: Commercial RE Interesting read today from Barry Ritholtz on interest only mortgages in CRE – read his full post here.  [...]

  11. KellyD3 says:

    I was speaking to an acquaintance of mine who is an executive at a large commercial mortgage broker, at a time when the yield curve was inverted. I asked him if they were using the yield curve inversion as an opportunity to lower borrowing cost for their clients. He answered that no, their interest was to refi the loan every few years and rack up fees. They put extra fees on if the borrower wanted a longer term, thereby negating any yield savings.
    Nice to know they were looking out for their clients’ interests :(