Conduit Loans
Commercial Mortgage-Backed Securities (CMBS) are pools of commercial (rather than residential) mortgage loans of varying sizes, property types and locations that are pooled (securitized) and transferred to a trust. The trust then divides these mortgages into a series of "tranches" or "classes" that are of varying risk of default, terms, yield, and payment priority. Bonds are then issued backed by the mortgages assigned to the tranches and are rated by independent bond rating agencies; the trust will have various bonds rated from investment grade to an unrated class. In a traditional CMBS, the issued securities represent an undivided interest in those mortgages with interest and principal passed to investors on a pro rata basis.
As an investment vehicle, mortgage securities were initially authorized by the Tax Reform Act of 1986 which provided that under specific circumstances mortgage trusts are not subject to a double taxation as its income is passed- through to its interest holders.
Similar to Mortgage Backed Securities in the residential market offered by Ginnie Mae, they differ because these mortgages are guaranteed by the US government and are not restricted to the residential market.
CMBS bonds are generally call protected -- underlying mortgages cannot be prepaid without some form of compensating payment to enable investors to maintain their expected yield.
Defeasance is a mechanism that can be used when prepayment is required. Defeasance is the substitution of government securities for the property pledged to the trust as collateral for the mortgage. Technically the note remains outstanding, but is repaid from cash flow from the government security rather than through cash flow generated by the property.
Investment Banks or large Mortgage Brokers may act as originators (identifying those who want to borrow money). They will tend to use either their capitol or short-term money from the Commercial Paper market when providing the initial funding for loans. Once sufficient loans have been made, they will be transferred to a Trust and securitized. Bonds will then be issued on the secondary market, backed by the Trusts assets.
Discount Window is a term used to describe a mechanism that allows banks and other eligible institutions to borrow money on a short-term basis, to meet temporary shortages of liquidity. The interest rate charged, called the discount rate, is set by the Federal Reserve and is an important tool in controlling the nation's money supply.
The Government National Mortgage Association (Ginnie Mae) administers a Real Estate Mortgage Investment Conduits (REMIC) program that invests in securities guaranteed by HUD and the VA.
Portfolio loans are the other types of financing available for loans and are originated by a leader (typically a bank or insurance fund) and held on its balance sheet through maturity. CMBS has become an attractive capital source for commercial mortgage lending because the bonds backed by a pool of loans are generally worth more than the sum of the value if the whole loans. The enhanced liquidity and structure of CMBS attracts a broader range of investors to the commercial mortgage market. This value creation effect allows loans intended for securitization to be aggressively priced, benefiting Borrowers.
A Real Estate Mortgage Investment Conduits (REMIC) is also an investment grade Commercial Mortgage Backed Security (CMBS) bond. Conduit loans are commercial mortgages which have standardized guidelines for issuance, and are in turn bundled, securitized, and sold as CMBS.
A REMIC can be a corporation, trust, or partnership and exempt from federal tax under the Tax Reform Act of 1986; removing double taxation, investors in the REMIC are fully taxable. The Act also allowed a REMIC to structure a offering of a mortgage backed securities as a sale of the bank's assets, effectively removing the loans from the originating lender's balance sheet. The bank (a REMIC's typical sponsor) receives asset-management fees and investment profits.
The principal and interest payments in REMICs are not passed through to investors pro rata; instead they are divided into varying payment streams to create classes with different expected maturities, differing levels of seniority or subordination or other characteristics. The trust then issues a variety of bonds with different yields, duration, and payment priorities. The assets underlying REMIC securities can be either other commercial or residential mortgage backed securities or whole mortgage loans. Bond rating agencies then assign credit ratings to the various bond classes ranging from investment grade to an unrated class which is subordinated to all other classes.
Among the major issuers of REMICs are Freddie Mac and Gennie Mae, as well as privately operated mortgage conduits owned by mortgage bankers, mortgage insurance companies, and savings institutions.
Many REMICs borrow short-term money (maturing in less than one year) and use these short-term funds (typically commercial paper) to finance long term mortgages or other bonds paying higher rates. This conduit model breaks down in times of financial uncertainty, when the commercial paper market dries up.
According to Standard & Poors, a major evaluator of the risk of CMBS, in the first 1/4 of 2007 there was about $983 million in asset backed commercial securities that have been issued world wide, an amount up just under five time from 10 years earlier.
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