Understanding Wall Street Lenders

In this article

• Wall Street Lenders—Conduits
• Wall Street Lenders—The Process
  • Pooling
  • Step One
  • Step Two
  • Step Three
  • Step Four
• Order of the Tranches
• Appreciating Concepts—First-Tranche Investors
• Profits
• FAQs
• We Can Help
• About The Author

This blog deals with lenders who make money from loans by selling off them as soon as they are lent, called Wall Street Lenders. As will be explained, they profit from selling the loans at a higher rate than they loaned for and from closing costs. The process of buying and selling loans is an extremely complicated one, and most of it is beyond the scope of the responsibilities of a mortgage broker. It is important, however, to acquire the basic understanding presented in this blog to best serve your clients.

WALL STREET LENDERS—CONDUITS

Wall Street lenders have a limited amount of money and lend out that money to different borrowers for mortgage-backed loans. Then, instead of keeping these loans and collecting their interest over the terms of the loans, they sell all of the loans to investors. This means that investors buy the ownership of the loans from Wall Street lenders so that they can collect the interest or foreclose on the properties. The Wall Street lender turns a profit from the sale and from the closing costs. Lenders such as these are also called conduit lenders since they are the bridge between the borrower and the investor. The investments that Wall Street lenders sell are called Commercial Mortgage Backed Securities (CMBS).

The profit made by the Wall Street lender on these loans is less than that which could be made by keeping the loans and collecting the interest. The advantage to this method is that by selling the loans, they get back the money that they lent right away, with the profit. Since they do not have to wait for the end of the terms of the loans to get back their money, they can then lend out the same money again to make another profit. In this way, the same money is used many times over in the span of one loan term.

The Process

Pooling

It is not feasible or profitable to sell each of the mortgage backed loans individually. To do this, an investor would have to be found for each specific loan, with its own specific terms and level of risk. Instead, the conduit lender pools together a group of loans and sells them off in pieces. In this way, an investor, who would rather not be involved in lending directly, could choose the exact level of risk that he wants to invest in and buy into a general pool of loans.

Step 1

The Wall Street lender lends out, for example, $100,000,000 in mortgaged loans. [Most often, this is borrowed money.] The money is lent out to different types of loans at different levels of risk. For example, they may lend out $50,000,000 for multifamily properties, $35,000,000 for industrial properties, $10,000,000 for office buildings, and $5,000,000 for retail properties. Altogether, the entire $100,000,000 of loans is referred to as the pool.

Step 2

The pool is then rated. This is done by rating each loan individually and then rating the pool as a whole, as the average of all of the individual loans. Generally, 65% of the pool is made up of loans of AAA/Aaa (the highest rating). The remaining 35%, contains many layers of loans, ranging from an AA/aa rating to unrated (below the level of the lowest rating). A rating agency rates a real estate pool based on the mix of tenants, property types (multifamily, commercial, etc.), and average loan-to-value.

Step 3

The pool is then separated into tranches or parts. The first tranche comprises the ‘bottom’ 50% of the pool. After that, each tranche is much smaller, from 5% to 10%. Each tranche represents a different level of risk. (How the tranches represent risk will be explained shortly.) The first tranche is the least risky and therefore has the lowest yield. As you go higher in the tranches, the level of risk rises, as does the yield.

The investors can now choose the exact mix of tranches they want to buy based on the level of risk vs. reward they are comfortable with.

Step 4

Once the loans are sold off, the Wall Street lenders turn over the management of the loans to a servicing agency. They are now free to take their profits and start the process over again.

Order of Tranches

The first-tranche investors are in the last-loss position, while the last-tranche investors are in the first-loss position.  To understand how the different levels of tranches represent different levels of risk, you must first understand how the loans in a CMBS pool are paid.

Each month, as the mortgages are paid by the original borrowers, the moneys are pooled together. The money in this pool goes to the investors who bought the loans from the Wall Street lenders. However, the first tranche investors are the first in line to receive their money from the pool of payments. So, if the bottom tranche is made up of 50% of the pool, the first tranche investors receive 50% of the money. Next in line are the next tranche investors, who receive the amount of money corresponding to the percentage that their tranche takes up in the pool, and so on.

In this setup, the last tranche investors are in the position of the highest risk. If any of the payments default and the money cannot be recouped through foreclosure, the investors in the first loss position take the loss. On the other hand, the first tranche investors are virtually assured of seeing their return. Even if the markets were to crash, in all probability, the properties could be sold off for at least half of their value, thus, in the case of a 50% first tranche, recouping their total investment.

Following the formula of risk vs. reward, it follows that the first tranche investors, who are in the position of the least risk, also receive the lowest yield. The last tranche investors, who are in the position of first loss (and therefore highest risk), receive the highest yield on their investment should the loans come through.

APPRECIATING CONCEPTS: FIRST-TRANCHE INVESTORS

Who are first tranche investors? Often, they are conservative investors, such as pension funds or life insurance companies, who cannot afford to run any risk on their investments because they must guarantee a yield to their clients.

Lending directly to individual borrowers is not a viable option for them for two reasons. First of all, since these investors cannot afford to risk any of their investments, they must lend on an extremely low LTV. Most borrowers, however, want a loan with as high an LTV as they can get. Therefore, it may take time to find the right borrowers for their investment. Secondly, lending on any one mortgage, even a highly rated one, is inherently risky. There is always a possibility of something happening to that particular property or market.

The best option for these investors is to buy the bottom tranche of a diverse pool of mortgages. They do not have to wait for a specific type of borrower—the Wall Street lenders offer an investment in a pool consisting of all types of borrowers. Such a pool would contain a mix of, for example, multifamily, retail and commercial mortgages. In this way, even if one market falls, there is enough value in the properties of the other markets to pay up their loans in full. Thus, their investment is virtually assured.

PROFITS

To illustrate how the Wall Street lender profits from selling loans off at a higher rate, consider this example:

A Wall Street lender puts together a pool consisting of $100,000,000 of loans. The average interest rate for these loans is 10%. The lender then sells the first 50% of the loans at a 5% return to the investors. The 5% spread on the first 50% of the loans is the profit of the Wall Street lender.

As the Wall Street lender sells off more of the loan, a higher and higher rate must be offered. This is due to the higher risk taken by the later tranche investors, as explained. From some of these investors the Wall Street lender may not be making any profit at all. Indeed, by the time they sell to the last tranche investors, the lender may have to offer more than the average 10% rate. However, when the entire pool is sold, due to the enormous spread that the Wall Street lender makes on the lower portions of the pool, the Wall Street lender walks away with a sizable profit.  The lender’s usually equals to 1% to 3% of the pool’s total loan amount. In the above example, the profit made from this maneuver and closing costs ranges from $1,000,000 to $3,000,000.

FAQs:

1. What is a tranche?
   • A tranche is a portion or slice of a financial instrument, such as a bond, loan, or mortgage-backed security, which is structured to be divided into multiple parts that can be sold to investors separately. Tranches are typically created to suit different investment objectives and risk preferences of investors. Each tranche can have its own interest rate, maturity, and level of credit risk, which is determined based on the underlying asset’s characteristics. By dividing an investment into tranches, issuers can attract a wider range of investors and better manage their risk exposure.
2. Why would you want to use a Wall Street Lender?
   • There are several reasons why someone might choose to use a Wall Street lender:
     • Access to Capital: Wall Street lenders have access to significant amounts of capital, which makes them a good choice for large commercial transactions.
     • Expertise: Wall Street lenders have extensive expertise in structuring complex financial transactions and can provide valuable guidance and advice on the best financing options.
     • Competitive Rates: Wall Street lenders often have lower borrowing costs than traditional lenders, resulting in more favorable repayment terms.
     • Quick Turnaround: Wall Street lenders are known for their ability to move quickly and close deals faster than traditional lenders, which can be important for time-sensitive transactions.
     • Flexible Financing Options: Wall Street lenders can offer a wide range of financing options, including bridge loans, mezzanine financing, and structured financing, which can be customized to meet specific needs and objectives.

However, it’s important to note that Wall Street lenders may not be the best fit for everyone, particularly for small businesses or individuals seeking consumer loans. Wall Street lenders typically focus on larger transactions and may require higher creditworthiness and collateral than traditional lenders.

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