Loophole Lets Banks Back Risky Real Estate Loans

In a The Real Deal article, Banks are Far More Exposed to Risky Real Estate Loans than You Think, the authors report on how banks are increasingly backing debt funds and mortgage REITs despite post-recession reforms. After the government bailed out big banks over soured real estate loans, regulators set out to reduce banks' exposure to risky commercial mortgages, such as construction or bridge loans. However, banks are far more exposed to risky real estate loans than commonly thought thanks to a loophole: Instead of lending to construction projects directly, they increasingly lend to debt funds and mortgage trusts managed by private equity firms, which in turn lend to developers.

So should there be concern that banks are finding a way around regulations designed to keep them out of risky real estate lending? “For smart banks that do it with large, well-capitalized mezzanine lenders, it’s usually a bit safer,” Jerome Sanzo, head of real estate finance at the Industrial and Commercial Bank of China, said. “Unless there’s a huge problem, they’re not going to walk away from their investment.”

According to the article, private debt funds and mortgage REITs tend to specialize in high-yield real estate loans and are riskier. When the economy weakens as it did in 2008, banks can be at risk even if they merely hold the most senior debt.