Portfolio lenders vs. conduit lenders

Q. What is the difference between a portfolio lender and a conduit lender?

A. Many clients seeking commercial loans also want assistance to better understand the differences and benefits between a portfolio lender and a conduit lender.

A portfolio lender is usually an institution (commercial bank, mutual bank or credit union) that will originate loans kept on the books of the institution as an asset to offset the liability of deposits. The portfolio lender makes a profit by using the capital from depository customers to make loans to loan customers.

The interest is set theoretically at a spread over the costs of the deposited funds, but there are many subjective variations to the spreads set by portfolio lenders. Included in this spread must be the costs of operation of the institution, including servicing the loan portfolio, plus a profit. Also included in the spread calculation is a risk factor that a percentage of the loan portfolio will not pay according to the loan terms.

Capital to provide additional loans is controlled by the amount of deposits that the institution can attract, and often loan availability can be constrained by the amount of available capital. Other constraints can be portfolio concentrations — an institution feels that it has too high of a concentration in one collateral type and does not choose to make additional loans on that type of collateral until the concentration changes. Some portfolio lenders with limited capital will borrow funds (called matching funds) and lend those funds at a spread over borrowing cost.

Most portfolio lenders want the loans to be short term (three to five years) so that the funds can be lent again. Portfolio lenders typically require personal recourse from the loan sponsor and underwrite the loan sponsor’s credit as one of the most important criteria of the loan underwriting decision. Second to the sponsor’s credit will be the loan to value and net operating income from the collateral. Since the loan is staying within the lender’s portfolio, there can be flexibility on the loan structure to meet unusual circumstances.

In contrast, a conduit lender is typically a Wall Street brokerage firm, commercial bank with a capital markets group or finance company that originates the loan with the intent to sell. The loan will be warehoused and aggregated with other loans into a pool of loans that are converted and sold to investors as Commercial Mortgage Backed Securities (CMBS). Each loan must be structured in the same manner as they all will have to conform to the CMBS requirements. Such securities are actively traded and are held by many mutual funds and portfolio managers. Many of you may own a CMBS investment in your 401k or other retirement plan.

Conduit loan interest rates are established by offering a spread over an underlying, typically Treasury bonds. The conduit lender will make a profit by converting the loans to a CMBS and selling the CMBS to investors. It’s hoped that the yield required by the investors is less than the aggregate interest rate on the loan pool. The difference in investor yield requirements and income from the loans is converted into the sales price of the CMBS pool, which will provide the profit or loss on the conduit loan originations. The timing of selling a CMBS is critical to profitability, since the market is very volatile and subject to many external forces.

Capital to replenish a conduit lender is abundant, as there appears to be an insatiable appetite by investors for CMBS products. Some portfolio lenders are acquiring CMBS investments as a portfolio diversification strategy.

Conduit loans are predominantly underwritten based on likelihood of the income stream continuing and increasing through the life of the loan, with the asset value and sponsor credit as secondary concerns. Loans are typically non-recourse with no personal guarantee from the sponsors and carry longer terms than portfolio loans.

Both a portfolio and conduit lender have a value to borrowers. Understanding the benefits of each is the primary step in maximizing that value.

David B. Eaton, president of Eaton Partners, Manchester, manages the firm’s Commercial Mortgage Group. Questions can be submitted to him at Commercialnotes@eatonpartners.com.