Commercial construction slows, worsening credit blamed

An already fragile market for commercial construction and mortgage loans turned abruptly chaotic in September with the failure of Lehman Brothers, Merrill Lynch, and AIG.
August 11, 2010

An already fragile market for commercial construction and mortgage loans turned abruptly chaotic in September with the failure of Lehman Brothers, Merrill Lynch, and AIG. While the Federal Reserve Board and the U.S. Treasury Department quickly provided funds to prevent routine worldwide financial transactions from being disrupted, they could not prevent lenders from becoming more risk-adverse. 

Lenders implement their risk preferences by changing credit rates, equity, and collateral requirements for borrowers. Most lenders today own slices of loans originated by distant lenders, and they rely on insurance on the loan principal and/or anticipated interest to convert otherwise risky loans into ones with relatively low risk. They do not know the borrower or the borrowers’ collateral, and they have no role in working out troubled loans. 

AIG and Lehman Brothers provided much of this insurance, while the rest is provided by other financial giants whose solvency is now questionable. Lenders had to defensively raise credit rates and credit approval standards to protect their own solvency, which happened at the same time that profit prospects for commercial projects were deteriorating. The consequence for late 2008 is that lenders will ration their scare capital and reject some loan requests that would have been approved during the summer. 

While September’s access-to-capital-crisis could progressively worsen, it is more likely to gradually ease by early next year. The risk premiums for commercial construction and real estate loans are a bigger strain on the market than subpar economic growth. Space demand will likely weaken slightly, but risk premiums will be reduced as lenders recognize that their insurance policies on loan payments are now guaranteed by the U.S. government. This policy is probably not a good one for the long term, but was necessary because the seizure of AIG guarantees commercial construction loans and mortgages just as the seizure of Fannie Mae and Freddie Mac guaranteed residential prime rate mortgages.





         
 

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