KeyCorp's purchase of National Realty Funding, announced this week, signals that the Cleveland banking company is serious about commercial mortgage securitization -- and bolsters the theory that banks will come to dominate the business.
National Realty will be a stronger competitor with Key behind it, said E.J. Burke, co-founder and president of the Kansas City, Mo., finance company. "Our business over the last two years has been increasingly more volatile than in previous years," he said. "It requires a principal with a strong balance sheet and the ability to weather the storm."
Conduits originate fixed-rate, long-term real estate loans of $1 million to $15 million with the intent of pooling them into securities and selling them at a profit to institutional investors. In the mid-1990s these lenders made windfall profits as the spread, or difference in yield, between risky bonds and U.S. Treasury securities kept narrowing.
But in late 1998, when the Russian bond-default crisis caused spreads to suddenly balloon, the conduits found themselves sitting on huge inventories of underwater loans. Some top securitizers, notably Nomura Holding America's Capital America unit, closed shop.
National Realty, founded in 1997, survived because of its close relationship with Prudential Securities, Mr. Burke said. The investment bank, which owned a piece of Mr. Burke's firm, had extended it a warehouse line of credit and did not pull the plug as so many other Wall Street "repo" lenders did when the market tanked.
But "the lesson we learned is that to be successful we need to be part of a larger financial institution instead of a stand-alone, specialty finance company," Mr. Burke said. Banks have extensive customer bases, but more important, they have balance sheets and can hold loans when times get tough as they did during the Russian crisis, Mr. Burke said.
"They can weather the storm when bond spreads widen and it's not appropriate to go to market," he said. "Working with Key, I don't have to go get a warehouse line of credit. I'm funding loans off the bank's balance sheet. Plus, I have the bank's cost of funds."
He added that banks have more credibility in the eyes of investors. "The investors that buy our bonds see banks to be there for the long haul. The perception is that the credit quality of bank loans is better than that of specialty finance company -- or Street-originated -- collateral."
One competitor, speaking on condition of anonymity, said banks are still at a disadvantage because of their conservative and bureaucratic cultures. "The approval process is not as quick as an investment bank," said this executive, who works at a Wall Street firm. "You have to go through a zillion people."
But Mr. Burke does not see this as a problem. "Key's credit approval process is more streamlined than ours. Key doesn't have a credit committee," he said.
Before the deal, the terms of which were not disclosed, KeyCorp was not a major player in the conduit world, though it is big in other areas of realty finance. Key Commercial Mortgage originated $500 million last year and $750 million in 1998, and it has never securitized, instead selling its loans in whole-loan packages to National Realty. Nor did Key service conduit loans.
National Realty, on the other hand, was ranked 14th among securitizers in the first nine months of last year, contributing $930 million of collateral to bond offerings, according to Commercial Mortgage Alert, an industry newsletter. It is also among the largest commercial mortgage servicers, with a $3.4 billion portfolio.
Though National Realty will continue to be headquartered in Kansas City, it is to be integrated into Key's commercial mortgage unit, Mr. Burke said. Aside from Prudential, the firm's previous owners were Mr. Burke, two other co-founding executives, and Progressive Insurance Co.
The new Key Commercial Mortgage hopes to originate $1.4 billion of loans this year, Mr. Burke said. It plans three securitizations, the first to come in March or April. Prudential represented National Realty in the sale to Key and will distribute bonds for the new commercial mortgage powerhouse, Mr. Burke said.