PNC Bank Corp. is in the forefront of banks seeking to expand real estate lending while avoiding a rerun of the multimillion-dollar losses suffered in the 1980s.
The Pittsburgh-based bank--like a few other institutions such as BankAmerica Corp. and NationsBank Corp.--believes the answer lies in turning portfolios of commercial loans into securities and selling them to institutional investors.
Commercial loan securitization is becoming attractive to banks because it would allow them to stay in the real estate lending business--which has caused so much trouble in the past--without being subject to risk-based-capital rules. At the same time, banks could continue to derive fee income from servicing the loans, albeit less than from traditional servicing.
The question is: Can banks -- after losing millions of dollars on bad real estate loans in the 1980s -- convince Wall Street that they are now capable of issuing high quality securities backed by commercial loans?
PNC plans to issue its first security backed by commercial loans early in 1995. Initially, it will use a partner -- a firm it declined to name but says has already issued securitized commercial loans -- to do the actual issuance. PNC will underwrite and service the portfolios. The bank has high hopes for this strategy, estimating that within five years 80% of the profits of its real estate lending will come from securitization.
In fact, Herbert G. Summerfield, executive vice president at PNC, said that by the end of the decade, about half of all bank commercial debt -- about $600 billion worth -- will be securitized.
In order to persuade institutional investors to buy these securities, PNC is in the process of changing its underwriting techniques. It's also developing new information systems to gather more data and analyze it more effectively than in the past.
"One thing we're examining very hard right now is our real estate information systems," said Mr. Summerfield. "The issuer [of securitized commercial loans! who most effectively captures and manipulates data will be the most competitive, by demonstrating the quality of the portfolio."
In gearing up for this strategy PNC is in discussions with Melson Technologies, a Dallasbased real estate software firm, and ernst & Young's Real Estate Advisory Services, based in San Francisco.
Mr. Summerfield said PNC is considering working with Melson to build a system for securitizing loans, and with Ernst & Young to reengineer workflows in the underwriting, servicing, and securitization areas.
Melson and Ernst & Young recently formed an alliance aimed at helping banks and real estate investors structure investments based on real estate loans and better manage real estate investments.
Currently, there is no off-the-shelf system on the market for securitizing commercial loans.
"The way banks traditionally have made and tracked loans and reported current status is not adequate anymore," said Michael Evans, director of real estate advisory services at Ernst & Young. "The head of real estate lending can't get an up-to-date value on a loan, except once a year" when new property appraisals are made.
"When you securitize, you must have fewer and fewer defaults than in the traditional market," Mr. Evans added. "And that means spotting warning signs ahead of time."
While securitization of credit card debt and home mortgages is common, securitization of commercial loans is still relatively new. In the 1980s, the Resolution Trust Corp. began packaging real estate loans originated by failed savings and loans. In many cases few details were available about the loan portfolios, which were sold to institutional investors at a heavy discount.
Now it's a different situation. Higher standards and more detailed information have been required over the past two years as investment firms and insurance companies have begun to package loans originated by a bank, often as investment-grade instruments. But few banks are in this business.
Mr. Summerfield thinks banks should be the ones doing the securitizing. Investment firms can't do as good a job ensuring quality, he said, because they do not underwrite the loans.
"They don't go that far back in the food chain," so they have a harder time controlling the quality of the portfolio, said Mr. Summerfield. "We think banks can offer more uniform quality."
Banks have come a long way since the 1980s to improve the tracking and monitoring of portfolios. But securitization requires stringent and standardized underwriting techniques. Instead of focusing solely on the borrower and the borrower's financial standing, PNC is changing its process to focus more on the status of the tenants inside the commercial building.
It now looks monthly at the ratio of cash income to debt, rather than the traditional focus on the ratio of the loan outstanding to the value of the property. Now, if a major tenant moves out, the loss of income will show up more quickly than it would have under the old procedures. PNC also needs to be able to answer investors' questions, such as who the tenants are and when their leases expire.
In the traditional underwriting process, property valuations are updated once a year.
"This [new procedure] is a much more specific and less mystical way to underwrite," says Mr. Summerfield.
To support the securitization business, PNC is also spending several million dollars on client-server technology and consulting services, Mr. Summerfield said. The technology is being deployed in several stages.
PNC already has installed software from Melson, called the Asset Management Data System, a distributed system for managing real estate assets. This type of system is a prerequisite for securitization, because it collects much of the relevant information from disparate systems across the bank.
The system stores on a relational data base some 2,800 pieces of information about every commercial building and other type of collateral that PNC has a lien on. The data base contains the location of every property, the type of project it is, the licenses that have been obtained, and the terms of leases. The system analyzes such details as the profitability of each unit in a building, and can be used for designing plans to reduce the cost of operating a building.
"We revealed the operation of this system to the regulators in June and July," said Mr. Summerfield. "It's quite awesome what it can do."
Some information that was formerly buried in paper files or on separate computer systems, such as rent rolls and leasing terms, will now be accessible to the lenders across the unit. By early next year, 220 PNC lending officers will have access to the information.
Now the bank is focusing on finishing a securitization system by early next year -- around the time it issues its first securities. The bank is tying together "four or five" major systems to create a single securitization system that can create and value different securities tranches. Each tranche will be based on the ratio of cash instruments to debt.
Complicating the project is that it's not yet clear what information about the securities will be required by ratings agencies and investors. But, said Mr. Summerfield, "We can't wait for them."
He said discussions with Melson and Ernst & Young center on questions such as, "What data fields are really needed to deal with the multiple tranche-rated instruments."
The new information system will also be used to generate new products and instruments once PNC's new business is off the ground.
At a Glance
PNC BANK CORP.
Assets $59.6 billion
(*) 1994 1.26%
(*) 1994 17.60%
(*) 1994 53.78%
Potential Melson Technologies
Ernst & Young Real
Estate Advisory Services
(*)Nine months ended Sept. 30.