Since the 2007–10 financial crisis, regulators have cracked down on one of its causes: the securitization of high-risk mortgage loans. The Basel Committee on Banking Supervision has set thresholds for the amount of equity a commercial bank must hold relative to assets, forcing traditional lenders to restrain new debt issuance. And the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States has restricted the activity of investment banks and other securitized lenders by forcing them to retain at least 5 percent of the credit risk on loans they issue.

At least for commercial real estate, this void is largely being filled by private-equity firms offering high-yield mortgage loans. However, the instruments remain complex and opaque. It’s unclear whether investors are being fairly compensated for the risks they’re taking, suggests research by Chicago Booth’s Joe Pagliari.


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Almost 70 high-yield real-estate-debt funds existed at the start of 2017, Pagliari estimates. Together, these funds, part of the largely unregulated shadow-banking sector, aimed to raise almost $65 billion from institutional investors hoping to profit from debt issued for the portion of a property not covered by a first-mortgage loan.

Such investments are practically the definition of the phrase “high risk, high reward.” Although the funds set targeted returns averaging 14 percent, modeling by Pagliari suggests that one in seven of the highest-risk varieties of this debt will lose some or all of investors’ money.

Pagliari also finds troubling results when modeling a popular practice among high-yield lenders, that of funding these loans with money they themselves have borrowed from other financial institutions. In theory, this leverage can help the high-yield funds boost their returns. But many high-yield funds try to depress borrowing costs by agreeing to permit these institutions to foreclose on the whole package of loans if one or more of them goes into default.

A default on one mortgage can consume collateral from another. Even when only a moderate number of loans in a portfolio actually defaults, it can exacerbate a fund’s overall losses and quickly deplete its capital.

To simplify the modeling, Pagliari does not account for economic cycles, assuming for the analysis that returns on real estate are “stationary and normally distributed.” In fact, the opposite may be true; if so, high-yield lenders making loans toward the end of a real-estate cycle may be taking on significantly more risk than those holding debt issued early in the cycle.

One of the main messages for investors is that what might seem like insignificant details can seriously deflate returns, if not worse. Sparse empirical data make pricing “a daunting task,” Pagliari writes. “Whether or not investors are fairly compensated for all the risks to which they have been exposed is an open question.”

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