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A Bridge Too Far to Cross

In 2018, bridge loans—or fix-and-flip loans—entered the residential mortgage-backed securitization (RMBS) market. To take stock of this new situation, Morningstar Credit Ratings, LLC has issued a report that gives the company’s perspective on the risk of default posed by these new and as-yet-unrated loans.

Those who take out bridge loans usually do so when buying, renovating, or rebuilding residential properties. They are called fix-and-flip loans because the majority of those who take them out do so in order to resell or rent, and borrowers who typically seek to make a quick profit flipping homes often seek out short-term loans to refinance.

Morningstar identifies a few specific risks that bridge loans pose to RMBS investors. These include miscalculation in the cost to renovate or rebuild. Also, a borrower’s profits may drop or evaporate if they overestimate the property’s market value after repairs or rebuilding. There is also the fear that the borrower could overestimate demand after the property is built, failing to secure the funds necessary to avoid delaying repayment or going into default.

Bridge loans typically have higher interest rates than conventional mortgage loans, and they require borrowers to confirm that the loan is for a business purpose. For that reason, the mortgagee is often a business entity—a limited-liability corporation, limited partnership, or trust—while the lender is usually what Morningstar refers to as “relatively small nonbanking companies with a specialized knowledge of local real estate.” Bridge loans also differ from conventional mortgage loans because the funds can be disbursed as a series of payments or in a lump sum, with amounts tied to property purchase and renovation activities.

Even so, Morningstar believes the default risk posed by bridge loans is offset by multiple factors. These include the home equity of the borrower, the shorter terms of bridge loans, the customary borrowers’ usual experience in flipping properties, and the constellation of interests between borrower and lender.

Borrowers with more equity in the property are less inclined to abandon a property and default on it, even if the property value drops. A borrower with greater knowledge and experience purchasing, renovating, and selling or renting properties is also considered less of a risk than a borrower with none. Also, because most bridge loans have a short maturity, lenders are able to assess risks of falling home prices far more accurately.

As for risk posed to homeowners via the inflation of some bubble in the RMBS market, this seems farfetched in light of the alignment of interests between business entities who usually take out bridge loans and those which usually provide them. Even so, Morningstar states that as the issuance of securitizations backed by bridge loans increase, more historical performance data will become available to ascertain their overall risk.

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