LTV and DCR Are Not the Only Determining Factors for Defaults on Commercial Mortgages

Note: This article was originally published in Winter 2014 issue of  CREFC World Magazine published by the Commercial Real Estate Finance Council.

By:
Steve Guggenmos, Senior Director, Freddie Mac
Jun Li, Director, Freddie Mac
Yu Guan, Analyst, Freddie Mac
Malay Bansal, Senior Director, Freddie Mac

For simplicity, some models used by CMBS investors assume that the non-recourse borrower will default immediately if the DCR falls below 1.0 or LTV goes above 100 (percent). This is sometimes referred to as “ruthless default” behavior. In reality, however, borrowers do not choose to default just because DCR is below 1.0 or LTV is higher than 100. This article examines some historical data and attempts to look at various factors that have an impact on the borrower’s decision to default, and presents historical default rates for each category.

Using different default rates for the different categories may be a better approach for scenario analysis for CMBS investors than trying to use fixed cutoff numbers for DCR and LTV to examine each loan to determine if it will default or not.  An important underlying factor that motivates borrower behavior is the option value embedded in owning the real property.

Also, borrower selection impacts ruthlessness.  Market expertise helps borrowers measure the benefits of supporting an underperforming property based on potential future upside.  Further, key to the decision to support the property is the borrower’s access to capital and overall liquidity – without which there is no ability to subsidize the property until the market improves.

Introduction

As part of their investment analysis, CMBS Investors run various scenarios of changes in economic conditions, cap rates, vacancies, NOIs, etc. The resulting DCR and LTV are used to decide if the loan will default in that scenario and what the loss severity will be in case of default. If DCR falls below 1.0, that clearly increases the likelihood of default during the loan term as borrowers are required to pay out-of-pocket to cover property expenses.  When the property value is below the loan amount default is more likely and losses will be higher in case of default. Also, if the LTV is above 100 at maturity, the loan is not likely to not qualify for a new loan without putting more equity into the property, and hence there may be a maturity default.

In practice borrowers do not choose to default just because DCR is below 1.0 or LTV is higher than 100. There is an option value to owning real property that impacts borrower behavior. The option value captures the possibility of upside in the future.

Investors are aware of the option value. However, if 1.0 DCR and 100 LTV are not the cut off points, what are the levels that drive borrower behavior? Even more complex models must address this question as well. In this research we focus on the multifamily loans and look at the borrower default behavior in loans in both CMBS and Freddie Mac collateral.

See full article at: Freddie Mac Research page, or CREFC World website.

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By Malay Bansal

A Simple and easy to implement idea for reforming the issuer-paid model for credit ratings that accomplishes the goal of the Franken Amendment.

Note: A version of this article was also published on Seeking Alpha.

Five years since the credit crisis, debates on how to reform the ratings process continue with no good solution or consensus in sight, even though there is general agreement about the conflict of interest inherent in the issuer-paid model which allows ratings-shopping by issuers, and the need for reform, especially for Structured Finance securities. The Franken Amendment to the Dodd-Frank Act  specifies a solution to be used if the SEC cannot find a better alternative, which proposes creating a board, overseen by the SEC, which will assign rating agencies to provide initial ratings for structured debt securities.  Even though the goal of eliminating the conflicts arising from issuers selecting the agencies is desirable, the proposal has not garnered support from many industry participants as a practical solution. This article suggests an alternative reform which is simpler and easier to implement, and achieves the same basic goal.

The basic problem, especially in structured finance (and especially in securitization of mortgage and other debt), is that the issuers or their underwriters select the agencies that will rate a structured debt issuance. They obtain preliminary ratings from all agencies, and then the agencies providing the highest ratings are selected to rate that transaction. Since agencies get paid only if they are selected to rate the deal, they have an incentive to provide the highest rating possible, which creates the conflict of interest.

The Franken amendment solution seems to address this conflict. However, it addresses the wrong part of the problem. The real problem is not that the issuers want to get the best ratings possible. It is rational behavior for any issuer to want to know what the economics of a deal will look like before proceeding, and want to get the best economic result from a debt issuance. Having a board to assign rating agencies could result in issuers not knowing till too late which agencies might rate their deal and what the economics of the issuance might look like. This will introduce unnecessary uncertainty for the issuers. The same outcome could also be achieved by simply prohibiting issuers from obtaining preliminary ratings. This will avoid having to create the bureaucracy of a new board, but will have the same undesirable consequence of uncertainty for the issuers.

The real problem is that the rating agencies depend on issuers to select them to rate specific transaction for all of their revenues. Usually two agencies are selected to rate the transaction. They get paid, others do not. Keeping too high a standard means not being selected and not having any revenue. The higher ratings they can give, the more transactions they will rate and the more money they will make. That is the perverse incentive and the conflict of interest in the current system, that needs to be resolved. The problem is in the system which leads to undesirable outcome with people trying to be economically rational in behavior. In some ways, this issue may become worse this time as there are many more rating agencies now competing than the three dominant ones in the past, and the overall structured finance issuance volume is much smaller.

As one solution, SEC tried to promote unsolicited ratings from agencies that were not selected by the issuer to rate the deal. However, the due-diligence for rating asset-backed deals is expensive. Also, the rating agencies do not want to alienate issuers for fear of not being selected for future deals. So, unsolicited ratings have not been given. Another alternative idea talked about is to have the users of the rating pay for it. That approach faces criticism that all investors should have access to the same information, not just those who can pay for it. Also, investors generally do not like the idea of paying for ratings. Neither the Franken Amendment solution, nor the above two seem like a viable solution. One key problem, especially in structured finance transactions, is that it is expensive to perform the right amount of due diligence to rate a deal, and some amount of upfront payment may be necessary, which as a practical matter, will have to come from the issuers, leading us back to the existing business model.

In an earlier article (Three Misconceptions about Issuer-Paid Ratings), I argued that this problem seems intractable because of three widely held misconceptions about the issuer-paid nature of the ratings. The biggest block is perhaps the third one – the belief that the “Ratings have to be either Issuer-Paid or Investor-Paid.” Almost everyone seems to think that ratings have to be either paid by issuers or investors.  However, it does not have to be one or the other. Just a sufficient portion of the fee has to come from, or be driven by, investors to provide the right incentives.

If we do not want the status quo, the solution has to accomplish the following goals:

  • Should not add uncertainty for issuers.
  • Should not require new bureaucracy of an SEC board specifying agencies to use for each issuance.
  • Reduce dependency of rating agencies on being selected by issuers for all of their revenue.
  • Give investors control of part of revenue.
  • Allow rating agencies to provide ratings without having to worry about if they will be selected.

Here is one solution that accomplishes all of these: Require an additional rating agency for each transaction. This agency will be paid from the proceeds of the issuance, just like the other two agencies picked by the issuer to rate the deal. However, this agency will provide the ratings after the transaction has settled. This will effectively achieve the same objective as attempts to get unsolicited opinions or ratings, but an agency will be hired and paid to do it to ensure the right amount of due diligence and quality. Also, to avoid the conflict of interest issue, the additional agency will not be selected by the issuers, but by investors. This can be easily achieved by letting the investors vote for the additional agency on a website maintained by the issuer’s underwriters. Websites are already used for transactions to share transaction information with investors, and it will be easy to add a page to let them vote on the additional rating agency. It will be important to include all investors in the voting process, not just those who purchased bonds in the deal, to avoid the conflict that may arise from investors wanting the best ratings once they have purchased the bonds.

This solution does require the issuer to pay for one more rating agency. However, the cost is easily manageable and worth the benefit, and better than having an SEC board assign rating agencies. More important, it means that at least one third of the rating agency revenues will be controlled by investors, and the agencies are not completely dependent on selection by issuers. It gives them an incentive to do better work for investors, both in the initial ratings, and in the on-going monitoring of the deals.

As I have suggested earlier (Rating Agency Reform: The Real Problem That Has Not Been Recognized), over time, everyone will be better off if rating agencies can move towards a subscription based model for at least part of their revenues. If investors have control over a significant enough portion of the total revenues of the rating agencies, investors, rating agencies (including their investors), and the entire financial system will benefit from the proper alignment of incentives that would be created.

Note: The views expressed are solely and strictly my own and not of any current or past employers, colleagues, or affiliated organizations. My writings are simply expressions of my intellectual thought process. The intent is not to promote any particular view point or agenda, and the writings are not influenced by any other groups or individuals.

By Malay Bansal

Why did CMBS perform well in 2012 and what lies ahead.

Note: These views were originally quoted on 19 Dec 2012 in article “Rally Drivers in Structured Credit Investor. This article was also published on Seeking Alpha.

In 2012, the CMBS market had a significant rally as is evident from the table below showing bond spreads over swaps.

2011 Year End

2012 Year End

GG10 A4

270

150

CMBS2 Senior AAA (A4)

120

90

CMBS2 Junior AAA

265

140

CMBS2 AA

400

180

CMBS2 BBB-

700

470

Not only were the spreads tighter significantly over the year, the performance was better than expectations by almost any measure. Issuance for the year was $48 Bn compared to forecast of $38 Bn. The new issue 10 year AAA spread to swaps ended at 90 compared to forecast of 140, and new issue BBB spreads ended at 410 compared to a forecast of 587 (all forecasts are averages of predictions by market participants as published in Commercial Mortgage Alert). The spread tightening was not limited to new issue either, legacy CMBS prices were up significantly too. Why did CMBS do better than expected, and can this trend of higher issuance and tighter spreads continue?

Why did Spreads Tighten?

There are two widely talked about reasons for spread tightening that generally apply to most of the spread products, and a third one that is specific to and very important for CMBS and commercial real estate.

First driver of spread tightening is the purchase of large amount of mortgage securities by the Federal Reserve under its quantitative easing programs and investors search for yield in this low yield environment.

Second significant factor is that the universe of spread product is shrinking as mortgage payoffs are greater than new issuance. $25-30 Bn of net negative supply per year in CMBS means that the money that was invested in CMBS is returned to investors and needs to be reinvested. More demand than supply leads to higher prices and tighter spreads.

The third factor is a chain reaction that is more interesting and significant. As the above two reasons lead to tighter spreads for new issue CMBS bonds, the borrowing cost for commercial real estate owners decreases. Lower debt service payments from lower rates mean they can get higher loan amounts on their properties. That means a lot of existing loans that were not re-financeable or were border-line and expected to default can now be refinanced and do not need to default. As more loans are expected to payoff and expected defaults decrease, investors expect smaller losses in legacy CMBS deals. That means tranches that were expected to be written off may be money good or have lower losses. So investors are willing to pay more for them, and as people move down the stack to these bonds with improved prospects, the result is tighter spreads for these legacy bonds. Lower financing cost resulting from tighter bond spreads also helps increase liquidity and activity in commercial real estate market as it allows more investors to put money to work at returns that meet their requirements. More activity in the real estate market leads to more confidence among investors and increases real estate values, further reducing expected losses in loans leading to even tighter bond spreads. This chain creates a sort of virtuous circle – the exact opposite of the downward spiral we saw in previous years when the commercial real estate market deteriorated rapidly.

Looking Ahead

As the virtuous cycle mentioned above continues, barring any shocks, spreads can continue tightening and lower financing cost from CMBS means that it can compete more with other sources of financing which means that CMBS volume can keep increasing. Indeed, the forecasts for CMBS issuance for 2013 generally range from $55 Bn to $75 Bn, up from $48 Bn in 2012.

Spreads, however, have less scope for tightening than last year in my view. Looking at historical spreads in a somewhat similar environment (see What’s Ahead for CMBS Spreads? April 4, 2011), CMBS2 AAA spreads could be tighter by 20 bps and BBB- by another 140 bps this year. Generally rising confidence in underlying assets should result in a flatter credit curve, which implies more potential for gains in the middle part of new issue stack. Spreads will move around. Given the unprecedented low yield environment, the search for yield by investors could drive spread slower than expected. At the same time, events in or outside US could cause unexpected widening. The market obviously remains subject to any macro shocks.

One concern cited by many investors is the potential loosening of credit standards by loan originators as competition heats up. That is a valid concern and if industry participants are not careful, history could repeat itself. However, though credit standards are becoming a little looser (LTVs were up to 75 in 2012 from 65-70 in 2011 and Debt Yields were down to 9-9.5% from 11% a year ago), we are nowhere close to where industry was in 2007. Still, investors should watch out for any occurrences of pro-forma underwriting if it starts to re-emerge.

Looking further ahead, maturities will spike up again in 2015-2017, with around US$100bn of 10-year loans coming due. This could cause distress, but hopefully the commercial real estate market will have recovered enough by then to absorb the maturities. Still, it is something that we need to be mindful of for next few years.

For me, one of the most important factors to watch out for is the continued supply of cheap financing for real estate owners. That has been one of the main factors that has brought us to this point from the depths of despair at the bottom and was the basis for programs like TALF & PPIP (see Solving the Bad Asset Pricing Problem) four years ago.

In the current low-growth and low-cap rate environment, investors cannot count on increase in NOI or further decrease in cap rates to drive real estate values significantly higher. That makes availability of cheap financing critical and much more important than historically for achieving their required rates of return to make investments.

Any disruption in availability of cheap financing can quickly reduce the capital flowing to real estate sector and may reverse the positive cycle that is driving spreads tighter and increasing real estate values. Anything that could reduce the availability of financing for commercial real estate owners will be the most important thing I will be looking out for this year other than the obvious factors.

In commercial real estate, hotels and multi-family have improved the most. Hospitality sector, with no long leases, was the first to suffer and among the first to gain as economy started improving. Multifamily sector has done well benefiting from the financing by GSEs. Office and retail sectors have seen increasing activity but face a high unemployment and low-growth environment. If the economy keeps improving at the current slow rate, I think the industrial sector will offer more opportunities and see more activity this year.

Note: The views expressed are solely my own and not of any current or past employers or affiliated organizations.

By Malay Bansal

Why New Issue CMBS deals see little interest in Mezz classes and what Issuers can do about it.

A year ago around this time, the mood amongst CMBS market participants was quiet optimistic. Estimates of new issuance for 2011 from market participants generally ranged from $35 Bn to $70 Bn or more, on the way to $100 Bn in a few years. However, over the course of the year, the optimism has faded. New issuance totaled just $30 Bn in 2011, and forecasts are not much higher for 2012.

With more conservative underwriting, higher subordination levels from rating agencies, and wider spreads, new issue CMBS was expected to be attractive to investors. Yet, investors seem to have pulled back, and spreads have widened for both legacy and new issue deals. Macro level issues, especially uncertainty about Europe, are part of the reason. However, CMBS spreads have been far more volatile than other sectors including corporate and other ABS. As the table below shows, even new issue AAA CMBS spreads widened a lot more than other sectors. This spread volatility not only deters investors, but also loan originators from making new loans as they do not have a good hedge to protect them while aggregating loans for securitization. It also requires wider spreads for CMBS loans which makes them less attractive to borrowers.

New Issue Spread Comparison Table

One of the main reasons CMSB spreads widen quickly is that the sector has far fewer investors than other ABS sectors and corporate bonds. The reason there are fewer investors is that, with fewer loans, CMBS deals are lumpy and investors need the expertise to analyze collateral at the loan level. Not every investor has that expertise. So, they can feel comfortable analyzing RMBS, Credit card, Auto, Equipment, and Student Loan etc deals, but not CMBS. The creation of a super-senior AAA tranche helped bring more investors to AAAs by making the tranche safer needing less analysis. That is part of the reason AAA spreads have tightened.

Spreads for classes below AAA, however, continue to be very wide, as the mezz tranches have even fewer investors. Unfortunately, Insurance companies, which are perhaps the most knowledgeable commercial real estate investors and ones with resources to analyze the CMBS deals at loan level, tend to buy mostly senior tranches. Mezz tranches are left to a very small set of buyers. That means lower liquidity for these tranches, and less certainty about receiving a decent bid if needed. An additional issue is lack of transparency on pricing, as these are small tranches that do not trade frequently and each one is different depending on deal collateral. These factors make these classes even less attractive to buyers.

The table below shows the structure of a recently priced CMBS deal. The $674 mm deal has $118 mm of senior AAA, $55 mm of junior AAA, $104 mm of mezz tranches and $44 mm of B-Piece.

Last 2011 CMBS Deal New Issue Spreads

What makes Mezz tranches more difficult for investors is that they have lower credit enhancement than AAAs and they are generally very thin tranches representing about 3% to 4% of the deal. In other words, a 3% higher collateral loss could result in 100% loss on the tranche. That means investors require even more conviction and expertise to invest in these classes. The thin tranches are also more susceptible to rating downgrades if any collateral in the deal faces problems. This fear of ratings volatility is another big concern for investors.

One idea, that addresses both the spread volatility and the potential ratings volatility, is to do the opposite of what we did for the AAA – combine all the Mezz tranches into one single class. In this deal, instead of creating classes B, C, D, and E, there could be just one Mezz class. It will be a $104 mm class with average rating of around A-. At a thickness of 15% of the deal, this class will not be at risk of 100% loss if collateral loss increased by mere 3%, and so will be much less susceptible to spread and rating volatility. Also, with just one larger class, there will be more owners of that class and there is likely to be more trading and visibility on spreads, enhancing transparency and liquidity. If the combined Mezz tranche is priced around 640 over swaps or tighter, the issuer will have the same or better economics as with the tranched mezz structure. This will still be a significant pickup in spread for the same rating compared to other sectors and will probably bring in some new investors who were considering CMBS but were hesitant. At about 15%, the Mezz tranche is thicker, but still a small part of the deal. So, even a small number of new investors will make a difference.

And the issuers can try this structure without taking any risk at all. That is possible by using a structural feature that has been used in residential deals (which are also REMICs): Exchangeable Classes. The deal can be setup so that some investors can buy the tranched classes while others buy a single Mezz class. The structure allows owners of one form to exchange for the other form at any point in future using the proportions defined in the documents. This has been used for a long time. I used exchangeable classes extensively in $52 Bn of new CMOs when I was trading and structuring CMOs. Freddie, Fannie, and Ginnie deals regularly have them under the names MACR, RCR, and MX respectively.

There is no single magic bullet, but small changes can sometimes make a big difference. Some, like this one, are easy to try with a little extra work, no downside, and possibility of enlarging the pool of CMBS investors with all the benefits that come from it for investors, issuers, and people employed in the sector.

Note: This article was originally published in Real Estate Finance and Intelligence.

Update 6/15/12:  UBS & Barclays introduced an exchangeable class combining part of mezz stack in their $1.2 Bn UBSBB 2012-C2 conduit CMBS deal. The 10 year tranche priced at S+160. The exchangeable class combining AS, B, and C tranches reportedly priced at S+280.

Update 7/9/12:  Morgan Stanley & Bank of America introduced a thick tranche combining parts of mezz stack in their  $1.35 Bn MSBAM 2012-C5 conduit CMBS deal.

Update 7/30/12:  Morgan Stanley  used exchangeable classes in  $340 mm MSC 2012-STAR CMBS deal.

Update 8/3/12:  Deutsche Bank & Cantor Commercial  introduced a thick tranche called PEZ combining the AM (junior AAA), B (AA), C (A), and D (BBB+)  classes  which is exchangeable into individual components in the $1.32 Bn COMM 2012-CCRE2 deal.

Understanding TRX.II

October 5, 2011

By Malay Bansal

Newly launched TRX.II may seem complicated, but is not difficult to understand.

Markit launched TRX.II or TRX 2 indices this week. Details and various documents can be found on their website, but for those not familiar with the working of the index, or if the details on upfront payment and dynamic nature of the index are not clear, this article might help understand the mechanics and the underlying logic.

The Basic Concept

The concept is simple. Going long or buying the TRX.II (or TRX) index is similar to buying a bond. If you buy a bond, you get the coupon. Also, if the spread goes lower or tightens, resulting in lower yield, the bond price increases. Same is true with going long the TRX index. If you go long the index, you get a coupon, and if spread tightens, the value of your position goes up. And just like a cash bond, if spreads widen, the value of the position goes down.

The concept is similar, but there are some differences in implementation as the TRX is a contract (Total Return Swap contract) rather than a physical bond. For one party to go long, there has to be another party to take the short side. All that is needed for a TRX trade are the two parties wanting to take the opposite positions, and neither has to actually own or find the underlying bonds to initiate or close a position. TRX contracts will trade with quarterly expirations with a maximum length of one year. Since the contracts will be standardized, the trade may be initiated with one party taking the other side, and may be closed before expiry, if desired by either party, by doing an opposite trade with a third party. This ability to short easily is what makes it possible for loan originators to hedge their loans being aggregated for securitization.

Once they enter into a contract, at the end of every month, the short party pays the coupon equivalent to the long party. Also, if the spread is tighter at the end of month than at the beginning, then the short side pays the price appreciation calculated based on average duration and spread change to the long side, and vice versa. These payments take place at the end of every month, or till the end of contract. Each month, the spread at the beginning of the month becomes the new starting point for spread change for that month. Also this spread is the coupon that the long party gets for that month. It is paid by the short party and represents the cost of hedging.

Upfront Payment

The main purpose of the upfront payment in TRX is to handle trades initiated in the middle of the month.

For example, if someone goes long on 11th day of month, they should get the coupon only for the remaining 20 days in the month, even though the short will pay full 30 days interest or coupon at the end of the month. So, just like in cash bond, the buyer pays an accrued interest for 10 days to the short. Net result will be the short will pay and the long will get net 20 days of the coupon for that month.

Similarly, upfront payment adjusts for spread movement and traded spread. An example may help. Let’s assume the spread at the beginning of the month was 200, at the time of the trade was 230, and at the end of month was 220. In this case, spread tightened from 230 at the trade date to 220 at the end of month. So, the long party should get payment for the value of 10 basis points tightening at the end of the month. However, the standard payment mechanics will see widening from 200 at the beginning of the month to 220 at the end of the month, and will require the long party to pay the value of 20 bps. The upfront payment provides the adjustment that enables the normal end of month payments to take place in the usual manner. In this case, the upfront payment will be the value of 30 basis points (30 bps widening from 200 at the beginning of the month to 230 trade spread) paid by the short to the long. The net effect will be the long getting the value of 10 bps tightening, as he should.

Revolving Nature of TRX.II

One big difference between TRX and TRX.II is that TRX.II is a dynamic index and has a revolving underlying portfolio whereas the original TRX or TRX.I was a static index. The TRX.II will be rebalanced every quarter to include recent deals meeting the inclusion criteria. The initial TRX.II index has 18 bonds. The index rules specify a maximum of 25 bonds. Once the index reaches 25 bonds, the older bonds will be removed as new bonds are added.

The dynamic nature introduces some complexity, but key points to keep in mind are that all TRX.II trades for a specific maturity are fungible with one another and each payment calculation references spreads and average duration for the same set of index constituents. What that means is that when the index changes, the end of month spread for payment at the end of that month is based on the old index, and the starting index for next month is based on the new version of index with new bonds. To enable this, Markit provides numbers for both the old and new version of the index. Rest of the mechanism stays the same.

Spread Determination

The spreads used for monthly settlements are calculated and provided by Markit based on spreads provided by the ten participating dealers for the underlying cash bonds. The fact that the TRX.II will settle every month to actual cash bond spreads means that it will be expected not to stray too far from cash bond spreads. The resulting high correlation with spreads on recently issued cash bonds makes the TRX.II a good hedge for loan originators.

The dealers provide spreads on the individual constituent bonds, not the spread for overall indices, which are computed by Markit. This ensures consistency between spreads for the old and new versions of the index, when the index is adjusted to include new deals.

For the more technically oriented, Markit’s calculation methodology involves using individual bond cashflows to calculate prices from the average bond spreads for each bond and then using aggregated index cashflows and average price to generate index spread, weighted average life, and duration. The end of month calculation of price change from spread change uses the averages of beginning and ending durations and index prices, which captures the majority of the convexity effect.

Outlook for TRX.II

I have asked for creation of a new TRX index for a long time (Restarting CMBS Lending, Feb 9, 2010). So I am happy to see it getting launched. I also like that Markit created a dynamic index which will always reflect spreads on new issue bonds, though that makes it more attractive to hedgers than to investors who may prefer to go long a known set of bonds.

TRX.II is a much better hedge than CMBX as it settles every month based on cash spreads and so is correlated with cash bond spreads, unlike CMBX which pays only when there are actual defaults (far into the future) and can trade purely based on technical factors with no correlation to new issue cash bond spreads. TRX.II is also a better hedge than TRX.I which references the old legacy CMBS deals and does not correlate well with new issue CMBS spreads.

One question on the minds of many people is if the index will gain traction. The general view is that the demand from originators will be there to short to hedge loans being aggregated for sale via securitization, but there may not be enough demand from the long side. It may turn out to be the other way. With spreads wide at present and few deals in the pipeline, the index may see more demand from long side than short side. Hedging of loans for spread movement today is not an almost mechanical process it used to be (CMBS Hedging Requires a New approach, July 5, 2011) and different originators favor different strategies. However, no matter what method is used, hedging has a cost. When spreads are wide and expected to tighten, many originators prefer to hedge just the interest rates and not the loan spreads. Barclays created a CMBS 2.0 index earlier in the year, but it has not been used much, partly for that reason. The TRX.II may benefit from the fact that some originators are now being pushed by their risk management groups to be fully hedged, and TRX.II will have higher correlation with actual cash bond spreads than any alternative. Also, TRX.II has ten licensed dealers. So, there may be more liquidity and more openness by their internal origination groups to use it for their hedging.

By Malay Bansal

CMBS loan hedging issues have often tripped even smart real-estate lenders. The current environment requires a careful and different approach than in the past.

Recent spread widening and volatility in CMBS market have drawn attention to hedging issues for loan originators in securitization shops.

An article in this week’s Commercial Mortgage Alert (New Markit Index May Solve Hedging Woes) reported comments from market participants that the recent spread widening, which was equivalent to about 3% decline in value of loans held, hit all lenders, though to different extent depending on their hedging approach. In an increasingly competitive market with declining profit margins in loans, a 3% hit is clearly very significant for any origination business.

Last week, a Bloomberg news story reported  that spread volatility was  as an important factor in Starwood Property Trust’s decision to back away from originating debt that would be sold entirely into securitizations.

Hedging issues, even when people believed they were hedged, have tripped many very smart real estate lenders in the past. During the previous crisis, after the Russian debt problems in late 90s, the hedges made a huge difference. At the time, many CMBS lenders hedged using only treasuries. Only some used swaps. Those who used only treasuries were hurt doubly as treasury yields declined increasing the prices of treasury hedges they were short, while swap spreads jumped higher decreasing the value of their assets which were valued at a spread over swaps. Those who had hedged using swaps did not suffer that much. Those who did not use swaps had devastating losses. After that painful experience, everyone in the market moved to hedging with swaps.

Hedging with swaps still left the risk of adverse movements in CMBS bond spreads, a smaller risk most of the time. Few years later, as competition increased and profit margins declined, some started using total return swaps on the Lehman CMBS indices (now Barclays Indices) to hedge that risk too. Those legacy indices are not useful now as they contain old deals. Some people have turned to CMBX1 for hedging, as it is closest to the new issue bonds amongst the five CMBX indices. CDS on IG Corp indices have been used at times by some, and I have heard people exploring use of other tools like equity indices. However, all of these approaches need to keep in mind that any hedge used needs to have a very good short-term correlation with new-issue CMBS bond spreads – longer-term relationships do not mean anything. If the hedge can move in the opposite direction of the asset in the short-term, it’s not really a hedge.

Lack of a good hedge was one of the reasons that delayed restarting of CMBS lending.  Last year, I suggested to Markit to create a new TRX 2 index based on the few new deals that had been done so far (Restarting CMBS Lending, Feb 9, 2010). The idea did not get much traction then. Julia Tcherkassova, who heads CMBS research at Barclays, articulated the need for a CMBS loan hedging mechanism internally, resulting in Barclays creating a US CMBS 2.0 Index earlier this year. That index provided a mechanism to hedge loans but it was not used much.

An instrument existed to allow hedging of loans but no significant attempt was made to use or develop liquidity in it by the industry. The reason is probably as simple as the fact that new issue spreads were generally in a continuous tightening mode till the recent sudden widening episode, and that made spread hedging seem not that important. Another factor is that the hedging is expensive. In the past, the cost of hedging with Lehman index was around 30 bps (on an annualized basis). With CMBS2 indices, that cost would have been about 110 bps. Given that the loan volumes are lower, giving up profitability becomes tougher. So the new Barclays index came, but was not met with a strong demand and remained unused. The wider bid-ask spreads also make hedging expensive.

Commercial Mortgage Alert reported that Markit is close to rolling out a new TRX index, dubbed TRX.2. Since it is coming out after a widening that was painful for many, it might attract more attention. Hopefully, it will provide a liquid instrument that can be used effectively for hedging loans being aggregated for securitization.

However, another point to think about is that the new TRX index will likely come with or be followed by new CMBX indices. It remains to be seen if the new synthetic CMBX indices will introduce more volatility in cash markets as did the legacy CMBX indices. One thing is sure though – hedging is as important as anything else for loan originators and needs to be given proper attention. All the careful real estate analysis while making loans can come to nothing if sufficient attention is not paid to hedging while loans are being aggregated for securitization. Mechanically following the past methodologies will not be the best approach. The current environment calls for adjustments and creative ideas for hedging to be effective and less costly.

By Malay Bansal & John Joshi

The issuer-paid model for ratings is widely seen as one of the most significant aspects of the process that needs to be reformed. Yet, no good solution to reform this process has emerged. Part of the reason for that are three widely held misconceptions.

Issuers select which NRSROs will rate their deal, and they pay the rating agencies rating their deals. Many blame this dynamic for causing a conflict for the agencies, and enabling ratings-shopping by issuers. This is perhaps seen as the biggest problem in the current ratings system. Dodd-Frank and other rules in the US and Europe are trying to reform the process. Some proposals suggest removing references to rating agencies from rules, while others suggest regulating them more heavily. The former leaves a hole; the latter increases the perception that the ratings have official approval. No good solutions have emerged.

A previous article in this blog and in Structured Credit Investor (The Unrecognised and Unaddressed Ratings Issue, Malay Bansal, 7 July 2010) made the point that the ratings reform is proving to be intractable because the real issue is not being recognized or addressed in any of the reform proposals. The real problem is that the rating agencies are combining two roles into one. The first role is to provide a rating based on statistical analysis of historical performance of the assets (remember that the ‘SR’ in NRSROs stands for Statistical Ratings). The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. The official NRSRO status gives their subjective opinions extraordinary power and can actually have an impact on the outcome, making the ratings more pro-cyclical.

The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events.

The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as ‘Informational Ratings’, without any legal or official role impacting investor charters, debt covenants, and so on, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started – as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.

The conflict of issuer-paid ratings could be avoided if issuers paid the fee for NRSRO ratings, which will be freely available to everyone, but investors paid the fee for research and informational rating available to subscribers only. Availability of the second will serve as the important function of checks and balances on the NRSRO ratings paid for by the issuers. However, neither issuers, nor the rating agencies seem to find that suggestion appealing. This is partly because of three widely held misconceptions about issuer-paid ratings.

Misconception 1: Issuers Pay for Ratings

Investors, naturally, don’t like the idea of having to pay for ratings, especially since they get it for free in the current system. However, the reality is that they are really the ones paying for it even now. The bankers for the issuer select, engage, and pay the rating agencies, but the payment comes from the money paid by investors for purchasing the bonds. By letting the bankers pick the agencies, investors tilt the balance of power to the issuer. Since they are paying for it anyway, investors should be open to paying for ratings more directly. This will reduce their concerns about the conflict of interest.

Some have criticized the high fees charged by the raters. However, there is another factor investors need to consider in this regard.  If they want good quality output from the agencies, they need to be paid sufficiently to be able to attract and retain talented people. Lowering the fee is not the solution. Any scheme which involves investors selecting and paying for research from the agencies that provide better information and analysis will increase competition and provide the right incentives.

Another point in this regard is that only investors who purchase the bonds at initial issuance pay for ratings at present. Cost for investors will be lower if it was spread over all the investors. Subscription fees could be partly based on AUM, making it easier for smaller investors to subscribe.

Misconception 2: Investor-Paid Rating System will be Bad for Rating Agencies

Many, though not all, on the rating agency side, do not like the idea of having to rely on investors for their earnings. It is much better to get all the fees upfront, which sometimes includes the fee for surveillance of the deal throughout its life. However, the preference for upfront payment misses some important considerations.

First, there are a lot more investors than issuers. Even smaller payments from investors could provide the same or more revenue. Also, a smaller charge will cause more investors to sign on for the service.

Second, if the revenue is coming from investors, it is not dependent on the volume of deals, and will not fluctuate dramatically based on volume of issuance. This will provide more stability to those organizations, and allow them to focus on the quality of their work.

Third, more stable revenue would mean a higher multiple for the valuation of their businesses, which will be a positive for their owners and investors.

Fourth, if payment for rating is at the time of issuance, the agencies have to be picked to rate it. This does not align the interests of rating agencies with those of investors, creates a credibility problem, and leaves them open to criticism. By reducing the incentive to be picked to rate the deals at issuance, agencies will be better off, as will be the overall financial system, including the issuers.

Misconception 3: Ratings have to be either Issuer-Paid or Investor-Paid

Almost everyone seems to think that ratings have to be either paid by issuers or investors.  However, it does not have to be one or the other. Just a sufficient portion of fee has to come from investors to provide the right incentives. Especially in structured finance transactions, where it is expensive to perform the right amount of due diligence to rate the deal, some amount of upfront payment may be necessary. However, if payment from investors is a significant portion of total revenue of rating agencies, investors and the financial system will benefit from the proper alignment of incentives that would create.

Clearly, splitting the rating agency role into two is a significant change. However, if done thoughtfully, it can be a significant improvement to the current system, and work for the benefit of everyone.

Notes:  Views expressed are personal views only, and not of any affiliated organization or group. This article was originally published in Structured Credit Investor.

By Malay Bansal

A revived CMBS market, with new deals getting done, is helpful to REITs and other commercial real estate owners as it has started making financing available again. Spreads had generally been narrowing which helped loan originators by reducing the hedging cost and has been good for owners of CMBS bonds. However, recent spread volatility has left some people concerned, and wondering about the future direction of spreads and how to look at spreads on the new CMBS 2.0 deals in the context of 2006-7 legacy deals.

I always find it useful to start with views of market participants, and historical data for some perspective. Also, for legacy deals, estimates of losses are an important element. Below are forecasts for spreads for 2007 vintage CMBS for June 2011 published by industry’s weekly newsletter, Commercial Mortgage Alert at the beginning of the year, along with some other data. Comments and thoughts follow.

CMBS Spread Forecasts For June 2011

Loss Estimates (%) by Market Participants

S e t

CMBX1 (2005) CMBX2 (2006) CMBX3 (Early 2007) CMBX4 (Late 2007) CMBX5 (Late 2007/ 2008)
1

6.7

7.2 10.3 12.0 9.9
2 6.6 8.3 10.9 13.9 12.3
3 4.2 6.2 6.9 8.8 7.5
4 6.8 8.4 11.8 15.6 13.3
5 7.0 10.1 12.7 14.0 13.9
Note: Loss estimates from market participants including sell-side research group, rating agencies, and advisory services. Periods for each CMBX series are approximate.

 

Recent Spread History

Spread Over Swaps

Dec 2010

11 Feb 2011

18 Mar 2011

1 Apr 2011

Generic 2007 A4

215

150

195

165

GG10 A4

245

190

240

190

CMBS 2.0 AAA

130

110

120

110

 

Historical Spreads
Average Spread Over Treasury 2003 2004 2005
CMBS AAA 78 72 74
CMBS AA 87 79 85
CMBS A 97 88 95
CMBS BBB 150 125 147
CMBS BBB- 200 164 196
Corp – Generic A Rated Industrial 88 69 74

Recent Spread Widening

To focus first on what had people worried most recently – widening of GG10 A4 bonds by 50 basis points from mid Feb to mid March, it is important to step back and look at the bigger picture. GG10 spreads are more visible because it is a benchmark deal and trades more frequently. As the table “Recent Spread History” shows, (i) spreads did widen out, but are generally back to where they were before widening, and (ii) even when they widened out, they were inside where they were at the beginning of the year.

Another factor to look at is where spreads are compared to market’s expectations. The table above shows average prediction for 2007 vintage A4 bonds to be 184 over swaps. Mid March wide was swaps + 190 and the current spreads are swaps plus 165. Again, not as alarming when looked at in that context.

CMBS 2.0 Spreads

Spreads for new CMBS 2.0 deals widened out too, but not by as much. They went from 110 over swaps at the tight to 120 and are back to 110, compared to swaps plus 130 at the beginning of the year. Spreads did not widen much, but where could they go now? One perspective is looking at the history. The underwriting, leverage, and subordination in the new deals are comparable to what they generally used to be 2003 to 2005. However, looking at spreads over swaps at that time will not be as helpful because of the impact of recent events in swap markets. A better approach will be to look at spreads over the risk-free rate, or the spread over treasury notes. In the 2003 to 2005 period, CMBS AAA bonds averaged around T+75, whereas generic single-A industrial corporates averaged T+77. Currently, new CMBS spreads are swap plus 110 or T+117 and single-A industrials are T+97. This back of the envelope analysis would suggest that new CMBS AAA spreads could tighten by 20 basis points from the current levels. The demand for bonds is there and there is not a big supply in the pipeline. So the technicals favor continued tightening.

CMBS 2.0 Vs Legacy CMBS

Legacy CMBS deals are a bit more complicated given the losses expected by market participants (see table above). In general, expectations of losses seem to average around 11.5% for 2006-8 deals. One simple way of looking at the deals would be to assume subordination remaining after expected losses. On that basis adjusted subordination for legacy A4 bonds goes from 30 to 18.5, which is similar to the subordination for AAA bonds in new deals. Subordination for legacy AM bonds with loss taken out goes from 20 to 9.5. That is roughly between single-A and BBB bonds in new deals.

This simplistic approach ignores several other factors that also come into play, but does the market see these as comparable? Market spreads for legacy AM bonds, at swap plus 280 seem wider than 190 and 270 for new deal single-A and BBB bonds. Similarly, legacy A4 spreads at S+170 are much wider than S+105 for new issue AAA bonds. However, if you look at yields, legacy A4 is around 4.65, close to the 4.60 on new issue AAA. Similarly 5.80 yield on legacy AM bonds is between 5.42 and 6.22 on new issue single-A and BBB bonds.

Logical inference from above is that, in this yield-hungry world, the legacy bonds are generally in line with the new issue bonds in terms of yield, and legacy bonds should tighten along with new issue. The choice between them comes down to investors preference for stability, hedging, leverage, duration, etc.

The above would suggest that a general widening in legacy but not in new issue bond spreads, unaccompanied by any deal specific news, as happened recently, may be an opportunity to pick up some cheap bonds if you can do detailed deal analysis and are confident in ability  to pick better deals.

 

 

By Malay Bansal

Predictions about future bond spreads by market participants provide a window on their thinking about their expectations regarding the performance of the underlying asset class. CMBS industry’s weekly newsletter, Commercial Mortgage Alert published its semi-annual polling of predictions on CMBS spreads six months later last month. One interesting fact in the data was that not a single person asked for their prediction thought that the spreads will be wider six months later! Does this unanimity reflect wisdom of crowds and indicates a steadily improving commercial real estate market, or is this a contrarian signal with respect to where commercial real estate and CMBS spreads are headed? And how does that reconcile with forecasts of the real estate market conditions?

 

Pros See CMBS Rally Continuing to Yearend

For the commercial real estate property market conditions, The Real Estate Roundtable has just published its 3rd Quarter 2010 Sentiment Index survey of more than 110 senior real estate executives. While the survey found significant concerns and uncertainty about economic & job recovery outlook, government policy, and capital markets, the overall sentiment is that the industry is in for a long slow recovery. The survey reports a Current Conditions Index (reflecting how markets are today vs 12 months ago), a Futures Conditions Index (expectations on how markets will be 12 months from now), and an Overall Sentiment Index, which is the average of the two. For the first time, the survey’s current and future conditions indices merged, scoring an Overall Sentiment Index of 74 (down from 76 in the previous quarter).  This score suggests a relatively positive trend and a flat trajectory.

 

Real Estate Roundtable Sentiment Index

Real Estate Roundtable Sentiment Index

The actual data on commercial real estate is sending conflicting signals and is being read by different people in different ways. Cushman & Wakefield report last month showing US CBD office vacancy dropping to 14.8 % in Q2 from 15% at end of Q1 -first drop since 2007, CMBS statistics showing declining pace of deterioration in delinquencies, etc are seen by many as signs that the CRE market is stabilizing. Others point to declining rents and high unemployment as factors that point to further declines ahead. Both the viewpoints have some validity, which probably implies that the CRE sector might move sideways in near term with some volatility caused by which of the two views is stronger at any given point, till additional market data clarifies the picture more.

Going back to CMBS spreads, the tightening probably just reflects the sentiment expressed in other surveys of an expectation of slowly stabilizing CRE market. For CMBS, as opposed to properties, a consensus that the property price decline has stopped will be enough for bond spreads to tighten. Real estate prices do not necessarily need to go up for CMBS spreads to tighten. What happens if the sentiment on the economy sours impacting the view on the commercial real estate too?  Even in that scenario, more and more people are coming to the view that the senior most CMBS bonds will likely not suffer a principal loss, which makes them attractive given the additional yield they provide compared to other similar investments. So, worsening economic conditions may actually cause people to move up in capital stack, creating demand for senior most bonds, and providing support for spreads. No one knows what future will bring, but logically, odds look in favor of the spreads moving in the direction suggested by the unanimous view.

All of the above is fine for trying to understand these markets, but one practical conclusion, and the real point of this article is this: if senior CMBS securities can go up in value even when property markets go sideways, and will have some support if the property markets decline, then logically, senior CMBS bonds have to be better investments at present than commercial real estate properties or loans for those who can invest in any of those.

Note: A version of this article was originally published on Seeking Alpha.The views in this article and my spread predictions in the Commercial Mortgage Alert article referenced are solely my own.

Follow-Up: 12 Nov 2010: AAA Spreads have tightened from 350 mid-year to approximately 250.


By Malay Bansal

What seems like the final chapter on Extended Stay for now is interesting to analyze. On Thursday, Centerbridge led consortium that includes Paulson & co and Blackstone Group won the auction for Extended Stay after 11 rounds of successively higher bids and a marathon bidding session lasting 19 hours, when the rival group including Starwood Capital and TPG decided against another higher bid. The final purchase price was $3.925 billion, which is good for holders of $4.1 billion CMBS bonds, who were looking at a much higher loss last year when Extended Stay’s advisors had pegged the value at somewhere between $2.8 to $3.6 billion. But, does the intensity of bidding indicate that market is reaching somewhat frothy levels? Probably not, especially if Blackstone is making a meaningful investment, as they know the assets and the company well, having owned it previously. They sold it at $8 billion to the Lightstone group in 2007, and are buying back in at $3.9 billion.

Also, since Extended Stay owns budget hotels and not trophy properties, the heavy bidding challenges the convenient notion of bifurcated markets with lot of demand for trophy type properties and lack of demand for others.

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