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.

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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.

 

 

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