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.

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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.

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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