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Note: Views expressed in my writings are solely my own.

See Also: Media Quotes, Market Comments, Some Useful Information

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.

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

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

I was on a panel on Tranche Warfare last month in IMN’s 11th Annual US Real Estate Opportunity & Private Fund Investing Forum. It was a very well organized conference with a lot of people in attendance, and provided a great opportunity to exchange ideas with and listen to views of significant participants in the industry.  The conference and views expressed have been reported earlier. Below are some of my thoughts on what I heard.

The most common thread in a lot of comments, both in the panels and in private conversations, was the lack of opportunities to invest. Investors, remembering how much money was made purchasing cheap assets from RTC sales during the last real estate downturn of early 1990s, have raised a lot of money in anticipation of a similar opportunity this time around. However, those fire sales have not materialized, causing some disappointment. Many do not seem to realize that the investors were not the only ones who learnt from the early 90s experience. The owners of the assets, and the regulators, learnt too – if the assets are sold at cheap fire sale type of prices, investors make a killing, but the owners of assets lose out. So, this time around, the owners of the assets are trying to hold out as long as they can and it makes sense. Regulators, having learnt from the experience too, seem to be doing everything they prudently can, to give latitude to owners to avoid fire sales. Somehow, many seem to be disappointed at things not having played out the same way as they did in 90s! Seems logical that they should not, still many are surprised.

The good news from many was that the opportunities, though not as plentiful, are there. And people are doing deals. They take a little more searching, a little more digging into the things that are out there to separate the good ones from the bad, and they are often a little smaller than ideally desired, but they are there. On the easy ones, there is competition, and sometimes those assets get overbid. So, discipline in the process is as important as ever.

Another lesson that I came back with was that those GPs who gave themselves (or were able to get) more flexibility when raising funds in terms of types of investments, timeframe, and returns are better placed to take advantage of opportunities as they come up than those who got narrower mandates from their LP investors.

The more I think about it, the more it seems to me that this time around, the process will be stretched out over a period of time. In commercial real estate, values are down – around 40% by some commonly used metrices, and there do not seem to be any immediate drivers that will quickly and significantly drive prices up. This is bound to result in transfer of assets from those owners who are overleveraged and do not have ability to put in more capital to refinance maturing loans in the new lower leverage environment. That will create opportunities for those with patient capital to invest. Just slowly. And they may not get fire sale prices, but they will be investing at today’s lower prices.

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.

Restarting CMBS Lending

February 9, 2010

By Malay Bansal

The DDR deal, the first CMBS deal after nearly eighteen months, was ten times oversubscribed. The following two deals also saw good demand even though they did not allow for TALF financing. So, clearly, there is good demand for CMBS bonds backed by well underwritten loans. Also, borrowers clearly want loans if they can get a reasonable cost of financing. DDR loan, with about 4.25% all-in cost of financing for the borrower, showed that a low cost of financing is possible even in the current market. Yet, prospects of a conduit style multi-borrower deal seem bleak at the moment. Any CMBS deals that come to market are expected to be single-borrower deals, as in those deals the borrower takes the market risk and not the underwriter doing the deal. Securitization shops do not want to take the spread risk while aggregating the pool because there is no way to hedge that risk, and so are unable to originate loans even though many are eager to restart their lending operation. If they do originate loans without ability to hedge, they would require much wider spread resulting in higher cost of financing than borrowers would find attractive.

Inability to hedge loans while aggregating a pool for securitization is one of the biggest obstacles preventing restarting of conduit lending for commercial real estate properties.

In the past, the conduit originators were able to hedge loans while they were aggregating a pool big enough to securitize. So, they were not exposed to risk from changes in interest rates and bond spreads between loan origination and securitization. The hedging generally involved hedging the interest rate risk by selling interest rate swaps, and hedging the bond spread risk by using Total Return Swaps on Lehman or Bank Of America CMBS indices. These indices allowed loan originators to effectively sell their risk to investors who wanted to gain exposure to CMBS in their investment portfolio. They sold the risk when they originated the loan, and bought it back when they securitized the loans. The hedge worked because spreads on new CMBS deals moved in parallel with the spreads on existing deals.

The problem now is that those indices are no longer appropriate for hedging, especially for new origination loans, because of two problems. One, ratings downgrades have impacted the composition of the indices. Second, and more important, the spreads on new bonds with newly underwritten loans cannot be expected to move in tandem with spreads on old bonds with the old underwriting. This lack of correlation between the two spreads makes the old bonds or indices unusable as a hedge for newly originated better quality loans.

What this means is that to hedge new loans with better underwriting, originators need bonds with better underwritten new loans. In other words, to originate loans, you need bonds with new underwriting, and to create bonds with better underwritten loans, you need the better underwritten loans. That’s the chicken-and-egg type problem of loan aggregation. This is what has prevented loan origination from restarting once the spreads on old bonds widened out.

To solve this chicken-and-egg problem, back in February 2008, I made a suggestion to Markit, which administers the CMBX indices. My suggestion was to create a new CMBX type of index based on future deals that met minimum credit quality. Only deals which met pre-set criteria based on LTV, DSCR, and other credit parameters would be eligible to be included in the new index. Trading of the index would have allowed the market to determine spreads on bonds backed by good newly originated loans, and provided a hedging mechanism for loan originators, solving the chicken-and-egg problem.

Markit discussed the idea in a conference call with the trading desks, but it was thought to require too much work to create, when dealers were busy with the market volatility. Also, the idea was complicated, since it was based on future deals. Additionally, the CMBX is based on CDS (Credit Default Swap), and cash and CDS markets do not always move together, and so the hedge would not have been as good as Total Return Swaps on cash bonds.

Luckily, things have changed since then.

One, MarkIt has created new indices called TRX, which are based on Total Return Swaps on cash CMBS spreads, which will be a much better hedge for loans than a CMBX or CDS type of hedge. Total Return Swaps are what many originators used in the past to hedge the credit spreads.

Second, new deals with newly underwritten loans have been done and exist now. So, it is not necessary to base the index on future deals, avoiding a lot of complexity. That simplifies things considerably.

One solution to the hedging problem for newly originated loans is to create a new TRX index based on the new deals. It will allow the originators to sell risk, and will allow all the investors (many who did not get any allocations in the over-subscribed deals that have been done recently) to get exposure to new CMBS bonds.

Some may argue that three deals is not enough diversity to create an index. Admittedly, it would be better to have a more diverse pool of deals for the index. However, even with just three deals, the index will allow many originators considering starting origination to solve the chicken-and-egg problem. Also, this by itself will not solve all the problems the CMBS industry is facing. Yet, it will be better to have something, even if it is not perfect, than to have nothing at all.

I urge Markit and the dealers to make available a new index that will be attractive to both loan originators and investors, and just might help solve one of the major roadblocks preventing restarting of CMBS lending.

Note: This article was published on Seeking Alpha.

By Malay Bansal

Wide media coverage of the Peter Cooper Village & Stuy Town loan might make a CMBS loss on that loan more likely.

Media has widely reported that the value of Peter Cooper Village/Stuy Town properties, which were purchased for $5.4 Bn in Nov 2006, is now estimated to be less than $2 Bn. Normally the low estimates do not matter. What really matters is the highest bid or the price one – just one – buyer is willing to pay. Valuation of properties like this is not totally a science, and it is entirely possible for one buyer to put a higher valuation on it than others based on their view of possible upside. However, in this case, such a wide dissemination and knowledge of the $1.8 to $1.9 current valuation numbers, might make it difficult for someone to put a higher valuation on it, even if they otherwise might have done so. With reserves running out, special servicer may not be too keen on taking over the properties.  That will make it more likely that they will end up accepting losses on the $3 Bn senior loan, included in five different CMBS deals, and modifying it for whoever emerges as the owner going forward.

Note: This article was published on Seeking Alpha, and is based on my comments originally reported a week earlier by Housing Wire.

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