By Malay Bansal

I recently attended the Dow Jones Private Equity Analyst Conference, which was the 17th annual event hosted by top editors from Dow Jones & the Wall Street Journal. It was a well organized event with a lot of people in attendance and provided an opportunity to listen to and exchange ideas with significant participants in the industry. Below are some thoughts and ideas that I heard more than once, or which stuck with me for some reason.

Opportunities in Emerging Markets

It was one of the themes that I heard most often in different conversations – both on-stage and off-stage. Facts are known – emerging markets are now equal in size to the US, bigger than Europe and growing faster. Consumers there have very little debt, as opposed to US, where 70% of GDP is consumer spending, and the consumer is over-leveraged. This presents all sorts of opportunities to financial and non-financial firms. Not surprisingly, China, India, and Brazil were mentioned as the places with the most opportunities. However, there was one cautionary note that was heard often too – an investment in an emerging country requires local presence and cannot be done remotely from US. A local partner may be helpful, with or without a local office there.

Opportunities in US

Many of the opportunities mentioned in US were in Energy & Infrastructure areas. And one hurdle or negative most often mentioned was the upcoming changes to accounting and regulatory policies, including changes to treatment of carried interest.

Energy was a major topic of conversation – both the current forms, and the newer clean-energy technologies and companies. Participants saw opportunities in many areas. One interesting viewpoint favored investment in natural gas assets, with the thought process that natural gas assets may be purchased at cheap prices based on lower natural gas prices, providing a bigger return when prices rise.

Infrastructure was another major area talked about with opportunities in US. PPP (Public-Private Partnership) volume has been low in US, which is lagging far behind Europe & Canada in this space. Issues in the Chicago Parking Meter program, Midway Airport, and others have slowed other similar efforts. However, need for infrastructure spending in US is huge, and deals are happening. 80% of these are estimated to be private-to-private deals and provide opportunities. Public-private opportunities will also develop with time. One view was that the second wave of Public-Private initiatives will come from cities and municipalities rather than states, which may mean that approval the process will be quicker.

In my opinion, with its ability to create jobs locally, we can expect to see more focus from politicians on the infrastructure sector. Also, with lower yield in other investments, private equity firms and other investors will find investments in infrastructure, which usually provide a built-in hedge for inflation, attractive. In some ways infrastructure investments are similar to investments in commercial real estate properties, and some of the money targeted towards distressed commercial real estate may be able to find a way to achieve desired returns by changing the focus to infrastructure investments, especially if the government provides appropriate incentives.


Two Points For Investors

September 27, 2010

By Malay Bansal

If a picture is worth thousand words, the graph below is a valuable illustration of two very important points that investors would be better off to remember. This graphic focuses on the returns from various sectors in fixed income market, but the same concept generally applies to equities too.

The Case for Active management

The creators of the graphic intended to make the case for active management. I am assuming that anyone managing investments for themselves or others already believes in benefit of active management to some extent. The points I want to make go a little further.

The first point is that sector selection is much more important for generating superior returns than individual security selection. You could be very active in selecting securities, but if they are not in the right sector, the returns might suffer, no matter how much effort is put into picking the individual bonds or stocks.

The second point that this graphic makes to me is that, when I am picking funds, it makes sense to pick funds that have broader focus and a manager with expertise in multiple sectors. In other words, funds in which the manager has the expertise and ability to switch between different sectors may be able to do a better job than an investor trying to move between different funds. That thinking leads me to pick funds like PIMCO Total Return (PTTRX), Blackrock Global Allocation (MALOX), Vanguard Wellington Income (VWELX), and others.

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

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

The most important and the most basic issue related to ratings and rating agencies has not been recognized or addressed in reforms announced so far. Here’s a new idea on a practical solution to address this most fundamental issue, which also addresses the conflict of interest issue that has received the most attention so far.

The Reforms

Ratings agencies have been criticized heavily by many for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been blamed for throwing fuel onto the fire of crises by belatedly and aggressively ratcheting down ratings. Numerous proposals have been put forward to reform the rating process to avoid these issues.

The US Congress, after resolving the differences between the House and Senate versions last week, is on the path to pass a sweeping financial regulatory reform bill aimed at increasing oversight and regulation of the US financial system. Among the issues addressed is reform of credit rating agencies. However, the compromise bill avoids most of the stronger proposals. The bill directs SEC to conduct a two-year study to determine if a board overseen by SEC should be setup to help pick which firms rate asset backed securities (the Senate version of the bill had required such a regulatory board). The bill also adopted a softer version of proposed liability provision than was in the house version of the bill (investors must show a company “knowingly or recklessly” failed to conduct a “reasonable” investigation before issuing a rating). The compromises are better than the extreme versions of proposals even though it means that the proposed regulations may not do much to change how the agencies operate.

Earlier, in mid April, SEC made some changes. In the update of Regulation AB, it eliminated the involvement of rating agencies in the shelf registration process by removing the requirement that the ABS be rated investment grade. This clearly has no impact on the rating process.

SEC also promulgated the Rule 17g-5, which went into effect on June 2, to address perceived conflicts of interest with issuer-paid ratings provided by nationally recognized statistical rating organizations (“NRSROs”). The rule aims to increase the number of ratings and promote unsolicited ratings for structured finance products. To achieve this goal, the rule requires issuers and hired rating agencies to maintain password-protected websites to share rating information with non-hired rating agencies. The concept is good, but if implementation means rating agencies will have to share all information with other agencies, they may have less incentive to dig deeper and find more data.

None of these changes are radical overhauls or even proportionate to the amount of criticism that was leveled at the agencies (Calpers has sued the three major bond rating agencies for $1 billion in losses it said were caused by “wildly inaccurate” risk assessments) or the wide ranging calls for ratings reform. In some ways, it is good that some of the more extreme proposals have not been adopted. But why is it so difficult to reform the rating process?

The Power of the Rating Agencies

One reason that makes it very difficult to make changes to the ratings process is that ratings are heavily embedded in almost every part of the financial systems around the world. They are used in investor’s charters defining what they can buy. They are used for calculation of capital charges for banks, insurance, and other financial companies. They are used in loan covenants and triggers on corporate debt. They are used to calculate haircuts on repo lines, along with many other uses.

Also, despite the recent failings, they serve a very useful purpose. Not everyone has the expertise and resources to analyze every security in detail. Presence of credit rating agencies gives smaller investors a starting point for analysis that they may not otherwise have.

This embedding of ratings in the financial system and reliance by so many participants on the ratings gives the nationally recognized statistical rating organizations or NRSROs tremendous power as ratings changes can have significant impact on companies, and even nations.

There are numerous examples of the impact that ratings changes can have. One recent one was during the onset of the 2010 European Sovereign Debt Crisis. What clearly played a role in triggering and escalating the crisis, even though it was not the cause, was the downgrade of Greece’s credit rating by three steps from investment grade BBB+ to junk rating of BB+. This came minutes after S&P downgraded Portugal by two steps to A- from A+. The announcement came at a sensitive time as the European Union policy makers and the International Monetary Fund were trying to hammer out measures to ease the panic over swelling budget deficits and create a financial rescue package for Greece. S&P followed the next day cutting Spain’s rating by one step to AA, and keeping the outlook as negative, reflecting the chance of further downgrades, with its projection of just 0.7% average real GDP growth annually from 2010 to 2016. Markets reacted violently to the cuts as investors worried about the safety of the debt of these countries, and contagion spread from Greece to other countries. Stock markets tumbled worldwide, and bond and currency markets had big moves and became very volatile.

Another way ratings impact markets is via the feedback loop between the markets and ratings through portfolios tied to indexes mandating certain holdings of particular debt. For example, the Barclays Euro Government Bond Index includes Greek debt as 4% of index, but only if the bonds maintain a certain credit quality based on lower of the rating from S&P and Moody’s. Greece had been 4% of that index but was excluded starting May 1, due to S&P’s downgrade. That in turn likely forced selling from investors tracking that index.

Critics assailed rating firms for fueling woe in Europe and Europeans criticized debt-rating agencies, accusing them of spooking the markets and worsening the plight of financially stretched governments such as Greece, struggling with heavy debt loads.

There are several other examples where a company needing to raise more debt in capital markets finds it cannot do so, or not at a reasonable cost, once it has been downgraded even while it was attempting to raise capital to improve its financial situation. The downgrade increases cost of financing as investors demand more yield reflecting lower rating. The downgrade may also result in existing investors having to sell holdings, further increasing the yields in the market. It can become a vicious circle increasing the likelihood of default. The downgrade reflects rating agency’s opinion of the outcome, but it also becomes a causal factor in determining that outcome. The rating agencies in effect become the judge, jury, and the hangman for the company.

The Real Problem That Has Not Been Recognized

In the current system, the rating agencies’ opinion can become a causal factor in making that opinion become reality. Time and again, in structured products and otherwise, it has been clear that the rating agencies are not infallible in their judgment, and do not have any special powers of predicting future. Their failures in predicting subprime mortgage performance have been appalling. But even if you look at the forecasts of defaults in corporate bonds, the predictions do not match the actual outcome, and the predictions themselves change over time, as they should.

So, if ratings are heavily embedded in the system and are needed, and yet rating agencies are not smarter than everybody else, and if they do not have special predictive powers about the future, how do we avoid giving their subjective opinions so much importance and extraordinary power?

The answer lies in recognizing the real problem – one that has not been addressed in any of the proposals so far. The real problem is that the rating agencies are combining two roles into one. First role is to provide a rating based on statistical analysis and past performance of the assets – remember that 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. At the same time, it leaves rating agencies open to criticism if they do not act and the feared worse outcome becomes reality before their downgrade. This also allows subjectivity and flexibility in ratings process that creates perceived conflicts of interest in issuer paid ratings.


The Solution

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, and cannot be blamed for not downgrading sooner. This role will be limited to those approved as NRSROs.

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, etc, 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 information provided to NRSROs should be made available to all NRSROs and other non-NRSRO rating agencies, in a manner similar to password-protected website required under SEC Rule 17g-5. However, to promote competition and improve quality, the other rating agencies should be free to gather more information and not have to share it with others.

The conflict of issuer paid rating could be avoided if issuers were required to pay a fixed fee based on deal type (maybe to a group set up by the SEC or an industry association for that purpose) which would be divided between all NRSRO raters informing issuers of their decision to rate the deal after the issuers post the information on the password-protected website for credit raters. This will avoid ratings-shopping by issuers even though the agencies will be indirectly paid by the issuers. The NRSRO Rating will be provided to investors without any charge. The NRSROs will only provide the current rating, along with disclosing their rating methodology to investors. They will not provide any opinions or qualitative information.

For more qualitative information and opinions, investors will look to the Informational Ratings and more details from research providers (including NRSROs and non-NRSROs). This will be paid for by the investors looking for enhanced information and research. This will be the main source of income for credit raters and will incentivize them to compete with others for investor subscriptions and produce quality results.

Separating the two roles avoids the issues of rating agencies precipitating events if they act or facing criticism if they do not. It avoids the perception of conflict from issuer-paid ratings, by allocating costs between the issuer and the investors. It also preserves the role of rating agencies where its needed, while encouraging the investors to do more work on their own and look for third party unbiased research and opinion.

Note: Versions of this article were published in Structured Credit Investor and Seeking Alpha.



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.

By Malay Bansal

It’s always interesting to analyze forecasts about future spreads and yields. CMBS industry’s weekly newsletter, Commercial Mortgage Alert publishes predictions on future CMBS spreads every January & July. I have always liked to look at them to see what market participants are thinking, and if any interesting insights can be gleaned from their predictions.

The table below is the latest set of forecasts published. It shows predictions from ten industry participants on where recent vintage (i.e. 2006 to 2008 deals) CMBS spreads will be six months later. Some observations follow.


Let’s start with the averages. The average prediction suggests that, six months later, Super Senior AAAs will be tighter but BBB spreads will be wider. Credit curve will be steeper. That makes sense and reflects the belief of many that CMBS will face losses but not to an extent that it will impact super-senior AAA tranches in most deals. Range of 350 to 975 is wide, but not that much given the current uncertainty.

The BBB forecasts are more interesting – with a really wide range from 3500 to 17500. The majority expects spreads to widen, but the widest spread is mine. Why am I negative on recent vintage BBB and BBB- bonds? My reasons are not different from others, and so are not that interesting (and hence listed as a footnote at the end). What is interesting to me is a question I have been asked multiple times – if I am twice as negative as the average and why? With average prediction of 8473, and my prediction of 17500, it is a fair question. So, let’s examine that in a little more detail.

The current spread for BBB is listed as 6500 bps over swaps. If we take a single bond as a representative of the sector, that spread implies a yield of about 68.5%, a price of about 10.40, and Modified Duration of 1.6. The bond has a coupon of 6%. If you buy the bond at a price of 10.40, at the end of second year, you would have received 12.00 in coupon payments (2 years at 6%/year), which is all of original price you paid for the bond plus about 15%. In effect, the market is saying that it expects these bonds to receive just about two years of coupon, and not much else after that. In other words, the market price implies that it expects these bonds to be wiped out after about two years.

If you logically follow that belief, then after 6 months, an owner of the bond would have received 3.00 and  should be expecting one and a half year more of cashflows. So the price of the bond would be roughly 3.00 lower than 10.40, or 7.40. Indeed, that price is not too far from what the average spread prediction would result in. In other words, the average spread prediction of 8475 implies that the market will be expecting about 1.5 years of cash flows. In comparison, my prediction of 17500 assumed expectation of only 1.0 year of cashflows. So, I am not twice as negative as the average, just a little more – difference being 6 months in cashflows for seven year bonds. So, why such a big difference in spreads? That has to do with the current low prices of these bonds, and the fact that as bond prices decrease, duration decreases too. For a bond priced at 10.00 with a duration of 1.0, a 100 basis point change in yield results in a change in price of 1%, or just 0.10 (1% of 10.00). As duration decreases, it takes a larger change in spreads to make a difference in price. That bond math explains the big difference in spreads, but that is not the important point. The important observation here is that, whether expectation is for 12 or 18 (or something in between) months of remaining cash flows, it reflects a pretty negative expectation for bonds that will have about 7 years remaining to maturity.

Despite the negative expectations, there is another point that is important to keep in mind – it is a simple one but is often missed by many, especially in media reports – CMBS and property markets are linked, but are separate markets, and one can be way ahead of the other. It is entirely possible for commercial real estate to face problems at property level, but CMBS BBBs to tighten. That is another way of saying that, despite all the issues mentioned, it is entirely possible that the majority may turn out to be wrong. Note that there were two predictions for tighter spreads on BBB. There are scenarios possible under which losses in CMBS will be limited even with problems at property level, and that will logically lead to a significant rally in the BBB tranches. A lot will depend on government and industry steps, some of which are helping tighten spreads, but I do not yet see steps that make the more optimistic scenarios likely. Apparently, neither does the majority.

Here is perhaps the most important point of this article: if you are not sure and have doubts about extent of losses in BBB and BBB- classes, then AA and single-A classes at prices in 20s with subordinations of 9.8% and 7.5% (and same about 6% coupon), have to be a bargain, especially if you can do the credit work and pick the right deals.

Note: The views in this article and my spread predictions in the Commercial Mortgage Alert article referenced are solely my own.

Nov 2010 Update:
Tranche                              Price in June 2009        Price in Nov 2010
BACM 2006-6 B                         26.00                              54.00
MLMT 2005-CKI1 C                   40.00                              80.50
GCCFC 2005-GG5 B                  40.00                              73.30



Some Reasons for being negative on recent vintage BBB & BBB-  CMBS

Consider the following facts and opinions:

  • Commercial property values are down 34.8% from Oct 2007 peak, as measured by the Moody’s/REAL CPPI index.
  • Average subordinations for 2007 BBB and BBB- were 4.20% and 3.10% respectively. That means losses of approximately 4.20% and 5.3% will result in complete write-down of these tranches.
  • Appraisal reductions can lead to interest shortfalls (via ASERs) and can stop cash flows to the subordinate bonds long before actual write-downs.
  • It remains very difficult to refinance maturing loans, especially those with larger sizes. 29% of all loans that matured this year remain outstanding. Of the 5 year loans that matured this year, only 50% were refinanced. Number of CMBS loans maturing increases dramatically from $18 Bn this year to 35 Bn next year, and 56 Bn two years later.
  • Loans going in special servicing generally require new appraisal and can result in appraisal reductions before actual losses. According to Fitch, loans in special servicing are expected to increase from current $50 Bn to 100 Bn (or about 14% of total outstanding universe on average) by year end. In addition to losses, the special servicing fee of 0.25% on loans in special servicing will reduce cash flow to bonds increasing interest shortfalls.
  • Among just the large loans, about 15 Bn with pro-forma underwriting with expectation of higher cash flows have not realized the expected increased cash flows. They are paying debt service at present, but may default in next 6 to 12 months once the interest reserves are completely used up.
  • Over next few years, partial IO loans will start to amortize after the initial 2 to 5 year interest-only period. Increased debt service may not be fully covered by property cash flow, leading to defaults. In 2007 vintage, about 32% loans were partial IO along with 53% that were interest only to maturity.
  • Delinquencies are still very low, even for loans with cash flow not covering debt service. In 2007 vintage, roughly 14.7% loans have debt service coverage level of less than 1.0.
  • Overall delinquencies are expected to increase. For example, JP research expects aggregate delinquency to reach 4% by year end, and 10% by end of 2010. DB research expects delinquencies to reach 6-7% by end of 2009 in aggregate, and high-teens to 20% for 2007 vintage. REIS expects delinquencies to possibly reach 7% by year-end. Last time delinquencies were higher than 6% was in 1991 after the S&L crisis.
  • Significant losses are expected in the recent vintage deals, even before maturity of loans. For example, DB research expects term losses, i.e. losses before maturity, to be 4.3 to 6.3% for the entire CMBS universe (with total cumulative losses of 10% including those at maturity), and 8.4% to 12.1% for the 2007 vintage. Fitch expects cumulative losses on 2006 to 2008 vintage deals of approximately 8% (maybe more than 14% for some 2007 deals), with 25% of loans possibly defaulting before maturity.

My Suggestions on TARP

October 19, 2008

Note:  These suggestions, sent to Treasury & FRB in Oct 2008, after the Treasury announced the original TARP plan to buy distressed assets,  proposed a plan similar to the TALF and PPIP programs, months before Treasury and others came around to the idea.  They were mentioned in the NY Times Executive Suite column by Joe Nocera and the complete document is available at here. The new Treasury plan was first announced by Treasury Secretary Tim Geithner on Feb 10, 2009. My writeup also included the Turbo concept of limiting interest payments and using  excess interest to pay down loan principal, which was included in the later TALF announcement on Legacy CMBS on May 19, 2009. Another suggestion was to use tax incentives to increase housing demand.

By Malay Bansal

After TARP plan came out, I made some suggestions for improving it  to the Treasury & Federal Reserve for their consideration.

My Suggestions included the following points:

  • Treasury should provide financing to private buyers rather than buying distressed assets itself. Financing will help private buyers reach their target returns, and get them started on buying distressed assets clogging the system. Also, by providing financing to highest bidder on distressed assets, treasury will create a mechanism for pricing these assets based on competition from private buyers. Treasury can protect public funds by getting paid first and ensuring the private buyers get no more than 4 or 5% coupon (to cover expenses) on their invested money before the treasury gets its money back. Also, by requiring recipients to agree to certain steps to help homeowners, the plan can help homeowners who may be facing difficulty.
  • Treasury will get the biggest bang for the buck by helping those on the cusp of defaulting, or those who may be considering buying a new home. Increasing home buying demand is as important as steps to decrease supply by reducing foreclosures. One step that will help more than a one-shot stimulus payment, will be to make the mortgage principal payments tax-deductible for next 5 to 10 or more years.
  • One of the easiest steps to lower monthly mortgage payments will be to extend the mortgage term by 5 or 10 years for those facing potential problems. This should be least controversial of the modifications being discussed, and will not encourage those who do not need it to ask for it.



Suggestions for Additional Steps for Tackling the Credit Crisis

By Malay Bansal

Oct 19, 2008

Several steps have been taken by the Treasury and Federal Reserve to address the current economic crisis. These are important and useful first steps, but as everyone knows, the problems are complex and will require additional action, including steps to tackle the root cause of the problem – declining house prices.

Obviously, any step to stabilize house prices will need to focus on decreasing supply by preventing foreclosures as much as possible, and increasing demand by providing incentives to new home buyers. Making mortgage payments more affordable is key to both. Most efficient will be approaches that help people on the margin – people on the verge of defaulting on their mortgage, or those considering buying a house.

Below are outlines of three suggestions I have for consideration along with other steps being contemplated:

1. Make mortgage principal payments tax-deductible for next 5 to 10 years.

  • Mortgage interest is already tax-deductible. Making principal also deductible will make it easier for those who want to but are barely able to make their mortgage payments, and those who are considering buying a house.
  • As an example, someone with a $350,000 mortgage and 28% marginal tax rate will save $6,250 over 5 years or $1,250/yr. Over 10 years, savings will be $14,900.
  • Better than a single-shot stimulus payment, since (i) it will provide relief over a longer period of time, (ii) it attacks the root cause of the problem by targeting housing, and (iii) it will benefit local governments by preventing loss of property taxes that will otherwise result from foreclosure.
  • The deduction may be limited to maximum 15 to 20% of total mortgage payment to focus the benefit more towards newer mortgages (after ten years, principal payment is likely to be more than 20% of total mortgage payment), &/or to mortgages issued in certain years to control total cost.
  • The deduction can be phased out above a certain level of AGI to focus the benefit towards those who need it more.

2. Better use of part of TARP Funds targeted to buy mortgage assets: Treasury can partner with private buyers instead of buying assets itself.

  • Will increase efficiency by tapping private funds. There is a lot of capital waiting to be invested in distressed assets, but has not been invested yet as prices need to be lower to achieve targeted returns without leverage.
  • Treasury can lend to or partner with private buyers of distressed mortgage assets with terms like the following:
    • Treasury will put up 50% and the private buyer will put up 50%, with Treasury’s interest being the senior interest.
    • Funds will be used to buy distressed mortgages and securities at a discount from various large and small banks and financial institutions.
    • Mortgage payments from purchased assets will be used in sequential order to (i) pay 5% interest to Treasury, (ii) 5% interest to the Private buyer, (iii) principal to Treasury, (iv) principal to the Private buyer, and finally (v) all residual to the private buyer as its return for the risk. This ensures that Treasury gets its money back first.
  • The 5% interest for Treasury will apply for 5 years. After that, it will increase by 0.5% every year till it reaches 9%. Interest for private buyer will stay at 5%.
  • Those taking the loan from treasury will need to agree to change mortgage terms to help homeowners including giving borrowers the option to (i) increase loan term by 5 to 10 years, and (ii) prepay loans at any time without penalty (any existing prepay penalties will be waived). Other terms to help homeowners may be included.
  • Treasury will offer mortgage assets from banks for bids. The private buyer with the highest bid will get funds from Treasury. Banks will have option of accepting the highest bid or keeping the assets themselves.
  • This type of plan will allow participation by numerous large and not-so-large investors. Since there will be multiple buyers competing to buy assets, with their own capital at risk, the plan would help in determination of fair market prices for distressed assets (instead of a situation in which TARP manager is the only buyer).
  • This program can run in parallel with direct purchases of assets by treasury, or can be used to sell off assets purchased by Treasury at a future date.

3. Encourage mortgage modifications to lower monthly payments by extending the mortgage term by 5 to 10 years.

  • Modify mortgages by increasing the term by 5 to 10 years to lower monthly payment. As an example, monthly payment on a 30 year mortgage with 6.5% rate will decrease by 4.4% (or $1,172/year on a $350,000 mortgage) if term is increased by 5 years. An increase of term by 10 years would reduce monthly payment by 7.4% (or $1,960/year on a $350,000 mortgage).
  • Lowering payment without lowering interest rate may be more palatable from fairness perspective, and should be attractive to lenders if it avoids default. Removing any prepayment penalties should also be part of the modification as much as possible.
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