By Malay Bansal

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

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

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

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

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

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

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

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

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

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

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By Malay Bansal

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.

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.

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