Tight Underwriting, Spread Volatility in CMBS Equals $40B Max

MBA (4/15/2008 ) Murray, Michael
With tightening underwriting standards and spread volatility continuing in the commercial mortgage-backed securities market, CMBS will likely price a maximum of $40 billion this year, said J.P. Morgan, New York.

“Overall, we find that the property, origination and securitization markets look to be quickly searching for a new equilibrium,” the weekly J.P. Morgan report said. “Cap rates are generally on the rise as buyers dominate the terms and the loans currently being originated are being held to rapidly tightening standards.”

Tom MacManus, chairman and CEO of Cushman & Wakefield Sonnenblick Goldman, New York, said CMBS issuance would not likely return to normalcy, "however that may be defined when it happens," for 12 to 18 months and possibly more.
"In the meantime, this a great time for lenders in the market to get very attractive risk-adjusted pricing—while all in nominal rates still remain attractive to borrowers," MacManus said. "In general today most capital providers have returned to a fundamentally sound approach to structuring debt and or equity requiring more attractive risk-djusted returns and rational structures."

Heightened spread volatility has made loan underwriting extremely difficult for CMBS originators—unable to know their ultimate pricing—and balance sheet constraints eliminated the ability for many originators to create new loans and hold them until the market recovers. Cash and synthetic spreads in the first quarter this year reached “new wides” based on consistently high volatility, the report said.

On Monday, Charlotte, N.C.-based Wachovia Corp. reported $2.8 billion in credit losses, nearly $2 billion in writedowns and net valuation losses of $521 million in commercial mortgage structured products. However, it did not have a major impact on the market. Last week, several financial firms reported increases in their Level 3 Assets, or those that are hardest to value, increasing concerns among investors that Wall Street would see more write downs.

“Nobody really knows the depths of the problems in commercial real estate yet,” said Clain Brandt, principal of BIHT Ltd., a sovereign wealth fund based in the Channel Islands.

Although some of the spread pressure was because of weak fundamentals in the sector, headline events related to the economy and financial markets at large were perhaps the biggest drivers on wider spreads, and they continue into the second quarter, the report said.

“Essentially each of the sharp sell-offs and rallies had some macro-economic, or larger financial market, factor associated with it,” the report said. “For roughly the first two months of the quarter, spreads widened sharply in anticipation of, or in reaction to, increased bank write downs, weak economic numbers and hedge fund unwinds."

The report said that passage of any new legislation would likely provide some relief to residential mortgages—particularly at the top of the capital structure—but the benefits appear less significant than initial industry expectations.

“In the second half of the quarter, these gloomy headlines were replaced with news of potentially extensive government intervention, sparking the sharp short-covering rally,” the report said.

“We believe these forces will likely pressure spreads wider over the next few weeks, even at the top of the capital structure,” said Alan Todd, head of CMBS at J.P Morgan Global Structured Finance Research. “Even though synthetic triple-A spreads may have tightened closer to what many think is a fair value level, their use as cheap shorts will likely push them wider over the near term.”

J.P. Morgan said it remains “neutral to slightly negative on the triple-A basis” during the very short term, but added that investors should continue to add long-risk exposure at the super-senior and ‘AM’ tranches on any spread widening.

“Although the bottom of the capital structure will feel many of the same pressures, we believe many of these tranches have become fundamentally rich after the rally,” Todd said.

The report said underwriting standards continued to improve among most measures in the first quarter after becoming “increasingly aggressive over the prior several years,” the report said.

Debt service coverage ratios fell, loan-to-values increased and bonds were protected by low subordination levels, but by the third quarter last year, Moody’s investors Service, New York, and the other rating agencies indicated potential increases in subordination levels. While subordination levels rose, appetite for risk declined, particularly for deals that contained the most aggressively underwritten collateral, which widened spreads more and reinforced hesitancy among originators, the J.P. Morgan report said.

Sharp declines in the fourth quarter continued into the first quarter with a total of three deals priced at less than $4.5 billion.

“This low issuance clearly depicts the dislocation in the ‘originate to securitize’ model," Todd said. "Given these conditions and their likely continuation, we foresee continued low issuance through 2008. For the entire year, we'll likely see totals less than that of the peak quarters in 2006 and 2007, as we expect at most only $30-40 billion to price this year.”

“We’re going back to what the CMBS was in 1992 when it first rolled out as just an alternative to the life insurance companies,” Brandt said. “It never should have gotten to the point to where it was when it fell apart by September of last year.”

By the middle of 2007, deal size peaked with an average near $4 billion, as the largest loan’s average size reached $410 million in the first quarter. This year, first quarter average deal size was down to $1.5 billion, off more than 60 percent from its peak, and average maximum loan size dropped 68 percent to $133 million, JP Morgan reported.

“The nature of the debt stack, the equity stack just to finance deals has changed,” said Sam Chandan, chief economist at Reis Inc., New York. “That means that there are fewer buyers. The cost of debt financing and transactions are significantly higher than it was last year and that is going to impact how competitive people are going to be in bidding on properties.”

In the first quarter of 2002, more than 92 percent of loans were fully amortizing, later dropping to 13 percent of loans in the first quarter of 2007. JP Morgan said underwriters are now accepting fewer full-term interest only loans, replacing them with a greater percentage of partial-term IO loans and amortizing deals—up nearly 20 percent. Loans also require higher cash flows relative to debt service and lower loan amounts relative to property value.

Based on average subordination levels across seven bond classes over time, subordination level increases accelerated in the first quarter this year—117-228 basis points higher than the lowest levels from the first half of 2007—with the largest percentage gains at the mezzanine and bottom of the capital structure, the report said.

Fitch’s stressed DSCR fell from nearly 1.40x in early 2002 to 1.07x on average in the second quarter of 2007, J.P. Morgan reported.

“The DSCR declines for deals rated by Moody’s were even more severe, dropping from an average of 1.40x in early 2002 to around 0.85x as of 2Q 2007,” the report said. “Although Moody’s has only rated two of the five fixed-rate deals brought forth this year, their average stressed DSCR jumped around 25 [basis points] from the values at the end of last year.”