CMBS: ‘No Skeletons in the Closet,’ Study Says

MBA (6/10/2008 ) Murray, Michael
While some industry analysts find low delinquencies and unjustified spreads in the commercial mortgage-backed securities (CMBS) market, others see a different set of issues holding back the market.

Current spreads for most CMBS vintages remain far wider than their fair value, but significant arbitrage opportunities exist for investors, said a study authored by Jun Han, founder and principal of JHP Capital, a New York City-based commercial real estate investment consulting firm. The study was commissioned by the Commercial Mortgage Securities Association.

"There are no skeletons in the CMBS closet," Han said. "Market fears and the liquidity crunch have dramatically distorted the value of commercial mortgage-backed securities, creating one of the best environments in history for investing in CMBS."

Clain Brandt, managing principal at BIHT Ltd. International, a sovereign wealth fund based in the Channel Islands, said the CMBS market would not return sooner than 12 to 18 months.

“It's going to take that long for investors to feel confident what they're purchasing is in fact worth what it's being priced at [regaining confidence in the rating agencies], but also the insurance is there to back their purchases up,” Brandt said.

Fitch Ratings, New York, expects more volatility in commercial real estate collateralized debt obligations (CRE CDOs) rather than with the CMBS delinquency index. CRE CDOs fall in a smaller universe of loans—35 CRE CDOs at $23.8 billion—compared with 500 CMBS deals at $562 billion. Fitch reported CRE CDOs at nearly three times the U.S. CMBS April loan delinquency rate of 0.35 percent.

Commercial mortgage delinquencies “are just a fraction of those experienced for residential mortgages,” based on a Global Trends Report from Real Capital Analytics, New York. The report said commercial real estate prices never soared and peaked as high as residential values—commercial prices off 2.6 percent since their peak while housing prices were off 15.8 percent nationally—and supply was constrained in commercial real estate.

Federal Reserve Chairman Ben Bernanke recently said investors of other highly complex securities—including commercial mortgage-backed securities—lumped together the complex vehicles with subprime residential mortgage-backed securities.

Brandt, however, said there is inherent risk involved with any security backed up by a commodity—including real estate—that has historically fluctuating prices.

“For the moment, until proven otherwise, real estate is real estate,” Brandt said. “We have not seen the bottom of the residential market, and anyone who has been in this business for over 30 years can tell you, problems in that segment of the industry eventually flow over in the income property/commercial side. You cannot bifurcate one segment of the industry from the other and pretend that commercial has immunity over residential real estate. Is no one around who recalls how commercial real estate's downfall post 1986 caused a major downturn in the residential industry?”

Han’s study performed multiple stress tests on CMBS bonds based on three historical and worst-case recession scenarios, analyzing more than 19,500 commercial mortgage loans in the 675 CMBS bonds that make up the four CMBX indices—nearly 39 percent of fixed rate conduit CMBS outstanding.

Han said recently traded CMBX 4 index spreads—one of the CMBX indices created to leverage CMBS pricing—implied that the annual collateral default rate would hit more than 100 percent for AAA-rated CMBS on March 20, compared to an historical CMBS average of less than 1 percent.

"Just how off-target is the CMBX market? We can actually put a dollar value on it," Han said.

He applied a worst case 1986 stress test scenario—the worst performing vintage from the savings and loan fallout. In the stress test, CMBX 4 index spreads hit nearly 1,200 basis points over treasury bills, nearly twice as high as fair value expectations.

“This demonstrates the kinds of distortions and limitations of ceding the determination of value of the nearly $1 trillion CMBS market to an untested and volatile derivatives index during an unprecedented credit and liquidity crisis," Han said.

“We think spreads at the top of the capital structure are likely to remain relatively range-bound into the summer months but would look to add exposure if spreads widen from their current levels,” said Alan Todd, head of CMBS research at JP Morgan Securities, New York.

But Brandt, noting that "it's not just stable spreads," questioned fiduciary relationships between ratings agencies and securitizers. He said potential government policy and oversight of the capital markets, bond insurance, future hedging strategies and the economy’s future could mean that a CMBS market revival could take time.