Commercial Defeasance Turns to Hedging Strategy

MBA (5/29/2008 ) Murray, Michael
With defeasance out of the commercial mortgage backed securities (CMBS) picture for the time being, one company has turned its attention toward hedging strategies.

"Defeasance is certainly still out there as a concept but because it depends on sale and refinance transactions to take place, in order to trigger the need to defease, volume is certainly down significantly just as lending volume is down," said John Hosmer, CEO of Commercial Defeasance LLC, Charlotte, N.C. "I think until we see more liquidity and capital in the marketplace, defeasance volume will still be depressed."
Commercial Defeasance LLC continues to service its defeasance loans in "several hundred billion dollars worth of CMBS loan documents," but Hosmer said the slowdown provided the company an opportunity to look at another concept—hedging interest rate risk. The company announced earlier this month formation of Custom Hedging Solutions LLC to advise commercial mortgage firms on managing interest rate risk through derivative products, including interest rate swaps, caps and options.

"It is something that our customers had inquired about periodically over the last year or two years, and it is something we had been discussing at a high level but were prompted to take steps to actually implement it as we had a little more time on our hands," Hosmer said.

Jennifer Imler, managing director of Custom Hedging Solutions, said Commercial Defeasance clients are learning the importance of managing interest rate risk in the current environment.

"Profit margins are not what they were a couple of years ago," Imler said."[Borrowers] are not seeing the same appreciation."

Imler said the new Custom Hedging Solutions could help borrowers with a floating rate debt by capping it or turning it into a fixed-rate loan. Also, if borrowers have future borrowing needs, they could lock in a loan through the LIBOR or swap curve.

"We can also help [borrowers] hedge their defeasance premium," Imler added. "We are even talking to people now about hedging—in the future—any type of prepay penalty they would have based on yield maintenance loans."

Hosmer said Commercial Defeasance is cautious about choosing the right business line without distractions from its primary services and that the right staff needs to exist to implement the business.

Imler, for example, traded and marketed derivative products at Wachovia Securities, Charlotte, N.C., for more than seven years, and worked on its commercial mortgage trading desk hedging a multi-billion dollar conduit warehouse while structuring derivatives into CMBS transactions.

"There is definitely a role for our defeasance employees for making our customer base aware of these projects and having sufficient education to speak intelligently about them," Hosmer said.

The CMBS market, in a holding pattern mostly since August, found some solace last month as synthetic CMBX spreads started to narrow, bringing some consistency to the market. However, many industry analysts said it would take another year—until mid-2009—before the CMBS market reaches any sense of normalcy.

"We're hopeful that by the end of the year, we see some uptick...maybe that'll come in 2009," Hosmer said. "One thing that we do know is that markets in the United States are very efficient and sooner or later, where there's a need and there's demand, someone will fill that demand with supply. It's just a question—in my mind—of when."

Hosmer said it will take time for some stability before the more typical CMBS investors at different levels of the credit stack return to the market, but the first step already taking place in tighter underwriting. Until then, Commercial Defeasance focuses on its current deals and attends to customer needs and requests waiting for the lending market to return.

"I think now we need a little bit of stability and some of the players to step up, make some loans and test the waters in the securitization market to give everybody a little bit of guidance," Hosmer said. "As to when that will take place, I don't know. I only know it will happen."