Mortgage market participants have been keeping a close eye on the CMBS market, which has seen spreads gap out drastically in recent months.
While many CMBS industry experts argue that credit concerns are overblown, the current crisis of confidence in the capital markets has made the entire mortgage sector virtually illiquid, driving down valuations. As a result, banks might face significant write-downs in the coming months as they mark-to-market their commercial mortgage assets, which could further pressure their already bruised balance sheets.
On Jan. 22, Wachovia recorded a loss provision of $1.5 billion for the fourth quarter of 2007 as a result of the "significant deterioration in the residential housing market and the related portions of the commercial real estate portfolio." Merrill Lynch wrote down $230 million in CMBS for the fourth quarter 2007, and Credit Suisse had a net CMBS write-down of $353 million for the quarter.
Then, late last month, as banks began to forecast first-quarter 2008 earnings, KeyCorp said it could face a $65 million loss in its portfolio, which is primarily made up of commercial real estate loans, due to volatility and illiquidity in the mortgage market. The bank said that it had approximately $545 million of commercial real estate mortgage loans held for sale as of Feb. 13. These loans were hedged to protect against interest rate changes but were not completely guarded against spread widening that has caused their value to decline.
Spread widening in the CMBS sector will pose challenges to bank balance sheets over the next several quarters, analysts project. Historically, the commercial real estate market follows residential real estate market trends by about two quarters, so commercial real estate valuations are potentially at risk in the very near future, Sanford C. Bernstein & Co. analysts said in the report.
They also said that all of the large domestic security firms were top-10 underwriters of U.S. CMBS in 2007 and have significant "net" commercial real estate and/or CMBS positions. Lehman Brothers has the highest exposure to commercial real estate-backed securities with $39.5 billion, while Morgan Stanley is not far behind with $31.5 billion in exposure, according to Brad Hintz, an analyst at Sanford C. Bernstein.
Last year, Morgan Stanley ranked number one on the 2007 U.S. CMBS manager league tables with $32.4 billion and a 14.5% market share, according to data provider Dealogic, which was cited in a Sanford Bernstein report. Wachovia and Banc of America Securities took the second- and third-place spots with $30.9 billion and $18.2 billion in issuance, respectively. Citigroup was not in the top five CMBS underwriters for 2007, but at the end of the fourth quarter the bank held $20.4 billion in direct loan commercial real estate exposure. Goldman Sachs analysts predicted last week that Citigroup could take a $12 billion write-down in securities, including CDOs, MBS and CMBS in 1Q08.
Goldman Sachs also predicted that Bear Stearns would face $1.4 billion of additional write-downs in the first quarter, primarily driven by Alt-A and CMBS exposure, while JPMorgan is facing $3.4 billion of additional write-downs across leveraged loans, RMBS and CMBS.
One driver behind CMBS spread widening is the lack of liquidity as well as concerns over the refinanceability of certain loans given the pullback by conduit lenders and the uncertainty over property valuations. These concerns are particularly true for floating rate CMBS and have made the sale of floating-rate transactions all but impossible to execute, said Lisa Pendergast, managing director in real estate finance and CMBS strategy and research at RBS Greenwich Capital. Moreover, the once core investors of floating-rate CMBS - non-U.S. investors and SIVs - are no longer investing or have temporarily pulled back from the market, further adding to the difficulties.
Investors have been taking advantage of performance uncertainties in the CMBX, whether or not they actually believe there is reason for concern, which has fueled volatility in the market. "The investors who blindly bought and sold instruments like RMBSs, CMBSs, CLOs, CDOs, CDO2s, CDO3s and the paper issued by VIEs, QSPEs and SIVs without knowing what they were buying and selling are now doing the same with Markit indexes that they know nothing about either," said Dick Bove, analyst at Punk Ziegel & Co., in a research note.
The volatility and subsequent spread widening has caused many classes of investors to back away from the market, particularly levered investors.
"Spread volatility can result in a margin call which will knock out levered investors, so many are sitting on the sideline," said Alan Todd, executive director and head of CMBS research at JPMorgan Securities. And while some real money players have invested further at current spread levels, it has not been particularly broad-based, Todd said. "Many [real money investors] have gotten into bad long positions,' where they have gotten longer and longer as spreads widened and are now looking at fairly significant mark-to-market losses. And despite the money goodness, when you have people staring over your shoulder because you have a long duration asset that is widening out, it not only limits your ability to go out and buy anything new but it also heightens your risk aversion."
However, while CMBS defaults are expected to rise, they will be coming off historical lows, RBS Greenwich's Pendergast said. "We may see fixed-rate delinquencies rise to 2% or even more over the next 12 to 18 months, but we've been at those delinquency rates before in the history of the CMBS marketplace, and frankly the reaction was nothing close to today's," she said, noting that in October 2003 the delinquency rate including 30-, 60- and 90-day-plus delinquencies, loans in foreclosure and REO loans totaled just under 2.5%.
At the same time, triple-A credit support was around 16.5% and bonds were trading at swaps plus 30 basis points. However, today, triple-A bonds boast 30% credit enhancement, almost double that of 2003, and the delinquency rate is just 0.47%, but spreads are at swaps plus 200 basis points. "It doesn't make a lot of sense fundamentally," she said
In total, $44.2 billion of commercial mortgage loans are maturing in 2008, including $19.5 billion of fixed-rate and $24.7 billion of floating-rate loans, Tad Phillip, managing director in commercial real estate finance at Moody's Investors Service, said in a recent conference call. He expected that 14% of the loans rolling over would have refinancing difficulty.
But most of the floating-rate loans that are resetting this year were made in 2006, and 94% of those loans have two-year terms with extensions mitigating their rollover risk, Phillip said.
Older loans, which include fixed-rate loans that traditionally have a 10-year term, have had a good tailwind that will help them through this refinancing period, Phillip said. "Properties supported by fixed-rate loans made between five and 10 years ago have had a big cushion built up. They may have had a 20% cushion already, and with property prices going up, build up an additional 50% cushion," Phillip said.
Property Values Shrink
However, this equity buildup in not insoluble and can shrink with property value declines, which are widely expected to drop 15% to 20% over the next few years, according to analysts. The growth in equity or the growth in property values which would imply equity growth, has largely been the manifestation of aggressive lending, JPMorgan's Todd said. "Credit expansion will lead to asset inflation, credit contraction will result in asset deflation," Todd said, noting that over the last two to three years property prices have gone up approximately 50% but cash flows have only grown by approximately 10%.
Seasoned loans coming due over the next year should not have trouble refinancing, Pendergast said. For example, the 1998 through 2004 vintages were secured by assets that had valuations at the time of issuance that were far lower than today's. "Even if you assume that property valuations today are going to fall a year from now, there should still be equity buildup in these older vintages. The increased equity is also helped by the fact that most of the loans were amortizing, suggesting even further equity buildup," she said.
In 2008, investors are going to be looking for more reasonable cap rates, north of 2007 numbers, which were at 5% and 6%, said Jim Barnard, director at Mission Capital Advisors and previously associate director in Bear Stearns' real estate capital markets. Barnard also expects that, after several quarters, the bid spread will start to narrow as sellers begin to recognize that property values are not what they thought they were.
Write-down concerns and wider spreads implying defaults are legitimate when looking at the bottom of the capital structure, in the triple-B area and below, market experts agreed. But for now, and most likely for the next 12 to 24 months, as property prices continue to decline, volatility will keep spreads wide, driving down new issuance volume, market participants say.
"Wall street has an originate-to-distribute model. Given that market volatility has resulted in limited certainty as to where one can price a deal, it makes it very difficult to price loans properly," Todd said.
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