There are those who predict that the next sky to fall with be the one above CMBS. The question for our markets is: Will it also land on leveraged finance?
“There is no doubt that [a widespread collapse in the CMBS market] would impact the leveraged finance market,” said a California-based investor. “There is a general correlation between the debt markets. If CMBS goes bad, other assets will sink with it. It would detrimentally impact the amount of capital banks have to redeploy to other assets, not to mention the general negative impact on the economy and therefore corporate credits.”
The CMBS market — which comprises mortgage loans made to apartments, offices, shopping malls, warehouses and hotels — has been hit hard by the recession. The fear intensified last week after Capmark Financial Group, a massive commercial real estate lender, filed for bankruptcy protection. Capmark formed in 2006 when GMAC agreed to sell the majority of its commercial real estate business to Kohlberg Kravis Roberts and other firms.
The default and delinquency rate for CMBS loans has risen to 4.52% from 0.8% this time last year, and from 3% in the second quarter, according to Reis Inc., a data provider for the commercial real estate market. Defaults may top 6% by the end of the year. Overall, U.S. commercial real estate values have fallen about 40% from their peaks in 2007.
The government’s Term Asset-Backed Securities Loan Facility (TALF) has reportedly made about $40 billion in TALF loans to investors who have bought these securities. While this has helped, some market participants say TALF will not be able rescue the entire CMBS market, especially with the lingering problems in the housing market and the fact that $500 billion in commercial mortgages are set to mature in the next few years. The commercial real estate market stands at approximately $3.5 trillion.
“A further deterioration in the CMBS market would mean two things. It could affect confidence in the market and banks’ willingness to lend,” said Neal Schweitzer, an independent observer of the leveraged loan market. That is because banks are required to hold a certain amount of capital under Basel and other regulations, he added.
What’s compounding the problem for the CMBS market is the fact that little has been done to correct weaknesses there, unlike the leveraged finance market, where practices such as “amend and extend” have become commonplace.
“I haven’t seen the same sort of entrepreneurial spirit among investment bankers and bankruptcy lawyers in the CMBS market as I have in the loan and bond market,” one market analyst said. “That implies that this market is really sick, and that it’s very difficult to fix. Maybe there are some folks out here who have some tricks up their sleeve in terms of how to bailout this market. It’s the most problematic asset class going forward.”
Besides the impact it could have on sell-side firms, a significant crash in the CMBS market could hurt buy-side players too, sources said. Institutional investors would be less likely to invest in bank loans or high yield bonds if their CMBS book took a significant hit, sources said.
“I do think that the CMBS meltdown is already having an effect on structured finance investors,” said an investor, who specializes in structured products. “Most CMBS buyers bought other credit-related structured products. These problems have an overall effect on their portfolios and the perceived higher risk profile of CDO investments.”
A New York-based investor added, “There is significant correlation between [the leveraged finance and CMBS] markets. It is all about funding and liquidity.”
However, not every player involved in leveraged finance will be impacted. “Not every investor has a large CMBS exposure,” said Schweitzer. “But if you do, there will be a reluctance to expand in any substantial way to leveraged finance.”
Market watchers also pointed out another way a CMBS meltdown could hurt the leveraged finance markets: prices. “If CMBS cracks and gets insanely cheap, other similar fixed income asset classes have to cheapen a little to maintain relative value,” said a CLO manager. “If banks try to blow out CMBS at cheap prices, but find no buyers, would they sell other stuff, perhaps corporate loans, to offset those losses?”
But while some market participants seem to fear a CMBS meltdown more than seeing Hannibal Lecter in a dark alley, others aren’t as spooked.
“The CMBS market has already blown up. And so far there has been no effect on the [loan] market,” said an investor specializing in midmarket loans.
A Boston-based investor added, “It’s the flavor of the day for the Chicken Littles. I think they are slowly running out of things to panic about. I don’t think the numbers in CMBS are big enough to rock the system.”
But whether you believe the sky is falling or not, keeping an eye on the CMBS market isn’t a bad idea. “Remember, it all started with the subprime market,” a New England-based investor said.