With the first round of the Federal Reserve's Term Asset-Backed Loan Facility (TALF) for CMBS set for the end of June, market players remain cautiously optimistic that the program could add some much-needed momentum to the sector.
However, experts said that it won't serve as cure-all for the fundamental problems that the CMBS market faces. The expectation for 2009 is for modest CMBS issuance , with much of the activity spurred by this TALF expansion.
"The May TALF sale was a great success, with more than $13 billion of eligible consumer ABS pricing," Citigroup Global Markets analysts said. "Large-scale spread tightening has recapitalized many investors and converted sidelined players into buyers."
They stated that this turn of events has provided legs to the spread rally, which has caused spreads to tighten even further, a trend they expect to continue. However, since consumer ABS has already shown a good move, it might be time to consider CMBS and RMBS as government policy starts to focus on those sectors, Citigroup analysts said
Citigroup analysts added that the five-year new-issuance TALF program could go as far as encouraging origination of new commercial mortgages and, eventually, securitization. "While the financing terms are complex, they do not significantly detract from the investment value in CMBS," analysts said.
Even if deals are slow to come to market and are issued in smaller size, it should provide support for spreads. The leverage offered by TALF could also provide an additional couple of hundred basis points of upside for super senior bonds. "As leverage is reintroduced into the system, however, we expect that investors will once again begin to chase products that offer the most spread/highest yield," JPMorgan Securities analysts said.
Working It Out
However, there are still some issues and a lot of details that need to be sorted through before the market can realize the full effect of the program. One concern, said Cynthia Williams, a partner at Dechert, is that the TALF program is slated to end in December 2009. "That period of time between now and the end of the year creates a relatively limited time frame," she said. "The question now is how soon can they get this up and running?"
Williams said that the TALF new-issuance CMBS program would be attractive to sponsors who want to securitize qualifying commercial mortgage loans currently on their balance sheets, although it remains to be seen whether the market would be able to originate a sizeable amount of new loans to fit the terms of the program between now and the end of the year.
Up until now, TALF loans have been three years in duration. However, the Fed has extended the terms, thereby calming concerns regarding the mismatch between the shorter facility term and the longer maturity schedules of securitized commercial mortgages that had been widely viewed as an obstacle to the efficacy of the program as it applies to CMBS.
The TALF program now permits TALF loans to be outstanding for up to five years secured by CMBS collateral with an average life of no more than 10 years. As a result, Williams said that some investors remain concerned about potential refinancing risks. Another concern for investors is how stable the final terms of the program might be - will the government change the rules on the people participating?
"Once people focus on new-issuance CMBS and decide what works best for them, you will likely see some changes and modifications to the program," Williams said. "The Fed has proved to be pretty flexible to make the terms of the program investor friendly. But, the Fed is unlikely to budge on maturity terms, as it has made it clear from the beginning that it doesn't want paper any longer than five years."
Legacy Assets
Sam Chandan, president and chief economist of Real Estate Econometrics, believes that recent introduction of legacy assets will create some much-needed liquidity on the secondary front, which will allay investors concerns regarding the tradability of these loans. The Fed expansion of eligibility for legacy CMBS will begin in late July. Legacy CMBS has been defined as securities issued before Jan. 1. As with new CMBS, longer-term, five-year TALF loans will be available for legacy CMBS investment.
The market was not expecting the announcement of legacy CMBS so soon after the Fed announced that it would include new CMBS as part of the program. "It's a very good question mark as to how much new CMBS will be issued anyways," said Laurence Pettit, a partner at Baker & McKenzie. "People didn't know how to make new loans against commercial real estate, but by presenting legacy assets the Fed has created the ability for players to issue in the near future."
According to Real Estate Econometrics figures, $264 billion in commercial mortgages (exclusive construction and land development loans) will mature in 2009; $273 billion will mature in 2010. By contrast, the largest Trouble Asset Relief Program recipients made only $5.8 billion in new commercial mortgage commitments in February. In March, new commitments totaled $6.5 billion. Exacerbating 14 consecutive quarters of tightening credit standards, Chandan said that many institutions have suspended new lending in commercial real estate or are deliberately diversifying away from the sector.
Matthew Sandiford, an associate at Baker & McKenzie, said that interestingly the Fed moved quickly to incorporate legacy CMBS assets when it has yet to get its Public-Private Investment Program (PPIP) off the ground, as PPIP was also designed for new investors to buy legacy securitization, including CMBS from banks. "PPIP, however, requires that banks have an acquisition buyer to match up with and decide on a price, but there is not much interest because buyers are waiting for asset prices to come down even lower, and sellers are not motivated to sell at distressed levels," he said. "Under the terms of TALF, sellers sitting on old assets can at least get something for it, or use it as a non-recourse loan."
It Takes More than Four Letters
It is unlikely that TALF will answer the deep profound questions on refinancing and defaults plaguing the future of CMBS.
Chandan pointed out that the constraints on lenders' capacity to engage in new lending have been a significant contributor to the current and projected deterioration in the commercial mortgage performance.
According to Real Estate Econometrics, 1Q09 projections show an increase in the national default rate to 3.9% by year-end 2009 from 1.6% at the end of 2008, and to 4.7% by year-end 2010.
The forecast increase in the default rate reflects relatively higher loan-to-value ratios on maturing loans, current deterioration in debt service coverage on loans not maturing and an imbalance in the supply and demand for credit resulting from a sharp increase in the volume of maturing loans and the absence of new lending and issuance.
Fitch Ratings analysts said defaults on commercial real estate loans are rising accordingly for mortgages that are linked to CMBS. The average rate of default among the hardest hit states increased 25 basis points to 1.78%, according to the rating agency's monthly CMBS loan delinquency index.
"Fitch does not expect TALF to have a direct impact on CMBS defaults," said Susan Merrick, managing director at Fitch. "However, it may add liquidity and result in property sales, financings and realistic property valuations, allowing borrowers to accurately value their equity, which, in turn, may incentivize borrowers to fund debt service on certain underperforming properties. In addition, CMBS defaults will likely improve as the general economic environment improves. TALF may contribute to that improvement."
Chandan said he also suspects that the potential for a dramatic deterioration in the performance of the underlying mortgages of recently issued legacy CMBS is a significant obstacle to the success of the TALF's legacy expansion.
"The expectation of increasing delinquency and default rates in the 2005, 2006 and 2007 pools, in particular, will limit interest among investor groups that are not able to independently evaluate the stability of the underlying properties' cash flows and the probable default trajectories of the pooled loans," he explained. "It is only to the extent that investors overcome these challenges that the newest TALF expansion has the potential to mitigate the shortfall in commercial real estate credit supply."
Even with success, TALF is not expected to generate the volumes that the CMBS market saw in 2006 and 2007, nor should it aspire to reach these unsustainable levels. Chandan said it was a mistake to think that the TALF had the potential to spur a robust securitization market in 2009. "It would be nice but unlikely," he said. "The market from 2005 to 2007 grew much faster than the market mechanisms. It's taught us that one shouldn't get out of step with the other, and we shouldn't be looking at TALF to get out of step again with increased levels of issuance that the market might not be able to handle at the moment."
Ultimately, the market needs to address an additional set of issues that have caused legitimate concerns around the nature of risk to which conduit originators respond, which is a much shorter term than the bank lender. Lenders said that they see a significantly lower demand for loans and refinancing. "It's not only the case that the credit markets are constrained with fewer buyers, but the demand is somewhat muted overall, and that tempers expectations for growth in the CMBS market," Chandan said.
He added that the broken relationship of the issuer to the rating agency still needs fixing. "What is the capacity of the rating agency to assess the underlying risk to these exposures at a level that investors will be comfortable with?" he added. "Steps must be taken to ensure that the realignment of systems is being addressed at a greater level."
These, he said are very legitimate concerns affecting the securitization market across the board, but participants are loathed to bring up these concerns again so as not to upset these positive steps that the market is taking with TALF.
The S&P Glitch
A possible hindrance to CMBS' success under TALF is the changes Standard and Poor's rating methodology.
Last month, S&P released a request for comment on a proposal to change its ratings methodology for fixed-rate CMBS conduit and fusion deals. The agency stated that it expected to downgrade 25%, 60% and 90% of super-senior 'AAA' bonds issued in 2005, 2006 and 2007, respectively. Bank of America/Merrill Lynch analysts noted in a report that if S&P's new methodology is implemented it will likely prompt a significant number of downgrades in recently issued - 2005-2008 vintage - CMBS conduits.
These include the super-senior classes of these transactions. Such downgrades, if they happen, place a considerable part of the CMBS universe in danger of no longer being TALF-eligible under the current Legacy program's guidelines.
The current triple-A rating on the senior bonds is a key determinant of value under the Legacy TALF guidelines. Considering the high percentage of deals S&P rates, and the firm's projection for heavy downgrades, this jeopardizes the effectiveness of Legacy TALF for CMBS, according to BofA/Merrill analysts.
What happens from here is difficult to project, according to analysts, but there are a few possibilities. They think there is a good chance the Federal Reserve revisits their inclusion criteria for the TALF Legacy program. Analysts think that S&P is very interested in industry participants' feedback on this proposal.
While it is impossible to say if S&P will make changes to its proposed criteria, institutions are encouraged to voice their opinion with the rating agency, BofA/Merrill analysts noted.
To give meaningful feedback, BofA/Merrill analysts would like to see more data on S&P's methodology and its implications, and not just forward looking but backward looking as well.
A question that analysts believe would be constructive to have answered is "what would the performance, the ratings and the rating migration of transactions that were brought over the past 10 years look under the new methodology?"
Meanwhile, a corollary to this question is: "What probability is S&P targeting, at each rating category, for a bond to default?"
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