In a research report released Thursday, Merrill Lynch looked at whether ABS widening will spell trouble for the CMBS sector. Analysts specifically addressed market concerns about the residential housing downturn and how this event could impact commercial real estate and CMBS.
These concerns have been in the minds of market players recently with the subprime ABS market experiencing a noticeable spread widening - at least as indicated by how the ABX index has traded, Merrill analysts said. For instance, the triple-B minus 06-2 index came close to the +1000 level earlier in the week last week, or out from +750 a week before that and sub 500 a month back. Merrill said that it has since recovered some and was closer to 870 basis points over as of last Wednesday night's close.
The firm said that this move has caught market participants' attention, especially those in the credit markets, as there is current concern over how this movement will affect sister products of ABS.
However, despite these apprehensions, Merrill analysts believe that the movement in the ABX index has not had any impact on CMBX nor is it expected to by them. Triple-B CMBX spreads, analysts believe, have virtually remained slightly tighter over the week and were still somewhere right at their all time lows as of the time the report was published. Triple-B minus off of the CMBX.2 index was then approximately two basis points from its late January low, they said.
The fundamentals driving residential housing - specifically subprime collateral - are very different compared with that of the commercial market, Merrill analysts said. Thus they retained their positive out look for most sectors of the commercial real estate market with fundamentals actually still improving.
The risk to the CMBS market stemming from a continued residential market downturn would be a "second order effect," analysts said. In other words, a continued and meaningful drop in the housing market could have a potential negative economic impact. For instance, this event could stop consumer spending, which, in turn, might eventually cause a reversal in fortune for commercial real estate, Merrill said. Each of these processes would, however, happen with a reasonable lag time, leaving analysts to believe that CMBS credit performance will stay strong throughout the year.
The widening in ABS will not attract buyers at the expense of CMBS, analysts believe, resulting in the latter's spreads widening. The number of investors who actually look at the residential ABS / CMBS crossover trade would have only a small impact on the demand picture, Merrill said.
A way in which the trouble in ABS land could have a spillover effect on CMBS is via CDOs, Merrill analysts said. They think that the triple-B sector has stayed essentially rich with the strong technical bid from CDO investors. If there was any reduction in ABS CDO volume resulting from the troubles in the subprime market, that might hinder demand for triple-B CMBS collateral, Merrill said.
Thus far, analysts said they have not witnessed any sign of this happening, nor do they really expect to. Aside from this, the effect of this would be limited to the lower mezzanine CMBS tranches, would be muted because analysts would expect the CRE CDO business to stay intact. Considering this, analysts think that the credit quality curve in CMBS would be remaining flat and triple-Bs should stay rich.
Negative events in the subprime residential market should serve as a wake-up call for the CMBS participants, Merrill analysts said, noting that deterioration in subprime underwriting standards - such as making loans to borrowers that should not have been made - is the foremost reason being cited for many of the current subprime home-equity woes. Subprime lenders are now reconfiguring their guidelines that they hope will help the market, Merrill analysts said. A bullish real estate market can "absolve the sins" of bad underwriting standards, allowing more risky loans to pay off or defease. But mortgages underwritten at the top of the cycle are more at risk, analysts said, and loose underwriting would make any performance change worse.
The market is continuing to experience a deterioration in CMBS underwriting standards, analysts said in the report. While they do not believe a commercial real estate cyclical turn will happen in the near term, or even that the 2006/2007 vintage will perform poorly, analysts still think that these mortgages are still more sensitive to negative real estate performance compared with prior vintages.
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