Derivative contracts that reference commercial mortgage loans held by third parties could be the next evolution within the growing synthetic CMBS market, according to a report issued last week by Nomura Securities. A deal using such contracts would reference a synthetic portfolio of loans from various lenders and vintages using information garnered from commercial data providers - effectively creating a mix of geographies, vintages, property types and originators impossible to garner through the cash market.
The development is likely not far off in the market, as interest in credit default swaps and CMBS continue to flourish amid relatively tight spread conditions. The most likely reason such a deal has yet to reach the market, according to the firm, is due to back office complications. "You can find the information on the loans, but I think it would be a little harder to put together the documentation," said James Manzi, vice president and CMBS analyst at Nomura and an author of the report.
The market for synthetic CMBS bonds has increased in the footsteps of the synthetic home equity ABS market - and generally, for the same reason. The use of derivative contracts is allowing CDO issuers and others to ramp up using innovative structures and a wider choice of underlying collateral, as well as a number of innovative hedging techniques. The Needham, Mass.-based investment manager CWCapital Investments in May 2005 was the self-acclaimed first manager to close a CDO that included synthetic CMBS bonds (CWCapital Cobalt I.) Along with growing liquidity within the single-name CDS market for CMBS, tradable indices for synthetic CMBS bonds, called the CMBX, were introduced by Markit Group on March 6 - three months after its asset-backed equivalent ABX.HE.
Currently, the growing use of synthetics within the CMBS sector could be leading to higher yields at a lower level of risk. A number of CMBS investors have commented on loosening underwriting standards within the sector recently, as well as diminished risk premiums. Because of the high demand for the securities, those two characteristics aren't expected to go away anytime soon. "Standards will likely not tighten back until either we see a major credit event, or investors lessen their demand for the products," Manzi said.
In order to gain higher spreads, a number of dealers have delved into lower rated cash CMBS, but even among the triple-B and triple-B minus tranches, spreads are looking tight. One solution to the problem offered by Nomura: investing in highly leveraged synthetic deals which reference highly rated CMBS assets. For example, at Libor plus 135 basis points, the first-loss class of a synthetic resecuritization of triple-A rated AJ tranches would offer about the same yield as the triple-B minus tranche of a so-called fusion CMBS deal, according to a sample scenario prepared by Nomura.
But, as the firm's analysts noted, one of the most important factors related to synthetic CMBS investment is understanding of both aspects. "Ignorance in either area could lead to costly mistakes," Nomura analysts wrote.
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