The Fed's Chicken-and-Egg Problem with CMBS

Originators want to originate new loans, investors want to buy bonds with new conservatively underwritten loans, Treasury & Federal Reserve want the new issue CMBS market to start, borrowers certainly want to take out new loans to refinance maturing loans, and yet, four months after the Treasury launched the program, not one new issue CMBS deal has come to the market.

This highlights the chicken-and-egg type problem that the CMBS market faces. Everyone knows that the new origination will be of higher quality and so should have tighter spreads than the legacy bonds. Yet, lacking an efficient hedge, all that the originators have for indication of spreads are the legacy bonds, which are still too wide for new issue deals. In other words, originators are looking for tighter and stable bond spreads to originate, and market is looking for new collateral for tighter spreads – sort of a chicken-and-egg type problem.

One solution is to wait till legacy bond spreads tighten and stabilize, giving loan originators more confidence, but that might mean new issue TALF program may not get much traction before it ends. Another approach is to accelerate the legacy TALF program by removing some of the uncertainty that borrowers in that program face today. There are two easy to implement steps that will be helpful and allow investors to buy bonds throughout the month, rather than waiting till just before the TALF subscription date. First, the price used for calculating loan amount can be adjusted for interest rate movement from purchase date to the subscription date, and second, Federal reserve can allow potential borrowers to submit a list of potential bonds for purchase before actually buying the bonds, with approvals announced two or three weeks before the subscription date. Pre-approval of bonds will be almost as effective as disclosure by the Fed of their bond approval (or rejection) methodology, which more and more market participants are asking the Fed to do, and which Fed has been reluctant to do, probably because doing so might reduce their flexibility.

Disclosure: Long PCM.

Comments

[Westcoaster:]

Malay,

Thank you for your insight and suggestions. CMBS needs to come back and will. A few of the other reasons it is still gone is a result of the government allowing special servicers the right to do work-outs with the borrowers. This has been very helpful and has slowed the foreclosures of many CRE, to the point that I believe is lowering the demand for new loans much more than the government and the market may have expected. I think they thought that because CMBS wouldn't do a workout the balance sheet lenders would need to come in and fix this market. All of the private equity funds thought they could come in and steal depressed CRE, this is just not happening. Instead they must sit on their cash and be content with a 3.5% return. Tax free bonds are down to 2%. Yes, this is good news. Cash holders must be punished for them to start taking new risks (CMBS) in the future.

Oct 30 02:28 PM

[crabsofsteel:]

Dear Mr Bansal,

I am new to this site. Why do you think investors, having been burnt by bogus ratings investing in a credit product where the credit is hidden or unknown, would go back and buy into it again? Do you really think that the people behind TALF are capable of distinguishing bonds which are money-good from future writedowns? I have not seen anything which would lead me to think so. What have you seen that supports your opinion?

MB

Oct 30 09:29 PM

[Malay Bansal:]

Speaking about CMBS, I will make two points.

One, obviously ther ecan always be more information, but the credit aspect is not completely hidden. There is a lot of information of information available that investors can look at.

Second, majority of the bonds that are eligible for TALF (senior most ones that have not suffered even downgrades even at this point after real estate prices are down more than 40%) are not expected by majority of market participants to take ultimate principal losses.

Also, Federal reserve folks implementing the plan are taking a cautious approach (some think too cautious) and are also using outside experts to help them where needed.


On Oct 30 09:29 PM crabsofsteel wrote:

> Dear Mr Bansal,
>
> I am new to this site. Why do you think investors, having been burnt
> by bogus ratings investing in a credit product where the credit is
> hidden or unknown, would go back and buy into it again? Do you
> really think that the people behind TALF are capable of distinguishing
> bonds which are money-good from future writedowns? I have not seen
> anything which would lead me to think so. What have you seen that
> supports your opinion?
>
> MB

Oct 31 04:37 PM

[crabsofsteel:]

>One, obviously there can always be more information, but the
>credit aspect is not completely hidden. There is a lot of
> information available that investors can look at.

I'll agree that there is a lot of information for investors to look at. However, it is not enough information. If you think of buying a bond as loaning out money, wouldn't you want to know who you are loaning that money to?

Take a deal and tell me how much exposure there is to, for example, Babcock & Brown. You cannot do this because the data isn't there. How could these deals be credit-rated without knowing the credit concentrations of the borrowers and tenants?

> Second, majority of the bonds that are eligible for TALF (senior
> most ones that have not suffered even downgrades even at this
> point after real estate prices are down more than 40%)

It's a little hard to trust anything the ratings agencies do anymore, don't you think? All three who rated CMBS have dropped ratings on AAA paper, most of the junior AJs and some cases senior. May I ask, if AAA is supposed to mean as good as gold, why were there ever such things as junior and senior AAA in the first place? This whole model was a house of cards, for which taxpayers will now pay for yet again, this time via TALF.

> are not expected by majority of market participants to take
> ultimate principal losses.

You admit that CRE is down 40%, and I agree because I can find evidence thereof. There is no reason to expect underwater borrowers to behave any differently in the commercial market than they did in the residential market. I can't speak for the majority of market participants, but I would not be long 30% loss-protected bonds backed by mortgages on properties now worth 40% less, unless it was a 1st or 2nd pay sure to be paid off from liquidations.
TALF is backing many of those (the cautious approach you speak of) but not entirely, and it's going to get them (meaning us) into trouble.

Case in point: they accepted CD 07-CD5 A4. This deal is already 10% in the toilet two years after issuance. Would you not think that another 20% could go bad over the next eight years? Considering that the previous deal from the same issuer is already 18% specially serviced and includes the totally speculative Riverton Apts loan, I would stay away from their paper like the plague.

> Also, Federal reserve folks implementing the plan are taking a
> cautious approach (some think too cautious) and are also using
> outside experts to help them where needed.

These outside experts often were never market participants putting their own money on the line. I think that could explain why they do things which make no sense, such as rejecting a 3rd pay from a deal where they had previously accepted the 4th pay 10 year bonds.

MB

Nov 02 09:48 AM

[Malay Bansal:]

One should never invest without doing detailed work and being comfortable with the the investment. The amount and type of work will depend on the investor and the position and type of investment, including the seniority of investment. If you are investing in senior most bond, you would focus more on different things than you would if you were buying mezzanine tranches. If you were buying subordinate bonds, you would want a lot more details than anyone else, and B-Piece buyers do get a lot more detail under confi and do their own underwriting and due-diligence. Again each investor decides what is sufficient for them to get comfortable. For some, knowing the major tenant exposure may be enough, for others it may be important to know each and every tenant, e.g. Babcock, even if they represent 2% of deal exposure. I would not say that everyone should have the same requirement.

I know the amount of distrust everyone has for rating agencies,and would not blindly defend their process or say that all 30% subordination bonds will be safe. What I am saying is that if you do the credit work and pick the right bonds, a really high amount of pool will need to default for that position to take a loss. So, for Fed to take a principal loss on their TALF loan, a pool would have to face a loss of 45% (30% subordination + 15% equity for TALF loan). That means if you assume 50% loss on defaulting loans, 90% of loans would have to default before TALF loan takes a $1 hit on principal! If you compare that to the current delinquencies of less than 5%, even though they are increasing, 90% is a long way from here,.

I am not a wide-eyed optimist on commercial real estate myself - if have read my other write-ups, but I believe that you need to look at each possible investment carefully and diligently to decide on each one on its own merits or weaknesses.


On Nov 02 09:48 AM crabsofsteel wrote:

> >One, obviously there can always be more information, but the

Nov 04 12:11 PM

[crabsofsteel:]

50% loss severity? 50% loss severity? BWA HAHA HA!!!

You are not looking at the same loans I am looking at.

Peter Cooper Village/Stuy Town is a $3B senior note followed by 7 mezz notes. Current valuation talk is as low as $1.5BB, without considering court-ordered refunds to tenants, transfer taxes, or special servicer fees . A 50% loss might be wishful thinking.

Extended Stay Hotels?
City View Center?

Do I need to go on?

TALF is an excellent program for helping hedge funds buy bonds which are money-good and burning taxpayers when they aren't. It is not going to restart the CMBS market any more than my left foot.

If you want to restart the CMBS market, you have to introduce transparency. I do not want to have to be a B-piece buyer to be able to look at the loan file. I do not want to have to look at REIT websites to find out who actually owns the mortgaged properties. I do not want to find out about second and third liens as a surprise. And I certainly do not want to have to read a 300 page prospectus to find out that I lent money on a shopping mall built on top of reclaimed landfill.

You also have to get the bad debt that is in the system, out of the system. Of course, as more and more speculative loans default that will happen on its own. And, thanks to TALF, that's now on our dime.

Nov 04 12:52 PM

[Malay Bansal:]

Clearly you are pretty bearish and expecting much more than 30% losses on most of the CMBS deals. What is your average loss expectation for TALF eligible CMBS AAA bonds?


On Nov 04 12:52 PM crabsofsteel wrote:

> 50% loss severity? 50% loss severity? BWA HAHA HA!!!
>
> You are not looking at the same loans I am looking at.
>
> Peter Cooper Village/Stuy Town is a $3B senior note followed by 7
> mezz notes. Current valuation talk is as low as $1.5BB, without considering
> court-ordered refunds to tenants, transfer taxes, or special servicer
> fees . A 50% loss might be wishful thinking.
>
> Extended Stay Hotels?
> City View Center?
>
> Do I need to go on?
>
> TALF is an excellent program for helping hedge funds buy bonds which
> are money-good and burning taxpayers when they aren't. It is not
> going to restart the CMBS market any more than my left foot.
>
> If you want to restart the CMBS market, you have to introduce transparency.
> I do not want to have to be a B-piece buyer to be able to look at
> the loan file. I do not want to have to look at REIT websites to
> find out who actually owns the mortgaged properties. I do not want
> to find out about second and third liens as a surprise. And I certainly
> do not want to have to read a 300 page prospectus to find out that
> I lent money on a shopping mall built on top of reclaimed landfill.
>
>
> You also have to get the bad debt that is in the system, out of the
> system. Of course, as more and more speculative loans default that
> will happen on its own. And, thanks to TALF, that's now on our dime.

Nov 05 10:08 PM

[crabsofsteel:]

I'm not so much bearish as I am looking at data on bad loans and liquidations. Yours is a difficult question to answer because it is so deal-specific. Although every originator got silly, some got sillier before others. 2007 deals with 80+% interest-only loans from the worst originators (according to my read: Lasalle, Citi, Deutsche, Lehman and Column) will easily see 30% in losses and possibly a lot more. However, 2/3rds of the time, they are soon going to be downgraded by S&P if they haven't already been, rendering them ineligible for TALF. Since the CRE CDO bid effectively removed credit risk from lending, deals from CDO underwriters (e,g, Merrill, Wachovia) will also get hammered. So, to answer your question, I don't know how bad it's going to get, but Moodys/Fitch rated 2007 deals will get there first.


On Nov 05 10:08 PM Malay Bansal wrote:

> Clearly you are pretty bearish and expecting much more than 30%
> losses on most of the CMBS deals. What is your average loss expectation
> for TALF eligible CMBS AAA bonds?

Nov 06 07:49 PM

[Malay Bansal:]

Actually by saying that Fed will take losses on TALF'ed CMBS bonds, you are saying that the even the best of CMBS deals meeting TALF criteria will take more than 45% loss. That is an extreme view, compared to most people I know, and the belief of the market implied by the 80 to 90 or higher dollar price at which these bonds are trading.

Comment on Merrill: it was never big in Commercial Real Estate CDOs. It was biggest in residential, but that did not impact the commercial business.

Long chain of discussion ... will leave it by saying it's important to remember future performance will be very deal-specific necessitating detailed loan-level analysis before reaching conclusions on any specific deal.


On Nov 06 07:49 PM crabsofsteel wrote:

> I'm not so much bearish as I am looking at data on bad loans and
> liquidations. Yours is a difficult question to answer because it
> is so deal-specific. Although every originator got silly, some got
> sillier before others. 2007 deals with 80+% interest-only loans
> from the worst originators (according to my read: Lasalle, Citi,
> Deutsche, Lehman and Column) will easily see 30% in losses and possibly
> a lot more. However, 2/3rds of the time, they are soon going to
> be downgraded by S&P if they haven't already been, rendering
> them ineligible for TALF. Since the CRE CDO bid effectively removed
> credit risk from lending, deals from CDO underwriters (e,g, Merrill,
> Wachovia) will also get hammered. So, to answer your question, I
> don't know how bad it's going to get, but Moodys/Fitch rated 2007
> deals will get there first.

Nov 08 09:34 PM

[crabsofsteel:]

> Actually by saying that Fed will take losses on TALF'ed CMBS bonds,
> you are saying that the even the best of CMBS deals meeting TALF
> criteria will take more than 45% loss.

No, I am saying that some of the bonds backed by TALF are certain to take a loss of over 30%. With some deals composed of 80-98% speculative interest-only loans, it is baked into the cake.

> That is an extreme view, compared
> to most people I know, and the belief of the market implied by the
> 80 to 90 or higher dollar price at which these bonds are trading.

Hey, subprime AAAs used to trade there as well, didn't they? Now that delinquency levels are at 50% or more, they no longer do. Oh, you'll say, but CMBS isn't subprime. To which my reply is this: you're right to think it's better, but you have almost the same exact players as you did in subprime; incentivized lenders, dumb rating agencies, and blind bond buyers. So, why would you expect a different outcome?

You also have the knowledge that in the past, commercial has lagged residential, but performed likewise.

You may know that Moodys, who swore up and down that their AAA ratings were solid-as-a-rock good-as-gold and better-than-S&Ps, have just put their first super-senior AAAs on watchlist down. Didn't we see this dance before? Like when they revised their subprime loss estimates time and time again, to the point where no one could trust anything they said anymore. I do recall...

So, go pay $85 for a 20% c/e AAA, but don't come crying to me when you find out Countrywide was lender in 40% of the deal.
>
> Comment on Merrill: it was never big in Commercial Real Estate CDOs.

Thank you, I stand corrected. I was under the impression that ML would CDO anything that moved, but I see that Wachovia got there first.

> It was biggest in residential, but that did not impact the commercial
> business.
>
> Long chain of discussion ... will leave it by saying it's important
> to remember future performance will be very deal-specific necessitating
> detailed loan-level analysis before reaching conclusions on any specific
> deal.

I agree with you. Can you please tell this to the people at TALF?

Nov 10 01:17 PM