It has been just a couple of weeks since the sub prime market went through its hour of darkness. Looking back, the stocks bounced back once a couple of distressed debt players stepped in to provide some much needed capital to some of the weakest sub prime mortgage players, such as Accredited Home Lenders (LEND:NASDAQ). Amazingly, a US$1.1 billion bail-out isn’t a cure, but rather a band-aid:
Piper Jaffray analyst Robert P. Napoli said the new financing “clearly buys the company several more months” before the money runs out.
“Hopefully, long enough to wait out the industry’s liquidity mess,” he said.
While times may be better, the credit market is still like a coiled spring. We’ve talked in the past about the credit market being one masive ecosystem, and not discrete little elements that aren’t affected by pain suffered in another part of the market.
And according to one of the world’s largest credit raiting agencies, lax credit standards isn’t solely a problem for firms that gave mortgages to folks with poor credit ratings, or at loan-to-value levels that exceeded 100%.
This from Moody’s yesterday:
April 11 (Bloomberg) — Moody’s Investors Service, one of the two largest credit-rating firms, will require more protection for investors in securities backed by mortgages on apartment buildings, offices and other commercial properties because of “a continued slide'’ in lending standards.
Moody’s is raising the minimum subordination levels on new commercial mortgage bonds that will be needed to achieve better debt ratings. The higher subordination levels — or amount of lower-rated bonds needed in the transactions to take losses before the higher-rated securities — will reverse years of falling investor protection, Moody’s said in a statement today.
Surging delinquencies on subprime residential mortgages caused by looser lending practices are an “elephant in the room'’ that has called attention to standards on other loan types, Moody’s said. As with home loans, commercial mortgages have been requiring less documentation and including the use of more interest-only loans and secondary financing, it said.
“This is a direct response to the slow but steady erosion in underwriting quality within the securitized commercial mortgage lending world,'’ Jim Duca, a group managing director at Moody’s in New York, said in the statement.
The change in policy, which is to take place “over the next few months,'’ may force the Wall Street firms and other companies that package commercial mortgages into bonds to sell more of the debt created with lower-rating levels, and hence greater yields. Profit on the transactions would fall, unless the rates charged to new borrowers increase.
Commercial-mortgage bond issuance last quarter rose 30 percent from a year earlier to $62.5 billion, according to Merrill Lynch & Co. About $796.6 billion of commercial-mortgage bonds were outstanding as of Dec. 31, or about 26 percent of such loans outstanding, according to Moody’s.
Moody’s said that it had lowered protection for bond investors in recent years because earlier deals out-performed its expectations, property owners enjoyed easy access to debt, and rental and property prices were rising.
“We’ve had every possible positive thing happening in commercial real estate to support'’ lower bond-investor protection, including surging property prices and generally declining interest rates, Duca said in an interview. “We believe we’ve sort of reached an inflection point.'’
While also pointing to “troubling trends'’ in commercial-mortgage standards, Standard & Poor’s said today that the level of protection for investors it now requires is adequate.
Late payments on commercial mortgages in bonds fell to a record low of 0.34 percent of balances as of March securities filings, New York-based Bear Stearns Cos. analysts Marielle Jan de Beur and Naynika Chaubey said in a report yesterday.
Another similarity between home mortgages and commercial mortgages has been the rising ratio between the value of properties and the amount of debt borrowed against them.
Moody’s says commercial mortgages put into securities last quarter exceeded its estimated value of the properties by 11 percent. Moody’s used its own estimates of the cash flow the buildings produced and average historic ratio of income to prices to arrive at the figures. The loans were made at about 90 percent of properties’ values in early 2003, Moody’s said.
The “vast majority'’ of commercial mortgages in new bonds allow for payments of only interest, and property values have “reached unprecedented highs,'’ with annual property incomes sometimes representing only 3 percent of prices, New York-based S&P said. More loans don’t even require enough cash reserves when the incomes don’t exceed their payments, it said.
Avoiding a Wipe Out
“It doesn’t take much imagination to come up with a situation where you’re going to get wiped out'’ on such bonds sold in recent years with investment-grade ratings, said Ned Gerstman, chief investment officer for U.S. investments at Warren, New Jersey-based Chubb Corp., an insurer of commercial property and high-end homes. “That shouldn’t be the case.'’
Many of those bonds that included interest-only commercial mortgages may have only offered protection against loan losses of 4 percent, Gerstman said.
Concerns about fallout from subprime home loans helped drive yield premiums on commercial-mortgage bonds with the lowest investment-grade ratings 60 basis points wider in the past month to 170 basis points over the 10-year swap rate, or what’s paid in exchange for floating-rate payments tied to short-term rates, according to Bear Stearns.
More investors seeking the lowest-rated commercial-mortgage bonds has reduced lenders’ discipline, S&P said. Until four or five years ago, only four companies regularly bought such bonds.
Today, “if one investor doesn’t purchase a particular CMBS transaction owing to perceived credit concerns, another is ready to step in and buy it instead, making it harder for investors to exert pressure on issuers by voting with their wallet,'’ Kim Diamond, a managing director in S&P’s global real estate finance group, said in the rating firm’s statement today.
Along with adding demand, the market for collateralized debt obligations backed by commercial-mortgage bonds also has allowed buyers to “lay off risk into CDOs instead of embracing a buy-and-hold strategy,'’ affecting motivations, S&P said. CDOs repackage loans, bonds and derivatives as new securities.
You have to admit that the idea of “laying off risk” sounds so appealing, but eventually someone, somewhere winds up owning the underlying paper. In our business, we retain all of our credit risk, but manage that loan risk by not utilizing massive leverage on the portfolio. One of the benefits of keeping loans on your own books is that you get to maintain the relationship with the borrower (and the management team), which is one of the most enjoyable aspects of our business.
But if anyone thought that the sub prime-inspired credit mess was really over, Moody’s has decided to tackle the commercial mortgage market before they get blamed should things start to go south there.
Which begs the question: how long before the senior risk managers at the commercial banks decide that they need to tighten their own credit books just a titch?