Mortgage REITs: Stick with the Seasoned Veterans

This may be no country for old men, but it's definitely no market for little boys either.

The headlines on February's mortgage delinquency numbers were either negligible or incredibly alarming, depending on who reported them and the comparisons they were using. The biggest surprise in all the data was the increase in multifamily delinquencies, which is traditionally the safer and less volatile of the four real estate "food groups". Here is a look behind some of the data.

A majority of the increase in multifamily delinquencies are linked to just one borrower, New Orleans-based MBS Companies. MBS has a checkered past and was attempting a comeback in Texas. The Company aggressively overpaid for its assets and then severely under-managed them.

Market participants involved in the sale of some of these defaulted loans indicated that MBS was almost inept. Despite some well-located properties, they said that some on-site property managers were accepting cash rent payments and under-reporting occupancies to MBS management (so they could line their pockets with said cash) and maintenance was not even an afterthought.

As of the end of 2007, MBS had over $900 million in multifamily loans that were either delinquent or in foreclosure. The Company raises equity from individual investors [OPM] and generates earnings through fees and carried interests. Thus, their earnings are decoupled from asset cash flows and not aligned well with either investors or lenders.

Most of the loans were originated by PNC Bank's (PNC) Midland Loan Services unit, and then securitized. Midland remains the "special servicer" on many of these loans. Because Anthracite Capital (AHR) reports a close relationship with Midland in its SEC filings, this could be something to watch for with respect to AHR.

Given the size and diversity of AHR's portfolio however, MBS is likely not much more than a fly on its elephantine behind. Other investors that own the below investment grade tranches on these loans are JER Investors Trust (JRT) and Centerline (CHC) – though Centerline is not a REIT, and neither is as exposed as Midland.

Meanwhile, the first three months of 2008 ended with only $6 billion of domestic CMBS issuance, the lowest first-quarter volume in a decade. Given current lending volumes, it is unlikely CMBS issuance will even reach half of 2007 volume and some are predicting less than $60 billion for the year.

A liquidity vacuum still exists in this market, despite last weeks BBB CMBX spreads of 1,100 of 1,200 basis points. Believe it or not, these spreads are actually in from about 1,500 basis points before the Fed bought Bear Stearns (BSC) and dropped rates yet again, all in the same day and on a weekend, no less.

It's only a matter of time before these incredibly high, unprecedented spreads combine with the Fed's largesse and the fundamentals of the commercial real estate market combine to overtake short-term speculators in the CMBX.

With respect to delinquencies, for some reason the research firm Real Point likes to paint an alarming picture. Perhaps they think it helps sell their research. According to their latest report, the delinquent unpaid balance for CMBS rose to a trailing 12-month high of $3.48 billion through February 2008, up from $3.16 billion a month prior.

They demonstrate that they can add, subtract, multiply and divide when they correctly state that this figure is up a remarkable 57% from the March 2007 six-year low of $2.21 billion in delinquencies. But this is a misleading way to deliver statistics on what is a fairly placid and benign market, at least in terms of delinquencies.

While it's true that delinquent balances jumped 57%, from $2.21 billion to $3.48 billion, there is almost $815 billion in CMBS debt outstanding. Thus, even with a 57% rise in delinquencies, troubled loans still represent less than half of 1% of the total market, and CMBS delinquencies overall remain at historic lows.

The real story in the increased delinquency rate is that it came primarily from two of the most recent, less seasoned vintages of CMBS. Over 40% of delinquent unpaid balances through February 2008 came from transactions issued in 2005 and 2006. Nearly 22% of all delinquencies came from the 2006 vintage alone. Almost seven percent of all delinquencies came from the 2007 vintage.

What is the significance of all this for Mortgage REIT investors? Stick to the seasoned veterans. Those who came late to the game have been hit the hardest and will take the longest to recover (if some of them ever do) because they bought at a time when underwriting standards suffered badly, and they stuffed their portfolios full of weak, demand-driven paper.

Chris Milner, Anthracite's CEO, punctuated the point in his Q4 earnings release: "The dislocation in the capital markets continued to worsen in the fourth quarter, causing CMBS spreads to reach unprecedented levels. While this development clearly has resulted in negative price changes in our portfolio, the relatively better performance of our non-U.S. and seasoned vintage U.S. CMBS assets muted the overall impact."

In Wall Street's latest game of grown-up musical chairs, it may be wise not entrust your investment dollars to those little boys who sat down last.

Comments

[fxtrader07]

the more obvious question is: why is it advisable to be invested in mortgage reits at all today - given the current situation and the unpleasant prospects of the US economy in general and the US financial system in particular?

[Joe Petro]

This article is a clear case of irresponsible journalism by the author. He is selectively choosing paragraphs from the Realpoint Monthly Delinquency report, rather than addressing the entire report, to make an inaccurate point that Realpoint is painting an alarming picture concerning delinquencies in CMBS. The realty is that the numbers he quoted from the Realpoint report concerning the increase in delinquency are accurate and are stated in the very first paragraph of the Realpoint report. The author obviously continued to read (and copy) the second paragraph of the Realpoint report regarding the delinquency contribution from 2005 & 2006 issuance. This must be where he stopped reading and copying the Realpoint report because had he read the next paragraph, he would have seen that Realpoint clearly addressed the overall delinquency percentage being less than half a percentage point of the outstanding balance.

The first three paragraphs of the Realpoint Monthly Delinquency Report read as follows:

Concerns relative to underlying collateral performance and payment ability are becoming more evident on a monthly basis, as the delinquent unpaid balance for CMBS increased to a trailing 12-month high of $3.48 billion through February 2008, up from $3.16 billion a month prior. This figure is also up 57% from a six year low of only $2.21 billion in March of 2007. On the surface, each delinquency category reflected an increase in February 2008, including a $206 million increase across the 30-day, 60-day, and 90+-day categories. Of greater concern however is that delinquency degradation continued in the 90-day, Foreclosure and REO delinquency categories for the third straight month. Collectively, these three categories grew by an additional $178.8 million in February (an increase of 9% from January, and 18% from December 2007). Furthermore, this degradation took place despite another $86.97 million in liquidations reported for February 2008 (at a low average severity of 20.3%). Liquidation activity however has slowed somewhat amidst the current credit market climate.

Increased delinquency for the more recent vintages remains at the center of our concerns, especially that of 2005 and 2006 vintage transactions. Over 40% of delinquent unpaid balance through February 2008 came from transactions issued in these two years, with nearly 22% of all delinquency found in 2006 transactions. If we extend our review to include the 2007 vintage, an additional 7% of total delinquency is found. We now expect to see continued high delinquency by unpaid balance for these three vintages in the near-term due to aggressive lending practices prevalent in such years, continued through the remainder 2008.

The total unpaid balance for all CMBS pools under review by Realpoint was $871.4 billion in February 2008. The delinquent unpaid balance over the trailing twelve months is shown in Chart 1 below. The delinquency ratio for February 2008 was 0.399%, increased from the prior month and 21% above the 0.329% reported one-year prior in February 2007.

If anyone is interested in obtaining a copy of the entire Realpoint Monthly Delinquency Report that was mentioned in this article, please send me an email and I will provide you with an electronic copy of the report.

Joseph Petro
Managing Director
Realpoint LLC
[e-mail]...

[richandmer]

Who do you consider to be the seasoned veterans?

[REITwrecks]

Joe, you are right. The suggestion that Real Point was using selective negative data to sell research was flippant. The "headline" increase in delinquencies in the first paragraph of the report was what caught my eye. The full report is obviously more comprehensive, but nonetheless much less attention grabbing - hence the irreverance toward Real Point. I apologize, and I have deleted that suggestion from the original source post.

To be fair however, the point of the article was not to besmirch Real Point. The point of the article was to illustrate out that the more recent vintages of CMBS are experiencing higher levels of default (as your research aptly pointed out), and more importantly, the implications of that for those Mortgage REITs that invested in them. Incidentally, the number on the total level of outstanding CMBS debt that I used in the article came from Wachovia/Intex.

[REITwrecks]

richandmer, you can find articles on the "veterans" here on Seeking Alpha (click on the "More By REIT Wrecks" link just below the article), or on reitwrecks.com.

[buyitcheap]

little boys? you mean the 30 somethings that brought us this debacle? Agreed! However, the seasoned vets were the ones watching the little boys play with matches while sitting on gas cans. :-(