Urgent Sell Signal from the CMBS Market, Finally

Includes: IYR, QQQ, SRS
by: Rakesh Saxena

Given the intense debate on the direction of the $700 billion bailout funds and the Detroit rescue package, Washington lawmakers and regulators have apparently forgotten about the “secondary” sectors of the economy. But, at some point in the not-too-distant future, somebody in authority must shift focus to the commercial mortgage-backed securities (CMBS) marketplace which has been in meltdown-mode this week.

Some of the data from the CMBS is nothing short of alarming. Yield spreads on “AAA” rated CMBX-5 indexes have reached a record (and shocking) 650 basis points. A Citibank portfolio manager reported that junior “AAA-” mortgage-backed securities are trading today at yields of 16% in thin conditions. At least two of largest mortgage-backed loans, including one for Westin Hotels, are close to default, and sell orders for a number of other similar securities will pile up as more disclosure comes into the public domain.

The credit rating agencies are, quite naturally, looking hopelessly inadequate today. The Treasury and Fed too will come under increasing criticism shortly for ignoring the embedded crisis right across the CMBS matrix. That said, investors are well-advised to act now by entering short positions in real estate ETFs (NYSEARCA:IYR) and in Ultra-Short real estate ETFs (NYSEARCA:SRS). Also, there is no doubt that the sorry state of the CMBS market is sending urgent sell-on-rally signals on the broader indexes (QQQQ).

In brief, the entire rating structure which sustained the explosion in the debt market for the better part two decades is clearly in danger of complete collapse. Following the CMBS lead, credit default swaps are widening to unprecedented levels; for example, bond risk insurance for Warren Buffett’s Berkshire Hathaway (AAA-) was transacted at 390 basis points on Tuesday, and sellers of risk for even better-known corporate names are avoiding pricing requests since early Wednesday. The immediate impact on lower-rated non-American issuers will be devastating.

This development in the CMBS sector also brings the financials (C, GE, AIG, GS, MS and BAC) into play, yet again, for good reason. There are two questions which must be answered this week.

In view of the breakdown in the rating structure, and the latest CMBS-related data, will banks and insurers be required to make substantially higher-than-previously-anticipated loan-loss provisions as soon as this and the next quarter? And does the guidance derived from rating impairments and CDS pricing mean more trouble for the derivatives complex, particularly the CDO (collateralized debt obligations) segment?

Both questions can only be answered in the affirmative.

Disclosure: Author holds a short position in IYR