CMBS... Long or Short?

Investing in CMBS may be one of the best ways to put money to work for those with fixed income type risk-return mandates. At the same time, record defaults are in cards for commercial mortgages asset class. Are these statements contradictory?

Indeed, there would be strong proponents of both of these theses. Perhaps, they are both right? How could that be? Don’t we know that securitization that most relied on as exit strategy (thus lent carelessly) is dead? There has been no new CMBS securitization for a long time. What about the claims that it would take a Depression much worse than Great Depression for super-duper CMBS classes to take any write-down?

These are all true, but you could still make money being long CMBS. You could lose money too. Very easily! It all depends on where you are on the capital structure, what’s your entry level, what’s your tolerance for risk.

It is hard to predict, especially if it involves the future. One of my habits is to go back and read the old reports from various strategists, economists, researchers. It is amazing how much off they have been the mark. It seems that in our human need to predict and make believe, we usually underestimate volatility, the extent that things could go bad and recover. This is why I think there would be ways to make money on both long and short side of the CMBS market in next couple of years.

First, CMBS is a very technical marketplace. By that, we mean the prices depend on myriad factors affecting the capital flows in this space, not just the fundamentals of economy. This is true in synthetic space (CMBX, TRS…), but also in plain cash CMBS. Why? Banks and insurers make up a very large percentage of the investors in this asset class. These investors are bound by many types of regulations involving their capital, liquidity, risk as well as rating/credit/counterpary risk guidelines. “Value” is just one of the many factors they take into account before they invest or divest in this sector.

To give an example of the strength of technicals in this space, we can point to events in May ’09. At that time, there were two pieces of news that caused a huge swing in CMBS prices. These had a huge impact on prices, more than 10 points change in prices of AAA CMBX for instance. First, the government announced TALF would be open to legacy CMBS. “Yippie!” cried out CMBS investors, even though this was anticipated by all for months. A few days after, S&P indicated they would like to downgrade many CMBS, asking for comments (rhetorically). Well, those comments were not coming out nice. Dealers and legacy CMBS investors were furious. How dare S&P spoil the TALF game? If not AAA, those CMBS would not be eligible for CMBS. The prices took a dive back to previous range. As usual, there was a great deal of frontrunning that was exacerbated by declined liquidity in the space.

As large as these price swings were, they were not too drastic when put into context of price moves in CMBS during the credit crisis:

Cash CMBS was scraping the floor at the year end ’08. CMBS spread of AAA tranche with 30% subordination and 10 yr life shows the extent of crash in the year end 2008:

To summarize, CMBS market is driven strongly on the words from government and rating agencies. Fundamentals play a role, but that role is limited on the top of the capital structure. For example, the bottom of the capital structure in CMBX has not followed the rhythm of bull market of Mar-May of 09. They kept going down. The lowest publicly rated CMBX tranche, CMBX5. BB is at 5-6 cents now compared to 9 cents in March:

Let’s review the fundamentals next. The fundamental picture is not pretty. Perhaps, what’s more interesting is that there is almost a universal consensus that it is going to get worse. In fact, pretty much what everyone discusses only is that how bad it could get in CMBS.

I added some charts/projections from Fitch showing CMBS delinquencies have been climbing up since 2007. The spike has been especially sharp in last few months and is not expected to slow down:

Majority of the stressed commercial mortgages are those loans that were given at the top of the credit/real estate bubble. As a result, it is not surprising to find more than 50% of the delinquencies belong to 2006-2007 vintages:


For projections, Fitch expects 15% decline in cashflows (combining rental drops & vacancies) and 35% drop in property value in next 3 years. As a result, they expect these recent vintages to accumulative a cumulative loss of 10% over their life.

Fitch expectations would actually be on the optimistic side when one tallies the research as well as anectodotal examples in this area! There are already many examples where commercial mortgages have lost more than 60% of their value. In many cases, the mezzanine investors have been wiped out.

There is a specific structural reason for the spiky loss characteristics of CMBS. Losses in CMBS bonds are likely to jump up during an economic downturn, rather than exhibiting a smooth uptrend. Most CMBS transactions are structured after carving out a mezzanine/equity piece to the sponsor. Up to a certain degree of stress, this mezzanine/equity investor would very likely continue to support their mortgage. But, once their investment is wiped out, they would no more have the incentive to invest time or resources to continue to support it. In a way, their behavior is similar to those of residential homeowners who default once they see their equity share in the house is wiped out. This effect is perhaps more pronounced in commercial mortgages, because there is simply no recourse to borrower in CMBS, so the behavior is simply rational.

Several factors affecting the loan size and types of recent years would worsen the future losses especially for recent vintage loans. One involves the size. A typical commercial mortgage in recent years was extraordinarily large. Large loans dominated the recent CMBS vintages. (Share of loans with size greater than $25M approached to 57% in 2007 compared to teens several years ago). Another factor was that there were a lot of IO loans that would carry a DSCR of less than 1.0 if they switched to amortizing loans. There are already more than $30 B of loans in 2007 vintage where the last reported DSCR is less than 1.0 (Source: Barclays). There should be indeed a huge amount of defaults coming in commercial mortgages.

Unless securitization comes back to life, the prognosis cannot be good for such loans. CMBS securitization market has been dead for months. This means all these loans that were extended with the hope of CMBS exit strategy would face immense challenges to be refinanced. If stressed borrowers cannot convince their banks to extend loans, they will not likely to find alternatives to declaring outright default. (REITs are unlikely to be saviors of this market). What’s worse, CMBS securitization is not likely to come back in a significant size in the next few years (barring extensive government life support) because there has been great structural damage in the underpinnings of this market.

Outlook on economy and vacancies matter but not as much. The picture on fundamentals is admittedly not good, yet this may prove to be only a temporary thing. It is possible that we could transition into a very different economic environment, where the economy is growing again, inflation is abundant and real estate has bottomed out. This may be hard to picture now, but sooner or later, we should arrive at such an environment. The question is really how long it would take? Does the economy turn around before all these borrowers that have no choice but default or do they get such relief? Perhaps, at that point, there may develop new exit strategies for CMBS borrowers. Alternatively, the losses, writedowns could have been taken fully, covered bonds could come back and perhaps we might even see new securitization in new forms and with correct pricing of risk. CMBS might in fact do very well in an inflationary environment. But, that is going to take time.

A sweet spot in this sector currently may be AJ tranches; these are still safe from credit writedowns. At the same time, they are very likely to get downgraded multiple times over their life. CMBX5.AJ tranche has already seen a price range of 22 to 42 cents.just in the last two months. They offer both short and long opportunities at the tail ends of such price range:

Overall, this asset class has very unique challenges, starting from property, location, local economy assessment to general appreciation of market technicals, rating/regulatory requirements and inflation expectations. There would be huge market volatility at the top end of the capital structure, as almost all these factors remain unstable.

There would be both short and long opportunities in this market. More then ever, it is now crucial to select the right place on capital structure. As important, an investor should have the risk appetite to tolerate the inevitable swings he will experience during his holding period. (Unless one has the Delphic powers of figuring out ahead the best entry price).

Big Bang of CDS: Radical Changes in CDS Contracts

Better news for CDS markets. Radical changes are coming. As of April 8. More liquidity is expected to follow. It may be too late to save CDS markets, but better late than never.

"Big Bang" is just a pretentious term referring to the day of April 8, 2009. That day will see radical changes in some of the standard terms or conventions of CDS contracts. These changes are:

For all CDS globally:

• Hardwiring of Auction Protocol
• Formation of Event Determination Committees
• Changing of Effective Dates for Protection

For CDS in North America only:

• Setting of 100/500 bps Fixed Coupons
• Removing of Restructuring Clause
• Changing the Convention for Accrual to Full Coupon

These contract changes will involve new contracts immediately. It will also be possible to make the new changes effective for legacy contracts.

These changes are intended to make CDS contracts more liquid. There will be more standardization and more clarity regarding credit and succession events. These changes will make it easier to offset existing contracts.

The most significant one change involves the use of fixed coupons for all CDS contracts in North America. That is a very logical thing to do and is probably agreed by all market participants. In contrast, the removal of "Restructuring" as a credit event may be more questionable. This will reduce the impact or efficient of CDS contracts. It has an economic impact because less is the coverage of credit events, less is the value of bought protection. Restructuring is already not included as a credit event in credit indices. Making single name CDS to follow the same convention as these indices will help with their liquidity.

Detailed information can be found at Markit’s website at this link.

More important changes are those that involve the CDS contracts in North America:

• Setting of 100/500 bps Fixed Coupon: Any single name CDS will have a pre-set coupon of either 100 bps or 500 bps. Currently, a new trade for CDS on a single name is entered at the current market spread by convention. As a result, a new trade does not require cashflow exchange. Only when there is a considerable default risk, trading of CDS contracts shift to a set 500 bps coupon and the quotes involve the upfront amount required to be posted for trade. Generalizing this to all CDS means new trades will require cashflow exchanges. This is not much different than the trading of a bond for example. There is a fixed coupon, but the current effective spread is most usually different than that fixed coupon. The market quotes a yield or spread that is different than the origination yield or spread. Besides the benefit of added liquidity, this change will help with a typical CDS problem. A party that entered into a CDS contract can close it by either unwinding or by entering into another CDS contract at opposite direction at a different spread. This eliminates the jump to default risk but keeps in the books an interest-only type strip that still carries a risk exposure.

• Removing of Restructuring Clause: Restructuring will be dropped from the definition of credit events for standard contracts. Currently, the CDS contracts referencing the investment-grade credits trade with “Modified-Restructuring” being defined as a credit event. On the other hand, neither the credit indices nor those CDS contracts referencing high yield credits include that definition. Restructuring will drop out as a potential trigger/credit event for all North American CDS contracts.

• Changing to Full Coupon Convention for Accrual: This will involve just a convention change concerning the first premium calculations. Current conventions use either a short stub or long stub to calculate the accrual depending on the timing of trade entry during the quarter. The changes proposed will make the accrual calculations more in line with those for bonds.


As for the global contract changes, these incorporate the lessons of many credit events that occurred during this credit crisis:

• Hardwiring of Auction Protocol: Following a credit event, the dealers hold an auction to determine the recovery rates to be used in cash settlement of CDS. Those parties that agree to protocol before the auction will use the auction results to settle their CDS. Signing up to this auction protocol was optional. Those that wanted to sign up had to send in confirmations. This signup to accrual will be the default choice, rather than optional. Alternative is always to settle by physical delivery of the referenced debt. Those that want to opt out of auctions will have to state so beforehand.

• Formation of Event Determination Committees: It is not always clear cut whether and when a credit or succession event occurs. In the end, the market participants will have to interpret whether a corporate event fits into pre-defined legal language of the ISDA CDS contracts. To prevent potential disagreements, a committee of large market participants will make binding determinations on the existence and timing of credit or succession events.

• Changing of Effective Dates for Protection: This involves the CDS protection to be effective a little further in past, not simply the next day following the trade date. For credit events, the protection will be effective for 60 days before the current date. For succession dates, it would be 90 days prior.

Overall, these changes are a significant positive for credit markets. They should be considered one of the steps to eventually move CDS trading to exchanges.

Online Futures Game

Playing this online futures game by CME.... You can simulate a speculator or hedger and try to make money. It is a very popular game apparently.

I played 15-20 times simulating a "speculator".



I was averaging $700-$900 when listening to the "news" of the game. When I turned the sound off, I was averaging $1500-$2000. That's interesting!

In defense of Securitization

Credit crisis is about to claim its latest victim: securitization. This mechanism is now blamed by some as one of the important causes of this crisis. Lately, America’s most influential economist, Paul Krugman, was very harsh on securitization and the government’s efforts to revive it. He noted that “Bear Stearns failed; Lehman failed; but most of all, securitization failed”. I believe Krugman is making a big mistake here.

There is no doubt that securitization has been an enabler for banks to take ever larger risks. Yet, securitization is just a tool, like many others. It brings benefits, but it has its costs and risks as well. Using securitization to add more leverage, the bank managements were missing the larger picture. Systemic risks posed by this mechanism were not understood, even when the individual portfolios of securitization products were risk managed in excruciating detail. There was very little questioning of the systemic risks! What would occur in a dynamic, interactive system when everyone follows the same strategy. What was the extent of liquidity? How could you take it granted that markets would trust the accounting of banking books ignoring market realities?

Such risks of systemic nature are not unique to securitization. Every financial product, every financial mechanism is subject to abuse and misuse. Even good regulatory systems are no guarantee of stability. Paths of financial crashes follow the same contours: ever increasing risk exposures in the face of diminishing margins, overcrowding and eventual collapse. Consider Iceland’s financial crash in late 2008, for example. That has been achieved thanks to no help from securitization markets. From Asian crisis, to 2000 tech crash, we observed the same: the rush of capital to an increasingly crowded, competitive market, followed by the inevitable flush. Just as it would have been wrong to stop globalization, to stop influx of money to internet ventures at those times, it is wrong at this time to stop the securitization engine.

Let’s remember that securitization was only one part of the credit bubble. Our credit risk taking was not limited subprime mortgages. It involved prime mortgages, commercial mortgages, company debts, levered buyouts and acquisitions that inflated the equity markets and a lot more. Even without securitization, we had reached to an over-levered financial system primed to burst in short order.

Let’s consider also what would happen if there were no securitization. A large part of the world lives under such constraints. Obtaining credit in such countries is difficult or impossible. Financing is largely done by individual savings. Getting a house, financing a new business venture is prohibitive. Existence of securitization in richer countries has benefited their borrowers.

Just to put a number on it, I have made some calculations. I have found some figures on the debt accumulation of households and non-financial corporations in United States. The data I found indicates $16 trillion cumulative borrowing by them since 1995 (approximately the point when securitization has accelerated). I assume 50% of this borrowing has benefited from securitization. Here is my critical assumption: I suppose these borrowers may have paid 2%-3% less on their loans they would have otherwise, thanks to securitization. Assuming 2.5% less interest rate on the loans for every year, I guesstimate the total reduction in interest paid by these borrowers might have added up to nearly $2 trillion. Credit crisis has been costly, but perhaps it has not yet erased all the savings achieved so far.

As usual, the story is a lot more complex than this simple calculation shows. Dismantling the securitization machine would not help us to prevent future bubbles and crashes. Instead, it is likely to make us poorer. We should focus instead on how to limit our systemic risks.

A Year after Bear Died

Bear Stearns died a year ago. Its stock was sold for $2 per share to JP Morgan. That was a shocking offer to market. We though the wires had a typo, they probably meant $20. A lot of wealth got destroyed, a lot of people got unemployed at that time. It was tragic!

Looking back, it seems naïve of us that we got shocked by what happened then. We lived up seeing much worse. Bear employees and stockholders actually got lucky in some ironic sense. $2 stock offer was raised to $10. Much better than $0 it would have reached otherwise. Most of the employees who were laid off found jobs elsewhere. The job market was not as bad at the time.

Still, it was not that hard to predict that economy and markets would get worse. Despite the two month long rally following the Bear’s fold into JP Morgan’s hands, this was a clear sign that the credit crisis had gotten to a new stage. Already, the government was the only hope, only reasonable solution out of this crisis. Over those months, many financial firms resorted to distortions to minimize their damage. History showed that a financial crisis was always costly, very costly.

Yet, things could have turned around by the end of 2008. It was not certain but possible. Paulson committed huge mistakes in September 2008. His mistakes were avoidable. He saved Bear Stearns because it was a system-critical player and then he let Lehman go bankrupt. Even though Lehman was several times more inter-connected or critical than Bear, he did not seem to have the wisdom or courage to do the same for Lehman.

I was surprised at that time not so much by Lehman’s bankruptcy but by the inaction of the US government. They did not seem to have a plan ready to put to action. Everyone knew after Bear Stearns, Lehman was next. Fed knew it! They asked even hedge funds about their exposure to Bear Stearns *and* Lehman Brothers in March 2008. Six months is plenty time to develop contingency plans.

Perhaps, you could say, the government was indeed prepared. Let Lehman die, but save AIG. Either there was no plan, no preparation or this indeed was the plan itself.

Credit Investments of Warren Buffett

What is the greatest investor doing in this credit crisis? He is spending most of his cash on corporate debt or preferred stock. We don’t see him making large company acquisitions as of yet. He sees value in debt not equity.

Table: Warren Buffett’s investments in credit since the start of credit crisis:

This speaks volumes!

Buffett is not alone in going where the value is. The world’s richest person by some ranking, Carlos Slim, also likes this idea. He recently lent $250 M convertible debt to New York Times company at 14%. Another shrewd investor, Carl Icahn, was reported to be collecting the debt of MGM at 38 cents on dollar in March ‘09.

CDS of GE

GE is in the news once again! This venerable company, probably the best industrial firm in the world, is being hugely discounted in the market. Its equity below $7, market cap below $70 B, credit markets are pricing its bonds and CDS as if it might go bankrupt.

Two questions can be asked: Does GE have a real risk of bankruptcy? If not, what is the reason for such violent reaction in the markets?


First, does GE have real bankruptcy risk? GE’s CDS has quickly shot up, going beyond the levels where Bear Stearns and Lehman were trading before their collapse. To emphasize again, these are the danger territory that not even Bear and Lehman has reached before their end. CDS markets indeed imply that there is a large probability of bankruptcy for GE. The cumulative probability of default over 5 years is about 50% as implied by the market spreads of roughly 1000 bps for 5 year CDS (arbitrarily assuming 40% recovery rate given default). At 20% upfront with 5% coupon over 5 years, protection buyers are paying almost half the notional that they will recover in case of default:


This reaction in CDS markets have been followed by equity and equity derivatives markets.


Taking Feb 11 as base (where there has not been a particular news for GE), we can observe the reaction in equity markets has been less moderate and lagging compared to CDS markets:



Part of the reason for more violent reasons in CDS markets arise from the put option like characteristics of CDS. Even taking into account the optionality of CDS, it is hard to reconcile the CDS market’s violent reaction with the fundamentals.

GE’s problems stem from the concerns with its looming rating downgrade. GE’s financial arm, GE Capital, is a AAA-rated company which by no means deserves that rating in this new environment where the counterparty risk is paramount. GE Capital has benefited from its AAA rating in past, but that might be now its Achille’s Heel. It might have to post collateral for certain transactions in which it has provided credit protection.

It is well known by now that the rating agencies will soon cut the rating of GE. The only question is how harsh that downgrade would be. Depending on the extent of this downgrade, GE could require substantial cash to post as collateral for its certain derivatives trades. Like a lot of highly rated companies, the financial engineers in GE were no doubt monetizing this credit rating during the credit bubble. Credit intermediation trades, credit guarantees, providing long-term liquidity with short-term funding, these are just some of the well known examples. It is not inconceivable that GE might experience what happened to AIG, a spiral down scenario where downgrade begets further credit weakness.

Is bankruptcy of a GE Capital a reasonable scenario then? Not really! Yes, GE may have to post a large amount of collateral (or come up with cash) in case of a harsh rating downgrade. But, here is the rub! GE Capital benefits from the easy funding facilities provided by US Treasury. This company is selling bonds, guaranteed by FDIC, under the TGLP program with very low spreads to US Treasuries. These bonds have a large demand, because they are effectively guaranteed by US government.

In order to GE to go bankrupt, the government will have to reverse its programs and ideology of supporting the large financial institutions. This is of course possible, but not very likely in the near term. Just as the AIG analogy is harmful to GE, the explicit and implict support of government is beneficial for GE.

Sharp moves in GE’s CDS are by and large involves the dysfunctionality of CDS markets. Fundamental credit indicators do not indicate a bankruptcy at all (adjusting the parameters for the new financial world). GE’s CDS has climbed up in huge amount mostly because of the lack of liquidity in CDS markets. CDS market has lost substantial liquidity. There are no natural sellers of protection. As soon as a bad news hits, it creates a demand for protection which finds a supply only at extraordinarily high rates. In old times, there would be many people who would be willing to take this risk. They could then lay off this risk in different ways. For example, dealers could have sold bespoke CDOs where the risk is sold off. No more of that in this environment. As a result, those couple of players who really need to get protection, will pay for it through the nose.

Then, we have the second question: If the bankruptcy risk is not concordant with the CDS levels, what is driving the valuation? GE’s issue is not bankruptcy but the potential for further equity dilution as it may have to raise capital. The government may not be so generous in future as now and GE Capital may have to come to market. This is somewhat similar to what happened to Citigroup and other financial institutions. Such a huge entity cannot be supported endlessly by the government. GE Capital will have to stand on its merits. Time might be a healer, but the market is not giving the company the benefit of doubt.