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:
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:
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).
