Spreads of U.S. commercial mortgage-backed securities (CMBS) widened to historic levels in March amid anxiety about the health of U.S. credit markets, but yield premiums have since narrowed thanks to a series of Federal Reserve Bank actions that aimed to improve liquidity, including its push for JPMorgan's purchase of Bear Stearns.
CMBS spreads had been widening since August 2007, largely in sympathy with other securities such as residential mortgage bonds and corporate debt as investors re-evaluated risk and leverage. In the first four months of 2008, issuance dropped dramatically, and the supply of new CMBS transactions this year could be at lows not seen since the mid-1990s, according to some industry forecasts.
In March, the widening in yield premiums of all spread products was so dramatic that CMBS transactions could no longer be done at cost-effective levels, and some lenders who relied on being able to resell commercial real estate mortgages as bonds stepped out of the market. Market participants believe these lenders will return if and when spreads narrow further.
‘Liquidity is coming back,’ says Jeffrey Given, portfolio manager at John Hancock Fund Management. ‘All along, you knew spreads were ridiculously wide.’
‘They widened significantly. [But] they have tightened in the last couple of weeks, recalls Andreas Pericli, chairman and CEO of Euclid Financial Group, a Washington, D.C.-based hedge fund. ‘We had CMBS exposure. We did not add exposure. There were opportunities for others to come in and buy.’
Pericli adds that the ‘spread widening was overdone. The spreads tightened closer to fair levels.’ At the same time, some fluctuations in spreads may be in store for the coming months, he warns.
‘We are emerging from this cloud that we have been under for some time,’ agrees Lisa Pendergast, a managing director in RBS Greenwich Capital's real estate research department, where she runs research and strategy for commercial mortgage-backed bonds. ‘The tone has improved from mid-March. In general, CMBS is taking its cues from broader market metrics. The flight to quality in the Treasury market has slowed, and people are now looking at spread products.’
Dramatic widening
The moves by the Fed this year included a series of interest rate cuts that have brought Fed funds rates down to levels not seen since 2004 and a broadening – announced in March – in the types of securities that can be used as collateral by primary dealers in the repurchase agreements.
March also featured dramatic widening in residential mortgage bond spreads amid hedge fund selling tied to margin calls. Similar widening was seen in CMBS.
‘We are wider from where we started the year. Super senior [classes of CMBS] were tighter last week (in the week ended April 18),’ says Roger Lehman, head of CMBS research at Merrill Lynch & Co. ‘Right now, they are at 165 basis points off of 10-year swaps. At the end of last year they were 82 basis points off of swaps. In March, they were as wide as 305 basis points.’
‘Up until last week, we had been in period of reduced activity,’ he adds, speaking of the week ended April 18. ‘We have started to see some buying. Investors were sidelined until recently. Some people held back because of a lack of liquidity and volatility of spreads.’
While liquidity has improved, Given notes that ‘there is still a wide margin in bid-offer spreads when you are looking to sell a bond. AAA-rated paper is easier to move, but even a clean AA bond is tough to move’ in the secondary market. That said, Given believes ‘everything the Fed has done for liquidity has helped’ the CMBS market.
Within the CMBS market, the most dramatic widening of yield premiums in March was evident in lower-rated classes of debt. For example, BBB-rated paper within CMBS transactions widened to as much as 2,100 basis points (bps) over swaps, Lehman recalls. By late April, these spreads were at 1,300 to 1,400 bps over swaps.
At the end of last year, the spread on these issues was at 850 bps over swaps, says Lehman.
‘At the top part of the capital structure, we still think there is good long-term value. However, investors should be prepared for continued mark-to-market volatility. The market may feel good this week, but all the bad news may not be behind us,’ he cautions.
The Merrill Lynch analyst adds that ‘our view is that the likelihood of extreme negative scenarios was reduced by the Fed's actions. [But] there are still underlying fundamental problems with the economy. We believe we will see more CMBS credit problems in coming months.’
Given believes that while spreads have narrowed dramatically and they continue to come in, investors may shift their focus to other securities that offer better returns such as high-grade and high-yield corporate debt. ‘There is corporate high-grade and high-yield paper that provides better rates of return,’ he points out.
Given says that his firm considered buying CMBS at their wides in March, but they ultimately did not buy any CMBS because spreads narrowed faster than expected. Instead, the company purchased AAA bonds backed by residential mortgages that included negative amortization loans.
Because these securities were trading at $0.50 to $0.60 on the dollar, Given and his colleagues stepped in to buy the bonds. Given now believes that CMBS ‘spreads should grind tighter,’ but it will be hard to see a ‘dramatic tightening’ of yield premiums.
Caution
Looking ahead, Pendergast predicts that CMBS spread levels will be ‘volatile. Tightening will be matched by moves wider. My sense is we don't move past the wides (of March).’
‘The quick money was probably made in CMBS,’ but the supply backdrop is very positive, according to Given.
While spreads have come in, investors are still jittery about the U.S. economy and how it affects various borrowers whose commercial real estate mortgages are resold as securities. Consumer confidence has plummeted amid dramatic declines in home prices and home sales, while rising gas prices have eroded consumer purchases.
The jump in gas prices not only limits purchases at retailers, but could also limit vacation traveling, thus hurting the hotel sector. At the same time, a rise in unemployment could further curtail spending.
‘Unless we see clear positive trends in the economy and the credit markets, securitization of commercial mortgages will be tough,’ says Euclid's Pericli. He predicts that liquidity will be difficult ‘for the next several months. It has improved from the middle of March, but it won't get significantly better any time soon before there are clear indications of economic growth.’
He adds that CMBS likely will see improved liquidity, but before this improvement happens, ‘you really need to see a resolution of the credit market woes – as well as more indicators of strength in the economy.’
That sentiment was echoed in an April 4 report published by JPMorgan's Alan Todd, who noted that ‘we caution investors that liquidity alone will not be enough to revive an economy that is tipping toward, or into, recession.’
Meanwhile, Michael Higgins, managing director and head of U.S. real estate finance at CIBC World Markets, agrees that spreads have come in, but they are still wide and make it more expensive to underwrite a commercial real estate mortgage.
He notes that lenders who rely on securitization have had to charge a spread of 450 bps over 10-year Treasuries, translating into roughly an 8% interest rate for borrowers. That number is up from a year ago, when the spread was 110 bps over 10-year Treasuries.
As a result, many borrowers are turning to insurers, where loans can be underwritten at a spread of 250 bps over Treasuries, translating into roughly a 6% interest rate for borrowers. Insurers can keep the loans on their books and do not have to rely on reselling commercial real estate mortgages into securities.
Not only are wider commercial mortgage-backed bond spreads limiting the number of loans that can be underwritten, but they are limiting the size of loans resold into bonds because the CMBS issues are smaller this year.
Issuance tumbles
Higgins recalls that last year, the market typically saw CMBS issues totaling $2 billion to $4 billion. These days, the deals are likely to be $1 billion to $2 billion. ‘It is hard to do deals with large loans since the total deal size has come down,’ says Higgins, adding that ‘you get penalized if you get a big concentration,’ meaning one loan makes up a large portion of the collateral pooled for a bond.
These days, buyers of CMBS will allow for a $100 million loan in a bond, but $200 million commercial mortgages are tougher to sell in a CMBS.
Although the hiccup in the credit markets slowed origination in late February and March, some lending was being done in January and February, recalls Higgins. He expects that ‘origination will pick up as spreads tighten’ and that this year, the CMBS market will likely see $50 billion of new issues. That total is down from some $230 billion last year.
JPMorgan, meanwhile, dropped its estimate of issuance to $35 billion to $40 billion from an original forecast of $55 billion. In an April 17 report, Morgan Stanley market watchers said that U.S. CMBS issuance in 2008 could total $25 billion – the lowest influx of supply since 1995.
RBS Greenwich Capital's Pendergast expects $30 billion worth of supply. Year-to-date, she says, there has been some $7 billion worth of supply.
While much of the focus has been on the credit market woes, the well-being of the US economy is very much on the minds of investors in the CMBS market.
‘You have to be careful with this recession. If it is deep, and if consumers pull back, retailers will have issues,’ warns CIBC's Higgins. ‘A lot of borrowers are over-leveraged. If the credit crunch is over soon, these guys will be okay. But, if the recession continues, you will have problems in terms of refinance risk and credit quality.’
In fact, Fitch recently reported a rise in delinquencies, much of it driven by problems within the multifamily arena.
‘Some of the rise in the multifamily delinquencies is because of defaults among a handful of borrowers,’ notes Larry Kay, an analyst at Standard & Poor's. Also, he says, some markets are seeing a flood of condominium and vacant homes come in as rentals, particularly in markets such as Florida and Las Vegas.
Additionally, areas with higher job losses are seeing a rise in multifamily delinquencies as job-seekers migrate to other geographic regions for employment opportunities.
‘The market believes defaults will rise, and I concur,’ says Pendergast. She adds, though, that ‘there is a difference of opinion in how much defaults will rise.’
Pendergast explains that the defaults will be driven by a weaker economy and a thinner number of lenders. She believes defaults could rise from 53 bps – or a 0.53% delinquency rate – to 1.50 bps in 12 to 18 months.
While this increase may appear to be a dramatic run-up in problem debt, Pendergast points out that in October 2003, ‘We saw a 2.48-percent high in delinquency rates and nobody blinked.’
In the meantime, the best gauge of borrower health and liquidity may be requests for loan extensions. In the floating-rate segment, for example, loans can have one- to three-year extensions.
According to S&P's Kay, the first quarter saw 16 retail loans that were extended, while zero were paid off. In 2007, 35 retail loans received extensions and three paid off, while in 2006, 17 retail loans were extended and 18 paid off. That increase in the number of retail extensions could be the result of softening retail fundamentals and less capital attracted to this sector, he says.
A.S. Rozens is a New York-based freelance writer.
