Collateralized Damage: Commercial Mortgage Securities Are at a Standstill

The Wharton School of Business published an article last month in their Finance and Investment section on the state of the Commercial Mortgage Industry that I found to be a good read:

Published: July 23, 2008 in Knowledge@Wharton

With so much media and federal regulatory attention focused on the global credit crunch, especially the securitization of massive pools of home loans, there has been little notice of what’s been happening with the market for commercial-mortgage backed securities, a younger cousin in the structured finance family.

“It’s pretty much gone,” says Wharton real estate professor Todd Sinai, speaking about the current state of CMBS issuance. “The liquidity crunch is across the board.”

The market for CMBS — packages of pooled loans backed by mortgages on office buildings, industrial properties, malls and other retail centers, and apartment buildings — has been ravaged by market conditions since last fall. In the first six months of 2007, 39 deals totaling $137 billion were brought to market and successfully sold, from the highest rated (triple-A) bonds down to the riskier, higher-yielding and lower-rated classes of bonds called B-pieces. Through mid-July 2008, only nine deals totaling $12.1 billion have been completed, a drop in issuance of more than 90%. No CMBS deal has been completed since a $1.27 billion offering from Banc of America Securities on June 19. There are currently no CMBS deals on the market.

Sinai believes there is little interest in the CMBS packages because they include both very secure and very risky bonds at a time when the market for the riskier elements is practically non-existent. Like their residential mortgage cousins, the CMBS are packaged in tranches, or layers, to offer protection for some buyers and higher yields for others. Without a market for the high-risk, high-yield layers, the overall package can’t sell. What’s more, Sinai says, for those deals sold so far this year, prices have been based on very few transactions, further distorting the market that had been steadily growing and stabilizing during the past decade. Due to the inactivity, “You don’t even really know where the market is,” Sinai adds. “All of the CMBS issued this year [were underwritten] in 2007, and only got unloaded this year.”

CMBS prices have plummeted, while yields, as measured in basis points over swap rates, have skyrocketed. As the CMBS market expanded, investors drove up prices for 10-year triple-A rated bonds. In their headiest days, in the three years leading up to summer 2007, those bonds were yielding consistent and reliable returns for CMBS investors, according to data from Commercial Real Estate Direct, an online news and information service based in Newtown, Pa. But these same securities are quoted today at prices that market watchers say are severely out of proportion to their value. These prices, or “spreads,” are the difference between the swap rate on a bond and the yield on a government bond of the same maturity, representing the risk associated with the investment. The lower the number, the better the price (and the tighter the spread).

Contagion, Plus

Joseph Gyourko, chairman of Wharton’s real estate department and director of the Samuel Zell and Robert Lurie Real Estate Center, says the CMBS market “took a huge hit around the same time as the credit crunch last August,” and the data bears that out. Blue-chip CMBS went from 26 basis points over swaps in July 2007 to about 70 basis points in September. Spreads eclipsed the 100 basis points threshold in late November and ballooned to their widest point in March 2008.

“Some of it was contagion from subprime,” Gyourko says. “The blowup in the housing market affected the commercial market, mostly for not very good reasons.

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