Finance CMBS
March 16, 2008
Editor-in-chief Suzann Silverman spoke with Brian Lancaster, managing director & head of structured products research at Wachovia Capital Markets L.L.C., about prospects for the CMBS and CDO markets. For more of this interview, see the March 16, 2008, issue of CPN.
CPN: What are your greatest concerns for the CMBS market?
Lancaster: The most immediate concerns in the market right now are twofold: One is refinancing risk, or extension risk. … There’s a significant amount of debt that has to come up for refinancing. The good news there is that almost all of the … 10-year fixed-rate CMBSes that are coming up for refinancing were originated before 2004 or 2005, and the biggest amount of commercial property appreciation was between 2004 and last year. So those loans and properties should have significant equity buildup in them, and so it shouldn’t be too difficult to refinance them. ...
The CMBS floater side has shorter-term loans that have to be refinanced. The good thing there is that CMBS floaters can extend, and they have all extended. In other words, a floater might be three years. The rating agencies will allow those borrowers a one- or two-year grace period without defaulting. In ’98, we had this problem of financing locking up, so the rating agencies will allow them to extend without defaulting. So one of the big concerns is refinancing or extension risk (but) it’s really confined to a few floaters that were very short-term loans that had no extension. Maclowe is someone who fits that category, which is why he’s gotten so much publicity.
And then there’s also some five-year fixed-rate paper. But (although) the refinancing risk is an issue, (and) one that we’re watching carefully … it’s not a gigantic issue.
And then the other potential problem in CMBS would be premature defaults on ‘06 and ’07 (loans), and by that I mean some of the properties (that are part) of the loans in those vintages were more transitional properties that had escrow associated with them to sort of tide them over and they were based on pro forma underwriting assumptions to cover the loans. So while the debt service coverage of the loan was not that high, there would be an escrow account to provide supplemental cash in case of problems. But the assumption was that in a year or two rents will go up to a sufficient level such that the property’s debt-service-coverage ratio will improve, by which time the escrow will have worn out—there’ll be no more escrow—but the issue there is that with the economy weakening and fundamentals tending to weaken, it does raise the specter that those hoped-for or planned-for increases in revenue that were supposed to improve the credit metrics of the loan don’t pan out but the escrow is all used up, and then you face the specter of a potential downgrade or loss.
CPN: It’s been said there are some potentially big losses, but do you see banks actually losing money on the deals out there or will they be able to hold onto them until the market returns and so come out OK?
Lancaster: I think that for institutions that haven’t managed their CMBS holdings well, there could potentially be losses—markdown losses, which are distinct from credit losses. And that’s a very important distinction. … We look at, for example, triple-A CMBS. We actually do a study every other year and will now be doing it every year of CMBS defaults and losses. And if you look at the triple-A CMBS sector, given where the CMBS spreads are trading right now, they’re trading at about a 17 percent loss rate, which is extraordinary. If you go back to 1972, the greatest loss we had was in 1986—the greatest cumulative loss, over the entire life of the loans. It was 8 percent. So if you look at that part of the market, the CMBX is pricing in slightly more than twice the greatest we’ve experienced in U.S. commercial real estate history in the last 36 years.
That’s telling me that this is not about credit, when you’re at the high end of the capital structure. It’s all about volatility. … So the marks and the losses that people are taking on those types of securities are really just paper losses, if you will. I don’t think that the likelihood of their having real credit losses is very high. In fact, I think it’s pretty low. … The odds are that once these markets recover and spreads come back in the financial institutions that have had all these losses that have held the very high-quality stuff will have billions of dollars of gains—say, in 2009.
However, as you get lower into the capital structure, like triple B-minuses and triple-Bs, (those are) trading at maybe one-and-a-half times the historic CMBS default rate, and that default rate’s based on 1995 to 2007, so … those holdings are actually likely, in my opinion, to experience potential losses over time. Obviously, the triple-As are 70, 80 percent of the market and the triple-Bs are a small sliver of that, but there are some significant holdings out there. …
The other problem you could have that we haven’t talked about are downgrades. It’s not unlikely that you could get triple-B-minuses and lower-rated stuff downgraded. In fact, I think that’s fairly likely. And that’s something that could happen in the next year or two.
CPN: Do you see similarities to 1998 or any other period that we can learn from?
Lancaster If we were having this conversation in late July or early August, I would have said maybe this is a little like 1998. But it’s become apparent that this is much more serious than 1998 in that in 1998 there was not the level of asset price appreciation across the board that there is now in the United States, not only in residential but in commercial in all sectors. And the level and extent of the credit contraction is far greater and has far bigger implications than in 1998. Also in 1998 there were a couple of institutions to intervene with long-term capital, et cetera. This for better or worse is now far more widespread. …
All of these things make for a more extreme experience than in 1998. It’s also certainly longer lasting. … We’re now rounding our one-year anniversary, and things have not gotten any better, whereas in 1998 that was not the case.
The other thing I would say is some people have raised issues like the RTC period—is it similar to that—and I would say that is not the case. In the positive sense. So if in terms of the capital markets it’s worse than 1998, if you look at what I call the space markets—in other words, the actual properties, the fundamentals—it’s multiples, multiples better than it was in the RTC period. Because there you had a lot of empty office buildings, a lot of spec stuff, and then you overlay a recession on top of that, so it really turned into a disaster.
The good thing on the commercial side is that … the fundamentals are actually in generally good shape. … And we would expect that the … increase in defaults and losses would be significantly less over time. … (We also think) the CMBS floater market … offers quite good value, particularly at the triple-A part of the curve. That whole market … had been supported by the structured investment vehicles that bought them, and with the collapse of the SIV market, a big natural buyer base just evaporated. So they’re trading very cheaply. And the thing that’s quite attractive about those investments is that there may be only 10 or 12 properties in them, or loans, and so the inherent quality of the bonds is based on the underlying quality of the actual loans and not some spurious mathematical formula, assuming correlation in diversification like you might find in some of the CDOs. For example, all of the loans backing a CMBS floater are investment grade and loan-to-value ratios are pretty low, like 55 percent, and then on top of that you have the subordination. So you’re talking pretty decent-quality investments. The other plus of those is that as the economy weakens and the Fed lowers rates, as those coupons come down, the credit quality of those loans goes up, because the debt-service-coverage ratio of the property borrower, the cost of their interest payments, goes down because rates are lower. So they actually look like a pretty decent bet in a market like this.
CPN: A lot of people were very enthusiastic about the growth of the CDO market before last summer. Do you see the CDO market returning?
Lancaster: It’s a market that I’m sad to say right now doesn’t look like it’s going to return in 2008. The biggest problem with the CDO market—well, the CRE CDO market—is the term “CDO.” That term right now, because of problems in other markets, is just anathema to many investors. I think there are actually tremendous values in that market, but any investors that were to even consider it would be taking a lot of career risk, since they would have to face their risk-management committees and they would have to justify why they’re buying this stuff. Some hedge funds might look at it, but again, where the kinds of spreads are for that paper, where it would possibly clear, make it uneconomical as a financing vehicle.
That said, the problem with the CRE CDO market right now is that the credit quality is somewhat heterogeneous. That is to say, the resecuritizations of the recent vintage paper, the resecuritizations of the lowest-rated paper, we think could have problems, and we’ve been saying that, whereas some of the managed deals of the so-called whole loans, where the managers are real commercial property players and they have sufficient financing … should actually do pretty well. But the market unfortunately is in a state where it’s shoot first and ask questions later.
CPN: So if it does return, do you see it returning in a different form or with a different name?
Lancaster: What typically happens when you have these kinds of problems, as we saw in the CMO market in 1995 and 1994, (is that) you’ll typically see the market adopt a simpler structure. I suspect that when it does come back it’ll be a simpler, more transparent structure, and I don’t know if it’ll have the moniker “CDO” on it because right now it just has such negative connotations. But it’s a little frustrating because I think that there actually can be some good value in that market. But people just hear the word “CDO” and draw a line through it.
Editor-in-chief Suzann Silverman spoke with Brian Lancaster, managing director & head of structured products research at Wachovia Capital Markets L.L.C., about prospects for the CMBS and CDO markets. For more of this interview, see the March 16, 2008, issue of CPN.
CPN: What are your greatest concerns for the CMBS market?
Lancaster: The most immediate concerns in the market right now are twofold: One is refinancing risk, or extension risk. … There’s a significant amount of debt that has to come up for refinancing. The good news there is that almost all of the … 10-year fixed-rate CMBSes that are coming up for refinancing were originated before 2004 or 2005, and the biggest amount of commercial property appreciation was between 2004 and last year. So those loans and properties should have significant equity buildup in them, and so it shouldn’t be too difficult to refinance them. ...
The CMBS floater side has shorter-term loans that have to be refinanced. The good thing there is that CMBS floaters can extend, and they have all extended. In other words, a floater might be three years. The rating agencies will allow those borrowers a one- or two-year grace period without defaulting. In ’98, we had this problem of financing locking up, so the rating agencies will allow them to extend without defaulting. So one of the big concerns is refinancing or extension risk (but) it’s really confined to a few floaters that were very short-term loans that had no extension. Maclowe is someone who fits that category, which is why he’s gotten so much publicity.
And then there’s also some five-year fixed-rate paper. But (although) the refinancing risk is an issue, (and) one that we’re watching carefully … it’s not a gigantic issue.
And then the other potential problem in CMBS would be premature defaults on ‘06 and ’07 (loans), and by that I mean some of the properties (that are part) of the loans in those vintages were more transitional properties that had escrow associated with them to sort of tide them over and they were based on pro forma underwriting assumptions to cover the loans. So while the debt service coverage of the loan was not that high, there would be an escrow account to provide supplemental cash in case of problems. But the assumption was that in a year or two rents will go up to a sufficient level such that the property’s debt-service-coverage ratio will improve, by which time the escrow will have worn out—there’ll be no more escrow—but the issue there is that with the economy weakening and fundamentals tending to weaken, it does raise the specter that those hoped-for or planned-for increases in revenue that were supposed to improve the credit metrics of the loan don’t pan out but the escrow is all used up, and then you face the specter of a potential downgrade or loss.
CPN: It’s been said there are some potentially big losses, but do you see banks actually losing money on the deals out there or will they be able to hold onto them until the market returns and so come out OK?
Lancaster: I think that for institutions that haven’t managed their CMBS holdings well, there could potentially be losses—markdown losses, which are distinct from credit losses. And that’s a very important distinction. … We look at, for example, triple-A CMBS. We actually do a study every other year and will now be doing it every year of CMBS defaults and losses. And if you look at the triple-A CMBS sector, given where the CMBS spreads are trading right now, they’re trading at about a 17 percent loss rate, which is extraordinary. If you go back to 1972, the greatest loss we had was in 1986—the greatest cumulative loss, over the entire life of the loans. It was 8 percent. So if you look at that part of the market, the CMBX is pricing in slightly more than twice the greatest we’ve experienced in U.S. commercial real estate history in the last 36 years.
That’s telling me that this is not about credit, when you’re at the high end of the capital structure. It’s all about volatility. … So the marks and the losses that people are taking on those types of securities are really just paper losses, if you will. I don’t think that the likelihood of their having real credit losses is very high. In fact, I think it’s pretty low. … The odds are that once these markets recover and spreads come back in the financial institutions that have had all these losses that have held the very high-quality stuff will have billions of dollars of gains—say, in 2009.
However, as you get lower into the capital structure, like triple B-minuses and triple-Bs, (those are) trading at maybe one-and-a-half times the historic CMBS default rate, and that default rate’s based on 1995 to 2007, so … those holdings are actually likely, in my opinion, to experience potential losses over time. Obviously, the triple-As are 70, 80 percent of the market and the triple-Bs are a small sliver of that, but there are some significant holdings out there. …
The other problem you could have that we haven’t talked about are downgrades. It’s not unlikely that you could get triple-B-minuses and lower-rated stuff downgraded. In fact, I think that’s fairly likely. And that’s something that could happen in the next year or two.
CPN: Do you see similarities to 1998 or any other period that we can learn from?
Lancaster If we were having this conversation in late July or early August, I would have said maybe this is a little like 1998. But it’s become apparent that this is much more serious than 1998 in that in 1998 there was not the level of asset price appreciation across the board that there is now in the United States, not only in residential but in commercial in all sectors. And the level and extent of the credit contraction is far greater and has far bigger implications than in 1998. Also in 1998 there were a couple of institutions to intervene with long-term capital, et cetera. This for better or worse is now far more widespread. …
All of these things make for a more extreme experience than in 1998. It’s also certainly longer lasting. … We’re now rounding our one-year anniversary, and things have not gotten any better, whereas in 1998 that was not the case.
The other thing I would say is some people have raised issues like the RTC period—is it similar to that—and I would say that is not the case. In the positive sense. So if in terms of the capital markets it’s worse than 1998, if you look at what I call the space markets—in other words, the actual properties, the fundamentals—it’s multiples, multiples better than it was in the RTC period. Because there you had a lot of empty office buildings, a lot of spec stuff, and then you overlay a recession on top of that, so it really turned into a disaster.
The good thing on the commercial side is that … the fundamentals are actually in generally good shape. … And we would expect that the … increase in defaults and losses would be significantly less over time. … (We also think) the CMBS floater market … offers quite good value, particularly at the triple-A part of the curve. That whole market … had been supported by the structured investment vehicles that bought them, and with the collapse of the SIV market, a big natural buyer base just evaporated. So they’re trading very cheaply. And the thing that’s quite attractive about those investments is that there may be only 10 or 12 properties in them, or loans, and so the inherent quality of the bonds is based on the underlying quality of the actual loans and not some spurious mathematical formula, assuming correlation in diversification like you might find in some of the CDOs. For example, all of the loans backing a CMBS floater are investment grade and loan-to-value ratios are pretty low, like 55 percent, and then on top of that you have the subordination. So you’re talking pretty decent-quality investments. The other plus of those is that as the economy weakens and the Fed lowers rates, as those coupons come down, the credit quality of those loans goes up, because the debt-service-coverage ratio of the property borrower, the cost of their interest payments, goes down because rates are lower. So they actually look like a pretty decent bet in a market like this.
CPN: A lot of people were very enthusiastic about the growth of the CDO market before last summer. Do you see the CDO market returning?
Lancaster: It’s a market that I’m sad to say right now doesn’t look like it’s going to return in 2008. The biggest problem with the CDO market—well, the CRE CDO market—is the term “CDO.” That term right now, because of problems in other markets, is just anathema to many investors. I think there are actually tremendous values in that market, but any investors that were to even consider it would be taking a lot of career risk, since they would have to face their risk-management committees and they would have to justify why they’re buying this stuff. Some hedge funds might look at it, but again, where the kinds of spreads are for that paper, where it would possibly clear, make it uneconomical as a financing vehicle.
That said, the problem with the CRE CDO market right now is that the credit quality is somewhat heterogeneous. That is to say, the resecuritizations of the recent vintage paper, the resecuritizations of the lowest-rated paper, we think could have problems, and we’ve been saying that, whereas some of the managed deals of the so-called whole loans, where the managers are real commercial property players and they have sufficient financing … should actually do pretty well. But the market unfortunately is in a state where it’s shoot first and ask questions later.
CPN: So if it does return, do you see it returning in a different form or with a different name?
Lancaster: What typically happens when you have these kinds of problems, as we saw in the CMO market in 1995 and 1994, (is that) you’ll typically see the market adopt a simpler structure. I suspect that when it does come back it’ll be a simpler, more transparent structure, and I don’t know if it’ll have the moniker “CDO” on it because right now it just has such negative connotations. But it’s a little frustrating because I think that there actually can be some good value in that market. But people just hear the word “CDO” and draw a line through it.
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