CMBS Ups and Downs
Market Flux May Bring New Discipline to Commercial Mortgage Lending.
The commercial mortgage-backed securities market is relatively young, having yet to complete its first decade. The market began in the early 1990s when the Resolution Trust Corp. issued CMBS to enhance its proceeds from the bulk sales of commercial mortgage pools inherited from defunct savings and loans. The success of those early CMBS sales attracted a new group of issuers and, by 1993, a few investment banks set up origination networks — typically through mortgage bankers — and securitized commercial loans. Other players worked with life companies and financial institutions that were trying to liquidate existing loan portfolios. One of the largest such deals was the $1.3 billion securitization of Canadian Confederation Life Insurance’s portfolio of U.S. commercial mortgages in 1995.
As the market quickly matured, more private developers and real estate investors began to turn to loan securitizers, typically referred to as conduits, for long-term mortgage financing. As CMBS volume swelled and bond investors began to take note of the market, CMBS spreads shrank, which allowed the conduit originators to offer loans at more competitive pricing. Early pricing on conduit-funded loans rarely broke margins below 400 basis points over corresponding U.S. Treasuries; loans on many hard-to-finance properties such as hotels commanded even wider margins. From about 1995 onward, however, conduit-funded loan rates have been competitive with equivalent rates charged by other real estate lenders such as banks and life companies.
The CMBS market also attracted some leading portfolio lenders such as Chase Manhattan and Wells Fargo. These banks, as well as Bank of America, Citicorp (now Citigroup), NationsBank (now merged with Bank of America), and First Union, realized early on that originating loans for CMBS securitization could complement their traditional portfolio-lending activities.
With origination networks already in place and regulators keeping a watchful eye on the concentration of commercial loans in bank portfolios, the movement of certain loans off the books via pooling and securitization brought a number of benefits. First, it provided a good fee income base. Second, it allowed banks to re-employ capital more frequently, thereby boosting revenue and, ultimately, return on equity. Third, it offered banks a legitimate balance-sheet management tool and delivered greater flexibility in strategic planning.
Through the involvement of Wall Street investment banks (Nomura Securities, Lehman Brothers, Goldman Sachs, Credit Suisse First Boston), major banks (NationsBank, Chase, Citicorp), and a host of mortgage banking originators, the CMBS market has become the dominant force in the commercial mortgage lending market. In 1997, the total volume of commercial mortgages originated, pooled, and issued as CMBS totaled $44 billion, up from $29 billion in 1996. As of November 1, 1998, issuance volume already had topped the previous year’s level at $60.7 billion and annual issuance volume was on a pace to reach $72 billion.
In terms of originations, one player stood out. By summer 1998, Nomura’s Capital Co. of America subsidiary had reached a reported funding pace of $1 billion in new mortgages a month, making it the clear leader with its closest non-CMBS competitor budgeting annual volume closer to $6 billion.
After setting a blistering origination pace in the first half of the year, conduit activity ground to a halt during September 1998, stalled by events in the capital markets, specifically Russia. Yet the final impact involves fundamental changes in the way the CMBS market operates.
Conduits fund commercial mortgages at traditional fixed rates, pool loans, and once they have achieved critical mass, create securities in which payments to bondholders are covered by mortgage payments on the properties. It may take three to six months before a conduit has enough volume to bring a deal to market — a critical period during which it has to hold the loans. Most often, the conduits fund and warehouse these loans using lines of credit granted by other investment banks.
It’s a lucrative business with huge amounts of money being made on both sides of the street. But it’s also fraught with risk. Conduits holding a large volume of mortgages typically use some sort of hedging device to protect against losses on the value of their loans if interest rates should move in either direction. But hedging — an art form more than an exact science — protects movements in interest rates, not changes in market spreads. In mid-September 1998, CMBS market spreads widened overnight and many major conduits were left holding the bag. The value of loans held on their warehouse lines sunk overnight because their interest rates were far lower than yields demanded by CMBS investors.
In a five-day period, Capital America and CS First Boston dropped out of the market. Capital America’s founder, Ethan Penner, resigned, and its parent company, Nomura Securities, announced huge losses. CS First Boston pulled back from the market with its CMBS guru, Andrew Stone, commenting that it would remain out of the market until spreads had returned to levels at which the company again could make money.
Credited with dragging the real estate market out of the credit crunch of the early 1990s, the CMBS market was supposed to deliver some form of stability to commercial real estate lending by CMBS issuers feeding product to an investor clientele operating under the economic law of supply and demand. (Previously, financial institutions typically prepared a budget at the beginning of the year, and once the loan allocation was met, they left the market until the following year. As a result, borrowers often were swamped with loan offers from January through September, then left high and dry from October on.)
But that stability was rocked by the events of September 1998. The exit of many major conduit lenders threatened to hit borrowers hard, especially as lenders such as Capital America reportedly already were sitting on a pile of loans that couldn’t be sold.
Continued Investor Support?
Whether fed by conduits or traditional real estate lenders such as banks and life companies, the CMBS market successfully has established itself as a legitimate investment market. It could be argued that during the September "bloodbath," bond investors did not leave the CMBS market but repriced it dramatically. As a result, some active investor groups such as hedge funds and mortgage real estate investment trusts may have left the market permanently. Currently there are investors for AAA-rated CMBS and growing interest for the B-rated classes, but no investor base yet for A- through BB-rated CMBS.
In essence, the market had turned from a seller’s market to a buyer’s market: Investors still wanted to buy CMBS, but they have yield requirements that current originations did not reflect.
The true concern for bond investors is "take-out" risk — the risk that borrowers will be unable to refinance when their loans come due. Take-out risk is affected by real estate fundamentals, such as overbuilding; softening in the general economy; the capital markets; as well as other sources of financing being repriced at rates that do not cover the balloon payments due.
The quality of mortgage underwriting also has a direct impact on investors’ perceptions of CMBS. Mortgages underwritten too aggressively are far more prone to default, causing problems for issuers and panic among bondholders. Only a handful of CMBS deals have featured loans that are delinquent or in default.
The October 1998 Chapter 11 filing by one of the biggest special servicers, Bethesda, Md.-based mortgage REIT Criimi Mae, sent shock waves through the CMBS market. One of the key special servicer roles is to provide a buffer against default losses by workout and other means. The inability of a special servicer to act quickly in supporting an issue isn’t attractive to bond investors.
Back to Fundamentals
For these reasons, investors and issuers are likely to take a much more careful look at how CMBS loans are underwritten and may perform far higher levels of due diligence. Detailed analysis of credit factors and net operating income will be far more focused and greater attention will be paid to verification procedures for property income, borrower creditworthiness, and other key underwriting factors. Issuers and investors alike
will pay far greater attention to fundamental real estate market conditions, mortgage underwriting standards, property performance, additional leverage, and a wide array of ancillary criteria. Market participants agree that the heated competition among conduits did not have a favorable impact on underwriting standards.
While the CMBS market may undergo a period of light issuance as a result of widening spreads, the market itself is unlikely to evaporate. Undoubtedly there will be changes. Some originators and issuers may well be out for the duration. Conduits will undoubtedly face a period of consolidation as they search for the equity strength needed to withstand market changes. It’s extremely likely that as banks, life companies, and other lenders regain a foothold in commercial mortgage lending they will — in addition to funding loans for their own portfolios — pass through a large proportion of their originations to Wall Street for securitization.
Decidedly, the commercial mortgage market is better off with securitization than without it. The events of 1998 proved that exposure to a public market can, at the very least, bring discipline to commercial mortgage lending. This should bode well for the entire commercial real estate market by providing a natural brake to development and, perhaps, prevent the specter of overbuilding that seems to threaten the market into recession every five to seven years.