Caught in the Credit Crunch: An Investigation into Commercial Mortgage Backed Securities
Commercial Mortgage Backed Securities (CMBS) investors could see significant losses in the near future.
October 5, 2009
With approximately $90 billion in Commercial Mortgage Backed Securities (CMBS) or CMBS related investments expected to mature in 2009-2013, and the increase in loan defaults for non-viable commercial loans, CMBS investors could see significant losses. From 2005 through 2007, the commercial real estate market saw incredible inflation in property value and sales, which led to an increased issuance and investment in CMBS. However, the foundation of the boom might as well have been on sand since many of the real estate loans supporting CMBS made during 2005-2007 experienced relaxed underwriting standards, and included more non-conventional loans than in previous years. In early 2008, the commercial real estate market started to come toppling down with the CMBS market following suit.
Commercial Mortgage Backed Securities
CMBS are supported by commercial loans on income producing properties including multifamily structures, office buildings, industrial buildings, shopping centers, hotels, and health care facilities. CMBS are created by pooling commercial loans varying in size, property type and location, and transferring the pools to a trust. The trust then slices the pool of mortgages into tranches which are underwritten and issued as a series of bonds. As part of the underwriting process, rating agencies assign ratings to the bond classes, or tranches, in the pools ranging from investment grade (AAA/Aaa through BBB-/Baa3) to sub-investment grade (BB+/Ba 1 through B-/B3). The CMBS bonds, once rated, are sold primarily to institutional investors.
As the mortgage payments are made, funds are first distributed to investors holding the senior, and highest rated, bonds with a flow down to the subordinate, and lower grade, bonds. If borrowers default on the commercial loans, or the loan collateral is liquidated, proceeds might not be enough to satisfy all the classes, which can lead to financial loss for investors.
CMBS issuance increased substantially during 2005 through 2007 compared to prior years. From 2000 to 2004, CMBS sales averaged approximately $75 billion per year. However, sales amounts increased dramatically to $179 billion in 2005, $221 billion in 2006, and topped out at $248 billion in 2007 before realizing a significant decrease in 2008.
Underwriting Problems in the CMBS Market
Beginning in 2005, with the increase in CMBS offered in the market, there was a dramatic decrease in underwriting standards created by commercial property purchasers seeking low interest debt to pay for higher priced properties, and banks seeking to sell as many loans as possible. Commercial loans moved away from their traditional underwriting standards and methodologies. For example, many commercial loans no longer required amortization of principal, but rather were interest only loans or partial interest loans (also referred to as negative amortization loans). In 2006 and 2007, almost 98% of loans included in CMBS were interest only or partial interest only loans. Other underwriting changes included moving away from multiples of existing cash flows from leases to projected, or proforma, cash flows, often with significant increases in rent rates. The changes in underwriting coupled with mezzanine financing widely available for the equity portion of the purchase price created an environment in which buyers could purchase commercial property for almost no money down.
In 2008, the commercial real estate bubble burst causing a massive trickle down effect. Sales of U.S. commercial property fell approximately 70% in 2008, and another drop of 25% is expected in 2009. Beyond the fall of commercial property sales, CMBS issuances fell over 90% in 2008 to $12.1 billion. The effects of the real estate crash have led to decreased credit options for commercial financing or refinancing, which has resulted in more loan defaults, and potentially significant losses for CMBS investors.
The scarcity of available credit has made it increasingly difficult to obtain a new commercial loan, or refinance a viable commercial loan. To help lessen the impact, the U.S. Federal Reserve introduced the Term Asset-Backed Securities Loan Facility (TALF) program on November 25, 2008. The program provides non-recourse funding from the Federal Reserve Bank of New York for certain AAA related assets without supplemental credit enhancements. The original program was geared towards consumer and small business loans, but as of May 1, 2009, it was extended to new CMBS and, on May 19, 2009, the program was extended to CMBS issued before January 1, 2009. The goal of the TALF expansion is to increase CMBS issuances, which will help borrowers finance new commercial purchases, or refinance to lessen defaults for commercially viable properties.
While TALF may help provide credit options for viable commercial loans, it is almost impossible for the loans created with substandard underwriting from 2006-2007 to refinance without a significant influx of equity. For the 2007 CMBS vintage, it is estimated that approximately 80% will not qualify for refinancing under the new standards, which leaves about $100 billion in excess equity needed to cure the deficiency.
Many borrowers don't want to put any more equity into a sinking ship. Because of the significant downturn in the real estate market including decreased commercial rental occupancy, landlords and owners don't have the cash flow necessary to repay debt. The result has been an increase in delinquency rates. Between the fourth quarter of 2008 and the first quarter of 2009, the 30 plus day delinquency rate on loans held in CMBS rose .68% to 1.85%. By the end of 2009, delinquencies could reach 6% or higher.
Approximately $90 billion in CMBS or CMBS related investments are expected to mature in 2009-2013. As these investments mature and loan defaults increase for non-viable commercial loans, CMBS investors could see significant losses. CMBS investors may seek recourse for their losses through collection on their credit default swaps, if they acquired one, or through potential litigation.
Credit Default Swaps
Starting in 2005, CMBS investors began acquiring credit default swaps (CDS) to protect their CMBS investments. Holders of a CMBS that acquired a CDS paid a small premium as a ‘buyer of protection' from a counterparty that was a ‘seller of protection.' If a trigger event occurred related to the CMBS, the buyer of protection would receive a payment from the counterparty.
Originally, a CDS issued related to CMBS product had similar trigger events as ordinary bonds, which were primarily focused on defaults (for example, bankruptcy, failure to pay or restructuring.) However, CDS issued on CMBS quickly changed trigger events to capture any non-default event which reduced cash flow, such as principal shortfalls, interest shortfalls or write-downs.
The buyer of protection would receive a payment from the seller of protection if one of these cash flow trigger events occurred. However, unlike ordinary bond trigger events, occasionally a cash flow trigger event on a CMBS may reverse itself in a subsequent period, and the buyer of protection may need to return a portion, or all, of the payment received from the seller of protection. Such a situation, sometimes referred to as a claw-back, could lead to a significant financial strain for the buyer of protection.
While there hasn't been much specific CMBS litigation yet, as CMBS mature over the next few years, litigation will likely be similar to lawsuits involving Collateralized Debt Obligations (CDO) and Residential Mortgage Backed Securities (RMBS). Claims could arise against underwriters, issuers, dealers, and possibly rating agencies for fraud, misrepresentation, misleading statements, breach of contract as well as securities violations.
However, these claims may be different than CDO and RMBS claims to reflect the structural disclosures in the CMBS offering materials. CMBS offering documents generally have substantially more property specific information than CDO or RMBS offering documents, which may eliminate certain claims used in CDO and RMBS litigation, particularly related to omissions of information. Yet, these additional disclosures may open new property specific claims that are not present in the current CDO and RMBS litigation.
Other areas of litigation may involve the terms of the related CDS, both on the initial collection side and potentially on the claw-back of paid amounts.
CMBS investors may be caught in the credit crunch over the next few years as buyers of real estate are unable to meet their obligations on their current loans and are not in a position to refinance their loans. Ultimately, the CMBS investor will be the loser in the commercial property credit crunch and may consider litigation to recover some of their potential losses.
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