Next Shoe to Drop: Commercial Real Estate Mortgages and Their Related Mortgage Backed Securities?
Nouriel Roubini | Jul 12, 2007
rgemonitor.com
At the beginning of 2007 very few - even on Wall Street - had heard of the ABX indices (and very few knew then even what subprime mortgages were). This blog was one of the very first ones in January to warn about the perils and implications of the fall of such ABX indices, even before the subprime sector started to bust in full force in Febrary (and this blog had also discussed the risks of a bust of subprime mortgages and housing already in August of 2006).
Of course by now the ABX term has almost become - as Andrew Leonard recently put it - a household term that anyone talks about in blogosphere, on Wall Street or otherwise.
So today let me talk about the CMBX index rather than the ABX one, as the latter is by now an old hat subject, even if its financial fallout is still largely underway.
The WSJ had an interesting story today about the rating agency Fitch getting concerned about commercial real estate lending having had some of the same reckless lending practices as subprime mortgages: interest rate only loans; high loan-to-value ratios; “unrealistic” expectations for rent increase; negative leverage (i.e. “when a buyer's debt payment is more than the income the property produces”).
The story also expresses concerns about “commercial mortgage-backed securities or CMBSs (i.e. the commercial real estate equivalent of residential mortgage backed securities, RMBSs) coming under stress if defaults on such commercial mortgages start to rise. Note also that a bunch of CDOs are loaded with such CMBSs in addition to subprime RMBSs.
One way to see whether the CMBSs are under pressure is to look at the CMBX indices provided by Markit. These CMBX indices are the equivalent for commmercial real estate mortgages of the ABX indices where the latter refer to cost of insuring against default on bonds backed by subprime residential mortgages. These indices give you a measure of the cost of insuring against defaults (i.e. CDS protection) in various tranches of subprime RMBSs (the ABX indices) and CMBSs (the CMBX indices).
Here is below a CMBX chart that gives you the CDS spread for a group of relatively low rated CMBSs, i.e. CMBSs with a BB3 rating. As you can see from the chart, in the last month alone the spread has increased from a low of 477 to the current 600. Granted, these are among the risky tranches of RMBS; still even BBB tranches and even single A tranches of CMBSs have recently experienced a sharp and similar spike in CDS spreads.
Is this rise in spread a "contagion" from subprime RMBSs and from the ABX market to RMBSs, and thus to the CMBX indices? That is one interpretation. The better and more ominous interpretation is that markets and investors are already noticing what Fitch just told us, i.e that the riskiness and default risk on such commercial real estate mortgages is significantly rising. So after subprime mortgages and their related RMBS, ABXs and subslime loaded CDOs the next show to drop - in this endless and sometime confusing alphabet soup of credit derivatives - may be commercial mortgages and their related CMBSs and CMBXs...
And here is the WSJ story:
Fitch Sees Rising Shakiness In Commercial Mortgage Arena
By RYAN CHITTUM and JENNIFER S. FORSYTH
Wall Street Journal July 12, 2007
Defaults on loans backing commercial mortgage-backed securities could soon begin to rise, as some owners of buildings purchased for high prices find they were too optimistic about future market conditions, a credit-rating company warned.
In a report yesterday, Fitch Ratings said the fervid lending conditions from 2005 until early this year allowed landlords and real-estate developers to load up on interest-only loans and loans with high loan-to-value ratios that were underwritten with expectations for rent increases that appear "unrealistic." While commercial rents are rising at the fastest levels in many years -- especially in some of the strongest commercial markets, including New York and Washington -- Fitch said owners have "overly optimistic expectations of future rental rates, sales growth and market growth."
The warning comes as investors have become more cautious about financing these deals. In the last three months, lenders have pulled back somewhat, tightened covenants and required borrowers to put up more cash. Meanwhile, interest rates have risen, making it harder to use borrowed money to amplify returns. "It's clearly had an effect on the number of people chasing deals," said Colin Dyer, chief executive of Jones Lang LaSalle Inc., a Chicago commercial real-estate services company. "It's taking deals longer to get completed, and it's stopped price growth for now."
As investing in commercial real estate has surged this decade and sales prices have skyrocketed, lenders competed aggressively to win market share. Some loans used so-called negative leverage -- when a buyer's debt payment is more than the income the property produces. In the past, banks underwrote loans based on current cash flow -- typically the rents landlords receive from tenants. As the market heated up and banks competed against each other to produce loans, some began underwriting loans based on expected future income levels.
Even though lenders have turned skittish in recent months and have started to require more equity in transactions, the higher risk loans that were written previously are now working their way into pools of loans packaged into commercial mortgage-back securities -- thus, raising the likelihood of higher defaults for the rest of 2007, said Fitch.
Some of these riskier loans, especially in the white-hot Manhattan office market had been based on the current pace of rent increases-about 25% in the past 12 months in Manhattan -- continuing for 10 years or more. "It was not just one bank doing this," Britt Johnson, a senior director at the ratings agency and a co-author of the report. "It was a common practice across originators."
That kind of aggressiveness, combined with the fact that CMBS default rates are at historic lows, led Fitch to predict the default rate will rise this year for the first time since 2003. The current default rate is 7.88% for CMBS issued in the last 10 years.
"If you look at historic levels of delinquency compared to today -- they're so low by any measure that it's only natural to conclude that there's likely to be an increase," said Tom MacManus, who heads the debt and equity group for Cushman & Wakefield Inc., a New York commercial real-estate services company... |
