Caught up in the hype

If residential mortgages have been problematic, the same must apply to commercial. Right? Wrong. The outlook is brighter than you might think. Stephanie Schwartz Driver reports

The year has begun ominously for commercial mortgage-backed securities (CMBS) in the US - for the first time in two decades, there were no new issues in January and minuscule issuance in February. As the financial markets struggle to right themselves, what is the outlook for CMBS?
Yields on 10-year CMBS reached record highs in January, as the Federal Reserve interest rate cuts failed to calm the markets. The10-year spread reached 175bps on 23 January, an intraday high. At the same time, yield premiums have risen to more than 145bps over interest-rate swaps since December, compared with 30bps in the first quarter of 2007.
At the same time, volatility is high - spreads can jump 20bps to 30bps in a day or two. Investors are not buying until they feel that the markets have settled down; issuers are not making new issues until they are able to clear their backlog, which means they need buyers to step up. 
It seems that CMBS is another casualty of the sub-prime crisis, but this time, it is playing the role of innocent bystander caught up in the action. 
The delinquencies that have troubled the residential mortgage space have not spread into commercial mortgages. In fact, 2007 saw historically low CMBS delinquencies, at 0.28%, according to research by Fitch ratings.
"CMBS fundamentals are performing really well," says Mary Macneill, managing director, CMBS surveillance, for Fitch Ratings. The 2007 delinquency rate, at 28bps, compares very favourably with 2006, when it stood at 42bps. "This is minuscule, compared with sub-prime," she notes. "CMBS has gotten caught up in the hype of the sub-prime crisis."
This is a point stressed by Leonard Cotton, vice-chairman of Centerline Capital Group and president of the Commercial Mortgage Securities Association (CMSA). "Even if delinquencies were to triple, we'd still be only at 110bps, and 1.5% is pretty much the norm," he says.
Although Fitch has predicted that delinquencies are likely to double, and perhaps even triple, over the course of 2008, this still leaves them only around the average annual default rate of 79bps. 
Although 2007 finished low in terms of delinquencies, there is one notable trend. A rise in delinquencies toward the end of the year was largely attributable to problems in the multi-family sector, according to Fitch research. The delinquent loans were also of recent vintage, with the highest concentrations of delinquent loans streaming from 2004, 2005, and 2006, delinquencies that occurred earlier in the cycle than would be expected.
The lack of issuance in January does not trouble Macneill. "There is going to be some issuance later in the year. There are five or six fixed-rate deals in our pipeline scheduled for this quarter," she says, pointing out that January has historically been a slow month as most institutions try to close their deals by the end of the year. "That said, the deals calendar volume is lighter, and there has been a rapid decline in origination." Fitch is expecting volume for this year to be around $80bn (€54bn), compared with a historical high in 2007 of $240bn.
Around $37bn in issues had been slated for the first ‑‑¬quarter of this year, but none has priced yet. New issuance is likely to be fixed-rate, as there is little or no investor interest in variable-rate deals. Blackstone's $9bn issuance, the largest CMBS deal to date, has been scheduled for the first quarter but has yet to materialise.
Why CMBS is stalled right now is a chicken and egg question, as many factors are interwoven.
Cotton believes that it is a case of the technicals outrunning the fundamentals. In his view, commercial real estate fundamentals remain solid - commercial real estate is not subject to a supply-demand imbalance as it was during the downturns of the 1970s and 1980s. 
Nor are institutional investors subject to the same faults that brought down residential mortgages, stresses Cotton. "This isn't like somebody who bought five houses in Las Vegas. Commercial mortgagees are sophisticated borrowers, well represented by legal counsel and financial advisers." 
At the same time, spreads are not justified, noted Cotton. "If you look at the CMBX at the BB or BBB level, to justify those spreads, you'd have to have double or triple the losses," another case of the technicals outrunning the fundamentals.
The problem now is that nobody is transacting. Increased volatility puts investors off, notes Mary Macneill. It also puts traders off: traders are unwilling to make markets, to take positions, apprehensive that the markets will surge or fall, and investors are reluctant to buy for the same reason.
"When the liquidity situation is so volatile, it causes everyone to be a bit paralysed," says Macneill. The prospect of economic recession or downturn is another big disincentive for investors. 
In addition, CMBS suffers from ‘guilt by association'. Because securitised residential mortgages have been problematic, there is an assumption that the asset type in general must be troubled. 
"When you get an environment like this, you get fear," says Cotton. There is a lack of confidence, driven in part by a lack of understanding, by a wrong belief that what happened in residential will happen in commercial." 
Getting back to basics, Cotton believes that CMBS issuance and transactions will inevitably rebound as the real estate market takes it course. "People need to transact, the 1998 cohort will need to be refinanced, people will need to build, to sell, to refinance."
CMBS investors hold around 24% of outstanding commercial real estate loans; banks hold 49% and life insurers hold 9%. Moody's estimates that both banks and insurers are close to their limits, and although many balance sheet lenders are getting back into the lending game, sensing a good opportunity at hand, the CMBS market will have to get moving again to restore liquidity to the market. 
Once the market gets moving again, its mettle will be proved, in Cotton's opinion. "Stability will be tested, and it will be tested and proved," he says.