A new generation of CMBS and CDOs has already hit the rocks. Shayla Walmsley asks what this means for the ailing securitised debt market
Investors have barely recovered from the, sometimes bitter, experiences of investing in old-style commercial mortgage-backed securities (CMBS), while collateralised debt obligations (CDO) have been justifiably slammed as ‘misleading' by regulators. But in recent weeks a new batch of both CMBS and CDOs have emerged. The problem is, the new-look ones are coming onto the market before the old ones have been properly worked out.
Even if it were not for the outstanding legacy issues, new-look debt products have not had the smoothest of runs. There was a promising start when around 20 investors signed up for Deutsche Bank's three-tranche securitisation of Chiswick Park in the UK. But in the US, Goldman Sachs and Citigroup were forced to pull a $1.5bn (€1.04bn) CMBS at the end of July, after it had been placed with investors, when Standard & Poor's withdrew its preliminary rating.
"Market confidence suffered but it wasn't the only factor contributing to volatility," says Julia Tcherkassova, New York-based CMBS strategist at Barclays Capital. "There's unemployment - and you can't ignore technical factors such as regulation and liquidity, either."
After S&P's July move, Prima Capital subsequently pulled its $670m (€465m) CDO. Although the US CDO market reached $70bn at its peak, this was the product that dared not speak its name. The Prima pre-sale report released on the securitisation did not mention CDOs. Given its fate, the next one is unlikely to, either.
That is even without the recent history. Walter Borst, recently appointed CEO of Promark, which manages General Motors pension scheme, declined an interview, but the SEC ruling on JPMorgan's CDO Squared, which requires JPMorgan to pay back $153.6m, accused the bank of "misleading" mezzanine investors, including not only pension schemes but Asian insurers.
Arguably, CDOs have their uses. Claudio Albanese, a quant and economics professor, was the author earlier this year of a model that would enable investors to trade counterparty risk via CDOs, in the process arbitraging Basel III's higher capital requirements. He argues full commercialisation effectively trades counterparty risk for liquidity risk.
"The volume of capital required is so large that you have to look forward to where the capital will come from," he says. "The potential for funding arbitrage is humongous."
After falling almost at the first hurdle, CDOs are unlikely to make a speedy recovery. But what of CMBS? According to unpublished data from Hatfield Phillips, 45% of industry specialists expect CMBS to return in 2012, with another 25% giving it until 2013. "It will happen," says Barry Osilaja, director of structured debt and equity solutions at Jones Lang LaSalle. "There is a huge demand for bonds that has to be met. For my money, we still need a capital market solution. But investors don't want things they can't compare, can't assess, and don't understand."
The CRE Finance Council's CMBS 2.0 committee is expected at a meeting in November to come up with something approaching an operating framework for the asset sub-class. Until then, there are still issues to be worked out. The re-emergence of the super-senior structure, for example, irked Moody's, which believes its existence would diminish credit risk to senior investors to such a degree that they fail to exert discipline on the underwriting. The rating agency sees CMBS 2.0 as having moved from two phases, with leverage ratios increasing from the conservative in the middle of last year to above 90% in the middle of this one.
Where there is appetite, it will be for AAA, single-category CMBS - UK offices, with Land Securities as the borrower, for example, says Osilaja. Yet S&P has raised concerns over increased leverage and inadequate underwriting. In the US, it has pointed out, more cautious single-borrower transactions have given way to multi-borrower deals and optimistic - it called them "questionable" - property valuations.
In their new incarnation, Osilaja believes, there will be no aggressive tranching. Yet CB Richard Ellis can not quite see how a tranche-free CMBS would work, given that much of the appetite comes from hedge funds investing at the bottom of the risk stack for higher returns.
Patrick Janssen, portfolio manager for fixed income structured credit products at M&G, believes you can split European CMBS investors into three camps. First, at the mezzanine level, short-term hedge fund cash is going where pension funds fear to tread. Second, large-loan CMBS associated with big corporate names are holding up well with no selling pressure. This category attracts pension funds and insurers because they are backed with good-quality assets. He expects to see more deals like this in the second half of the year. Third, a few real money managers (including M&G at the senior end) are investing in combination CMBS.
"If you buy the most senior tranche, you can have 10 loans and see defaults on nine of them without damaging to the yield," says Janssen. "People don't always realise how resilient they are."
Similarly, he believes investors should be looking at mezzanine debt in the secondary market. "It's an opportunity to buy mezzanines in the secondary market because there are no new issues. Supply is shrinking," he says.
Given market volatility and recent history, you can understand why investors might look at the less risky end of CMBS - if they look at all. Despite CMBS delinquencies in July approaching 10%, the US is still way ahead with investors, including not only hedge funds but public pension schemes, such as the $59bn Oregon Public Employees Retirement Fund (OPERF).
It is not clear whether European pension schemes will follow them back in but the appetite is not necessarily where you expect to find it.
"Fundamentally, if additional investors have an appetite. But so much depends on regulation," says Paul Lewis, director at CB Richard Ellis. "There are uncertainties still around Basel III and Solvency II. There is a whole lot of interest within the insurance sector in whole loans, which they've never done before, and that is driven by the regulatory impact of Solvency II, primarily."
He adds: "I don't think institutional investors are necessarily worried about CMBS-specific risks. The risks are more about the real estate market, not necessarily about the structures. But if you get the structures right, then why not?"