US government intervention intended to help the CMBS markets to start to move again could be hindered by the sheer complexity of the sector. Stephanie Schwartz-Driver reports

The news that the US government financial rescue programme would extend to commercial mortgage-backed securities (CMBS) gave a much-needed boost to the moribund sector. Although the details of the programme are still being worked out, the prospects are definitely brighter.

Risk premiums narrowed by as much as 25% and prices rose following the news that the Federal Reserve lending programme would be extended to investment in CMBS and that public-private partnerships would be formed to buy up securities, clearing the market and paving the way for new issuance in the future.

In the US, there has been no new CMBS issuance at all since the second quarter of 2008, and even in 2008 new issuance was dramatically down from the previous year.

From early February, the government began to talk about extending its Financial Stability Plan to CMBS, but it was not until 23 March that clarification was issued. Two separate programmes under the Public-Private Investment Fund (PPIF) will relate to the sale of legacy loans and legacy securities (legacy vehicles are those formerly called ‘toxic').

The Federal Deposit Insurance Corporation (FDIC) will assist member banks in auctioning off legacy loans and will guarantee debt for financing up to 85%; the Treasury will provide up to 50% of the equity for bid, although the private asset manager will retain control of the investment under the supervision of the FDIC.

"The hope is that banks will be able to sell at higher than current market price their existing loan portfolios," explained Christopher Hoeffel, the president of the Commercial Mortgage Securities Association (CMSA), in a webcast to association members.

Under the PPIF plan for legacy securities, which will be part of the existing Term Asset-Backed Securities Loan Facility (TALF) programme, the government will appoint around five fund managers who can buy legacy securities, with the Treasury providing up to 50% of the financing. The fund managers selected will need to show they have $10bn (€7.75bn) under management in similar asset classes and the ability to raise $500m.

The legacy securities available for purchase will include non-agency residential mortgage-backed securities (RMBS), as well as CMBS and asset-backed securities (ABS), originated prior to 2009; all will be AAA-rated, but further clarification on eligible assets is pending.

The announcement of these purchasing programmes triggered a dramatic spread tightening across the sector, not only among AAA-rated bonds but also extending to AA and A-rated.

However, Lisa Prendergast, managing director at RBS Global Banking & Markets, notes that a significant amount of uncertainty in the market led to a rollback soon after. "The market will see an ebb and flow of spreads," she warns.

One criticism of the PPIF legacy auction programme is that, in the first instance, smaller fund managers are restricted from the process. "I would like to see one-off buyers coming in first to take advantage of lower prices, and then bring in the five fund managers to raise the prices even further," Prendergast says.

"The key to the success of this programme is the financing," says Paul Vanderslice, managing director at Citigroup. The CMSA has urged that the financing terms be extended to better match the maturities of CMBS. Although the government financing has a term of three years, many CMBS have longer terms: up to seven to 10 years.

Hoeffel stressed that "all the programme does is change ownership of the bonds, not the servicing". The servicing issue is another key to resolution of the CMBS logjam. There is approximately $800bn-worth of securitised loans in around 1,000 pools. Some of these loans are going to need refinancing and some of them are going to end up in default.

In March, Lee Cotton, former vice-chairman of Centerline Capital Group, stressed that the commercial mortgage sector is in better shape than the buzz around it suggests. "It isn't all terribly weak," he said. "How can you say that, in two years' time, you won't be able to refinance?"

However, Chris Mayer, senior vice-dean and professor of real estate at Columbia University, took issue with this positive spin. "The best-case scenario of ‘we don't know whether we can refinance', is not a good case to put money in," he said.

The complication for CMBS is that the trust structure of the vehicle makes renegotiation of loan terms complicated, although not impossible. "Just because we created this complicated structure does not mean that there is not still a borrower and a lender in the room," he maintained. However, the relation between borrower and lender is no longer as clear-cut in a securitised loan as it is in a mortgage that remains on the bank balance sheet.

While the borrower remains the primary servicer, its discretion is constrained by the pooling and servicing agreement that set up the trust. In fact, it is normally the master servicer who holds the authorisation to vary the terms of any of the loans in the pool; the master servicer's discretion in this is also defined by the trust agreement. Should a loan go into default, it is then handled by a special servicer.

Many key decisions in a securitised vehicle, including the appointment of the special servicer, are made by the B-piece holder, who is known as the directing certificate holder or the controller class; since disbursements in a securitised loan pool are made from the top down, with losses thus coming out of the lower-rated tranche first and those holding AAA-rated tranches benefiting first, the B-piece holder is the one most likely to suffer in case of restrictions.

The figure above shows how complicated the transaction structure can be. This complexity ensures it is challenging to arrange loan extensions or renegotiated terms on a loan that is securitised.

This difficulty is compounded by the fact that credit in general is not easily available, making CMBS a complicated investment option. However, the hope is that government intervention and financing will help clear the backlog and get the market moving again.