The Repricing of Risk: Petra Peels the Onion

In Ever Increasing Numbers, Vulture Investors Are Circling Commercial Mortgages, Citing a Price/Value Disconnect, But Expect Book Values to Remain Under Pressure as More Distressed Trades Begin to Hit the Tape.

Petra Real Estate Opportunity Trust, a New York-base REIT intending to invest in commercial mortgage loans, recently filed a registration statement for an initial public offering with the U.S. Securities & Exchange Commission. Behind the REIT is Andrew Stone's Petra Capital Management, a $3.7 billion hedge fund focused on real estate debt and related financial instruments. Through its IPO, Petra is looking to raise $200 million, alongside a private 144a offering of $250 million which commenced on June 4th.

Stone began his career in 1981 at Salomon Brothers in the Mortgage-Backed Securities Department, where he became a senior trader responsible for the day-to-day management of the mortgage-backed securities trading group, which was headed by the legendary Lewis Ranieri. Stone and his team were responsible for structuring and trading the new real estate finance products that Salomon Brothers was then bringing to the market. Those products became the lifeblood of the mortgage market we now know and casually took for granted until late 2006.

After a series of senior real estate finance related positions at a number of Wall Street firms, Stone eventually landed at CSFB in 1995, where he formed the firm's Principal Transactions Group, or the PTG, which was Credit Suisse’s global real estate business. The PTG also functioned as a proprietary investment vehicle within Credit Suisse to invest in mortgage- and asset-backed and other real estate-related debt and equity. Stone was eventually forced out after management became concerned that he was literally betting the bank.

Stone then formed Petra, which had assets under management of approximately $3.7 billion as of March 31, 2008, consisting of commercial real estate finance investments of approximately $1.6 billion and approximately $418 million of equity. The Petra Fund has generated cumulative net returns since inception of approximately 23%, which ain't too shabby. Petra is named after a city in the Jordanian desert, which bible scholars believe is the place where true believers can go in order seek refuge after the arrival of the anti-christ.

With a successful hedge fund, creatively named to poke a finger in the eye of his former bosses, and a career of notable accomplishments behind him, why would Stone want to go to the trouble and hassle of organizing a lowly REIT, particularly one focused on the nuclear wasteland in mortgages? Well, it turns out that a quick look through the prospectus is both enlightening and interesting reading.

Petra's new REIT describes itself as:

"a newly organized, internally managed commercial real estate finance company formed to take advantage of inefficiencies and dislocations in the credit markets by opportunistically acquiring and originating commercial mortgage loans and other real estate-related assets that generate risk-adjusted returns that currently exceed those typically expected under normal market conditions."

These are obviously dangerous areas for investing right now, nevermind in an IPO for a newly organized commercial mortgage REIT, but Petra looks to be calling a bottom with this new offering. In the filing, Petra says it thinks that "current conditions in the credit markets have created investment opportunities of a magnitude that arise infrequently in the financial markets."

The draft S1 goes on to say that "concerns that began with the deterioration of the credit quality of sub-prime residential loans and other factors have resulted in an illiquidity contagion that has impacted the values of commercial mortgage loans and other real estate-related assets despite, in our view, the lack of a deterioration in the fundamentals of such loans and assets".

The S1 compares the current credit crunch to past market disruptions, such as the stock market crash of 1987, the S&L crisis, the Russian debt crisis, LTCM and the terrorist attacks on September 11, 2001, all of which turned out to be significant opportunities for intrepid investors.

Stone is one of them, and he is in a rush. Petra says in the filing that it believes the current opportunity will exist only for "a relatively limited time period". As he knows from experience, by the time the panic in the market catches up with underlying fundamentals, savvy opportunists like Stone will have already picked over the bargain bin.

The price/value disconnect is Petra's arbitrage, and it has never been greater in commercial mortgages. As the prospectus shows, spreads for 10-year AAA CMBS are approximately 150 basis points wider today than they were only nine months earlier, as illustrated below, even after a recent minor recovery.

Despite these unprecedented spreads, nothing has changed in commercial real estate fundamentals, which remain intact. Petra's whole investment thesis is their belief that the widening spread in the commercial real estate mortgage loan market is driven by illiquid credit markets, not by deteriorating credit fundamentals.

As they illustrate in the Petra prospectus, while yields on CMBS continue to widen, CMBS delinquency rates remain as low, or lower, than before the crisis began. The disclocation in credit quality between residential subprime and CMBS has created an Alpha that hedge fund managers can only dream about:

In addition to the low commercial mortgage delinqency rates (which I have also written about extensively), Petra points out that further evidence of strong credit fundamentals in commercial real estate mortgage loans is evident in the total number of CMBS upgrades by Fitch Ratings. As of year end 2007, the number of upgrades continues to significantly exceed the number of downgrades, with Fitch having upgraded 776 classes of U.S. CMBS during 2007, compared to 70 classes that were downgraded. This is an upgrade/downgrade ratio of 11:1.

Stone is not the only one to recognize this disparity. There are now heaps of private hedge funds beating the bushes for high net worth investors and pension funds wanting to invest in this space. North River Investment Management, for example, just launched its first commercial real estate private equity fund, North River Opportunity Partners I LP with $100 million of committed capital. The fund is but one of dozens that will also initially pursue investments in discounted pools of commercial mortgage debt and originate first mortgage and mezzanine loans on commercial real estate properties.

Echoing the Petra theme, the North River prospectus notes that "current economic pressures have led to wide-scale devaluations of assets such as commercial mortgage-backed securities. At the same time, due to capital constraints, many traditional lenders have retreated from commercial mortgage financing, even for highly credit-worthy properties," said Jonathan Kaye, co-founder of North River.

So what does this mean for all of you REITwrecks bargain hunters out there? As these new funds rush into the current liquidity vacuum, attracted by commercial mortgage yields that are dramatically mispriced relative to underlying fundamentals, valuations will remain under pressure as distressed trades start taking place in increasing numbers. The effect of these transactions on "mark to market" valuations will depress portfolio values throughout 2008 and possibly well into 2009, even though the underlying performance of the collateral will remain strong and dividends continue to get paid.

As the chart below shows, commercial banks and CMBS issuers are currently the largest holders of commercial and multifamily mortgage loans, and these holders are under increasing pressure to minimize their exposure to these asset classes. Consequently, they may often sell the loans at discounts in order to maintain their liquidity in this environment (just like a margin call), particularly the CMBS issuers who got stuck with the loans when they could no longer securitize them.

Depositing those dividends is the easy part; stomaching this roller coaster ride isn't. I don't believe it will get any easier any time soon, but the ride will eventually come to an end, and I think you will be glad you bought that ticket.

Thanks for reading.

Equity Investors Have Plenty of Capital

Although sales activity is stifled, investors' interest in commercial property acquisitions is acute

According to the latest PricewaterhouseCoopers Korpacz Real Estate Investor Survey, equity funds in the market this year are slated to raise more than $318 billion, which would be up 35% from the amount targeted by the funds in the market all of last year, the report noted, citing data from Real Capital Analytics.

"It's hard to see all of this capital because it is not moving," concluded the survey of REITs, pension funds, mortgage bankers, developers, insurers and other institutional investors and property managers.

Sales since last year's third quarter have been paralyzed by a lack of debt financing caused by credit markets dislocation and by uncertainty over how far lower property prices will move. The survey said that investment capital remains on the sidelines "waiting for signs that the worst is over."

It also noted that capital is growing increasingly concerned about how much a stalled economy may impact property fundamentals.

The $46.5 billion of commercial property sales, including hotels, closed in Q1 was down about 66% from more than $135 billion in the same period a year ago, the report noted, again citing Real Capital Analytics. Moreover, less than 50 investors have spent more than $100 million in Q1. That's down from 150 that spent $100 million or more on commercial property in the year-ago period.

Much of the capital waiting on the sidelines is from foreign buyers, who began exhibiting increased interest in U.S. property last year when they accounted for more than $50 billion in investments here, more than double their 2006 amount.

The Korpacz report also said that pension funds by and large over the past year have increased their allocation targets for real estate, but noted that many of those funds may divert a large portion of those increased allocations to foreign property markets.

Office market investors seem the most confident that pricing is already turning more in favor of buyers. "While pricing may still be tricky to figure out, it appears that this market is shifting in favor of buyers," said an office investor respondent.

The survey estimates that the average capitalization rate for central business district office properties rose 5 basis points between the fourth and first quarters to 6.68%, while the average for suburban office rose 15 bp to 7.28%.

The warehouse sector's average cap rate rose 9 bp to 6.56, while in the retail sector, the average for shopping centers rose 4 bp to 7.32%, for malls it rose 3 bp to 6.71% and for power centers it rose 4 bp to 7.17%.

The multifamily sector's average dropped 4 bp to 5.75, the only sector capitalization rate decline in the survey. The survey noted that multifamily sector investing has been buoyed by debt financing from Freddie Mac and Fannie Mae, which is "helping prices remain elevated."

Meanwhile, investors are getting skittish about the economy and how that might impact property fundamentals, which had been strong through much of the credit-markets islocation. "Fundamentals have held up relatively well, but we are starting to see rental growth decline and vacancy rates inch up, which ultimately reduces value," said another respondent to survey.

Job losses, one of the most obvious symptoms of a slowed economy, pose an immediate threat to demand for multifamily property, whose national vacancy rate grew 20 bp to 5.9% in Q1.

The report noted that multifamily is grappling with over-supply that's exacerbated by a shadow market of condominium units being added to the rental inventories in some markets.

The Korpacz survey's concern about the shadow market hurting multifamily fundamentals was cited earlier this by research firm Reis Inc. that noted Miami's rental market added 1,300 condo units in the first quarter and will add another 8,500 by the end of the year.

A slowing economy may already be impacting warehouse property fundamentals, as the Korpacz report noted that the segment's average initial-year market rent in the first quarter grew 2.94%, down 29 bp from the previous quarter's growth rate and the sector's first such quarterly decline in growth rate since Q4 2005.

As a result, survey respondents predicted that warehouse properties would appreciate an average of 50 bp this year, down from a 2.71% average appreciation predicted in the Korpacz survey a year ago. Some said warehouse values could depreciate up to 10% this year.

On the retail property side, one survey respondent lamented, "As consumers spend less money on retail goods, landlords will have a harder time pushing up rental rates and collecting percentage rent."

The 2.4% of growth in same store sales during 2007 was the sector's lowest annual growth in more than 20 years, according to Bank of Tokyo Mitsubishi. The Korpacz survey also reported that while slower sales have forced many retailers to declare bankruptcy or close some stores over the past year, concern is growing that still more will shelve expansion plans in the near-term.

Recently-built and under-construction malls will have trouble reaching strong occupancy levels, while many power centers face declining rents, the Korpacz report predicted. It added that a suspected softening in fundamentals will further weaken investor demand for class-B malls, while class-A malls remain in demand but rarely come to market.

Retail strip centers have suffered one of the largest property sector sales declines, with $3.3 billion in Q1 sales down 77% from the year ago-period. But, the Korpacz report says investor demand for these properties is keen in population growth markets such as Atlanta, where 104 strip centers were sold in Q1. That's about 2.3% of the total nationwide.

Office property fundamentals remain strong with a 9.9% national vacancy rate and 17.5 million sf of leasing activity in the first quarter, both comparable to levels reported in the same period a year ago, according to Cushman & Wakefield.

But, the Korpacz survey cited widespread concern that an ongoing economic slowdown will seriously cripple office fundamentals and investor demand in suburban and tertiary markets. The concern is particularly acute in markets that have had extensive construction, such as Phoenix, where 1.1 million sf of speculative office space was added in Q1.

Office investors are also concerned that the sector has not yet realized the full impact of the economic slowdown because it tends to lag the economy's performance. One office investor remarked, "While we do not see losses in occupancy, I do think they are coming."

CW Capital Takes B Piece on $1.4BB CMBS deal

Latest CMBS Deal Launched and Priced

CRE Direct (www.credirect.com) reported that CW Capital, the mortgage lending subsidiary of Caisse de dépôt et placement du Québec, took the entire subordinated "B" note on Bank of America's $1.3billion CMBS deal, which priced on the 19th, just one day after guidance was issued. It is only the eighth deal of the year and perhaps the last for months, and the quick pricing was thought to be a consequence of scarcity value. One wonders where AHR, JER, CHC and others were in the bidding. The transaction was obviously competitive; did CW Capital's access to Canadian bank deposits give it a funding cost advantage or did the REITs just intentionally price themselves out of this deal?

Accretive earnings would seem hard to come by, since just seven conduit deals totaling $9.4 billion have priced so far this year. By the same time last year, 29 conduits totaling $113.7 billion had priced. Because conduit shops have yet to start originating loans in any sort of volume (although Wachovia was rumored to have just recently been given the go-ahead to begin new originations), the expectation is that full-year conduit volume will be no greater than perhaps $20 billion to $25 billion.

For all of last year, in comparison, $188.6 billion of conduit deals priced. Another $41.9 billion of single-borrower or floating-rate deals priced as well, which brought last year's total CMBS volume to $230.5 billion.

The transaction, Banc of America Commercial Mortgage Inc., 2008-1, is backed by 110 mortgages with a weighted average underwritten debt-service coverage ratio of 1.34x and a loan-to-value ratio of 67.4%. Many of the loans were originated some time ago, with parts having been securitized through earlier deals. From REITwrecks's perspective, these are demonstrative of strong collateral, and it looks like a departure from the weaker underwriting of 2005/2006. This also likely had a beneficial effect on pricing.

Not surprisingly, among those is the deal's largest collateral loan, a $109.3 million piece of a $344.9 million debt package that BofA had provided for a portfolio of 27 extended-stay hotels with 3,439 rooms that were formerly owned by Apple Hospitality Five, Inc., which was acquired by Inland American Real Estate Trust in a $709 million deal last year. Hotels generally attract higher cap rates and lenders generally also require lower LTV ratios and higher debt coverage.

Despite the weakening economy, the hotels generated $47.9 million of net operating income over the past 12 months, even though they were underwritten to generate $46.1 million of NOI. Other pieces of the debt package were securitized through Merrill Lynch Mortgage Trust, 2008-C1, which priced last month, and Morgan Stanley Capital I, Inc., 2008-TOP29.

Also in the collateral pool is a $64.2 million piece of a $385 million debt package on Arundel Mills, a 1.3 million sf shopping center in Hanover, MD owned by a venture between Simon Property Group and Farallon Capital. Pieces of that debt have been securitized through Merrill Lynch Mortgage Trust, 2008-C1, and Banc of America Commercial Mortgage Trust, 2007-5.

The deal also includes a $97.5 million interest-only loan on 550 West Jackson Ave., a 401,651 sf office building in Chicago owned by a group led by Mark Karasick. The property had been encumbered by $116.5 million of financing that RBS Greenwich Capital had provided and was said to be shopping when the property came under pressure as a result of the departure of a major tenant, commodities broker Refco, Inc.

Karasick had purchased the property for $125 million in 2005 before Refco's disclosure of financial improprieties. The company filed for bankruptcy protection and ultimately was acquired by Man Financial. It gave up its space at 550 West Jackson, but much of it was ultimately leased to Calyon, which already had occupied space there.

The bulk of the deal's collateral loans, representing 41.6% of its balance, were assumed by BofA through its acquisition of LaSalle Bank, while 3.4% of the deal's loans were originated by Countrywide Commercial Real Estate Finance, whose parent BofA is in the process of acquiring. Barclays originated 15.3% of the deal's loans, by balance.

The deal's junior-AAA bond class has a subordination level of 13.75%. That compares with an average of 13.5% for the seven conduit deals that have priced so far this year, but is lower than the 14.75% for the JPMorgan Chase Commercial Mortgage Trust, 2008-C2 transaction, which priced at the end of April.

Meanwhile, CMBS conduit spreads have continued to widen. Spreads on super-senior AAA bonds had tightened steadily since reaching their all-time wides in mid-March, but reversed course three weeks ago. They ended last week at an average of 156.5 basis points over swaps, according to the Commercial Real Estate Direct CMBS Pricing Matrix. The widening is the result of overall softer conditions in the broader credit markets.

Thanks again to Commercial Real Estate Direct for the bulk of this story.

Disclosure: Long AHR

Concerns Grow on CMBS Price Manipulation

AS EVIDENCE GROWS THAT THE SELLOFF WAS OVERDONE, OPPORTUNITIES TO INVEST WILL FADE. BE GREEDY NOW WHILE OTHERS ARE FEARFUL.

In early April, I reported that the Commercial Mortgage Backed Securities Association had written to the Markit Group Ltd., the London-based administrator of the CMBX Index, a synthetic credit default swap derivatives index introduced in March 2006, requesting that trading data on the index, including total volume and number of daily trades, be made publicly available in order to "increase market transparency".

The move was a clear swipe at the Markit Group and the extent to which its CMBX synthetic credit default swap had come to dominate the cash market for commercial mortgage backed securities, and by extension had also become the playground of various hedge funds attempting to execute self-fulfilling niche short trades in the same market.

As Bloomberg subsequently reported when it picked up the story, rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market where no one knows how much is traded and speculators who bet on deteriorating credit quality can end up forcing that reality.

When the cash markets froze in late 2007 and early 2008, the indices became the only way for firms to value their portfolios in accordance with mark to market accounting requirements. Hedge funds quickly recognized the opportunity to profit by driving pricing of the CMBX indices higher, thereby forcing firms to mark down the value of the underlying cash instruments by a similar amount. Consequently, some credit-default indexes morphed into what Wachovia Corp. analyst Glenn Schultz called "Frankenstein's monster" because they now often drive prices in the so-called cash bond market, rather than the other way around.

All of this continues to have a dramatic effect on portfolio valuations for those firms subject to mark to market accounting, and possibly even played a role in the downfall of Bear Stearns. "The indices are just trading on their own account, with no relationship whatsoever to an underlying cash market," said Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co.

Fearing a repeat of losses and continued possible manipulation of their books, banks are refusing to support new indexes that would allow investors to wager on everything from auto loans to European mortgages, reining in a market that's about doubled in size every year for the past decade.

"The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with," said Andrew Dennis, the London-based head of the asset-backed debt syndication group for UBS AG of Zurich.

Indeed, Wachovia wrote down $600 million of commercial mortgages early this year because of declines in prices indicated by CMBX indexes, and Citigroup Inc., the largest U.S. bank by assets, wrote down its subprime holdings by $18.1 billion after using ABX credit-default swap indexes to help value the assets.

However, as the latest CMBS default figures from Fitch and others indicate, commercial real estate assets themselves continue to perform well and the commercial mortgages underlying the assets have therefore suffered very little deteriotation in quality.

"TOTALLY UNCORRELATED"

While the ABX Index was the best known offender, pricing in an underlying loss rate that was at least four times that expected by some analysts, the CMBX wasn't much better. According to Bloomberg, the cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, also more than four times the worst case 2.8 percent loss rate forecast by JPMorgan analyst Alan Todd.

"The ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market," Swiss Re's Aigrain said.

This is has all led to a great deal of controversy over the merits of mark to market accounting. Even Helicopter Ben saw fit to weigh in on the issue when asked about it recently in a question and answer session. According to Reuters, Bernanke said that on balance mark-to-market has worked well, but "it's also true in the current context, that mark-to-market accounting has been sometimes destabilizing in that sales of assets into very illiquid markets had led to reductions in prices, which have caused writedowns which have sometimes caused firesales, and you get into an adverse dynamic which has caused problems in some of our markets,"

While he said mark-to-market accounting has been a positive influence for investors, he also said that valuations should be determined during normally functioning, stable markets, not times when assets are illiquid.

It's a controversial topic, but any changes to mark to market accounting would be unfortunate and detrimental. This latest market dislocation is simply the result of the latest incarnation of the investment bubble, and protecting investors from the market's healthy aftermath would only encourage even more "irrational exuberance".

More importantly, it would penalize those investors who had the patience and foresight to avoid the bubble in the first place. For those fortunate few, the opportunities that now exist in the REITwrecks world have created one one of the best environments in history for investing in Mortgage REITs.

Multifamily Mortgage Market Stable & Growing

Delinquencies Remain Low in the Multifamily Sector; Level of Outstanding Debt Grew in the First Quarter

At least one corner of the mortgage market remains healthy: multifamily mortgages, which is good news for those mortgage REITs diversified among the four commerical real estate "food" groups. It is also a huge market, and one that is vitally important to our economy for a number of reasons, so good numbers are just that, good.

Most importantly, The Mortgage Bankers Association says that delinquency rates on commercial/multifamily mortgages remain low - up slightly from the fourth quarter of 2007 but still finishing the first quarter of 2008 near record lows.

These numbers come from figures reported by five of the largest investor-groups: commercial banks and thrifts, commercial mortgage-backed securities (CMBS), life insurance companies, Fannie Mae and Freddie Mac. Together these groups hold more than 80 percent of commercial/multifamily mortgage debt outstanding.

"In contrast to mortgages for single-family residential properties, commercial/multifamily mortgages continue to perform very well," said Jamie Woodwell, MBA's Senior Director of Commercial/Multifamily Research. "Most investor groups saw delinquency rates rise slightly in the first quarter, but they remain at the low end of their historical range."

The 30+ day delinquency rate on loans held in CMBS transactions rose less than one tenth of one percent (to 0.48 percent), while the 60+ day delinquency rate on loans held in life company portfolios remained flat at an incredibly low 0.01 percent. The delinquency rate on multifamily loans held or insured by Fannie Mae and Freddie remain under 1%, while the 90+day delinquency rate on loans held by FDIC-insured banks and thrifts rose 0.21 percentage points to 1.01 percent.

The delinquency figures also illustrate the success of the low leverage model employed by the life insurance companies - they typically underwrite loans with using lower LTV ratios and much better debt coverage. That was a difficult business model in the credit bubble, and their portfolios barely grew, but they stuck to their knitting and widows and orphans cashing those annuity checks can continue to sleep at night: of the 35,192 commercial/multifamily loans in life company portfolios, only 10 loans were 60+ days delinquent at the end of the quarter. These 10 loans had an aggregate unpaid principal balance of just $29 million, a virtual rain drop in the Pacific Ocean in comparison to the over $300 billion in multi-family loans held by insurance companies.

Based on the unpaid principal balance of loans, delinquency rates for each group at the end of the fourth quarter were as follows:

• CMBS: 0.48 percent (30+ days delinquent or in REO);
• Life company portfolios: 0.01 percent (60+days delinquent);
• Fannie Mae: 0.09 percent (60 or more days delinquent)
• Freddie Mac: 0.04 percent (60 or more days delinquent);
• Banks and thrifts: 1.01 percent (90+ days delinquent or in non-accrual).

Meanwhile, despite the contraction in the overall CMBS market, and almost every other credit market including, astonishingly enough, even the municipal bond market, the total level of commercial/multifamily mortgage debt outstanding managed to grow by 1.8 percent in the first quarter, to $3.4 trillion, according to Federal Reserve Board Flow of Funds data.

The $3.4 trillion in commercial/multifamily mortgage debt outstanding recorded by the Federal Reserve was an increase of $60.8 billion from the fourth quarter 2007. Multifamily mortgage debt outstanding grew to $856 billion, an increase of $18.5 billion or 2.2 percent from the fourth quarter.

"Investors continue to increase their holdings of commercial/multifamily mortgages," said the MBA's Woodwell. "The global credit crunch meant a net decline in the balance of mortgages held in CMBS, CDO and other ABS, but banks, thrifts, life insurance companies, Fannie Mae, Freddie Mac and nearly every other investor group increased their holdings of commercial and multifamily mortgages during the quarter."

The Federal Reserve's Flow of Funds data indicate that commercial banks continue to hold the largest share of commercial/multifamily mortgages, $1.43 trillion, or 42 percent of the "total", but many of these loans are actually corporate loans in which a piece of commercial property has been pledged as collateral. However, because the other loans reported are generally income property loans, meaning that the debt service comes only from rent payments, the commercial bank numbers are not strictly comparable.

Thus, the CMBS, CDO and other ABS issues are the largest holders of "pure" income producing commercial/multifamily mortgages, with $777 billion outstanding, according the the Fed (everybody reports this number differently, but it is a huge market no matter how it's measured). Life insurance companies hold $309 billion, and savings institutions hold $226 billion.

Government Sponsored Enterprises (GSEs) and GSE-backed mortgage pools, including Fannie Mae, Freddie Mac and Ginnie Mae, hold the largest share of multifamily mortgages, with $143 billion in securitized multifamily loans and an additional $158 billion "whole" loans in their own portfolios, or 35% of the total. (N.B., for you number fact freaks - I am one - many life insurance companies, banks and the GSEs also purchase and hold a large number of CMBS, CDO and other ABS issues. These loans are covered in the CMBS, CDO and other ABS category.)

MULTIFAMILY MORTGAGE DEBT OUTSTANDING

In this "new" credit environment, The GSEs (Fannie Mae, Freddie Mac, etc.,) and Ginnie Mae are now an even bigger factor in supporting our nation's housing stock. Not only do they hold the largest share of multi-family debt outstanding, but Fannie Mae is now almost the only game in town when it comes to financing multi-family property. Fannie Mae is there, and I can tell you they are writing checks.

This has been incredibly important in relieving at least some pressure on the demand for new commercial real estate credit, and probably for reducing overall default rates in CMBS pools, which still remain at historic lows. As I wrote in another post, High Yield Mortgage REITs, the Perfect Storm?, the low levels of CMBS debt scheduled to mature in 2008/2009 is also a big factor. Combined, these two supply inputs undoubtedly contributed to that fact that, according to Fitch Ratings, 99% of all maturing CMBS loans since August 2007 have been successfully refinanced.

Consequently, GSE's share of multi-family debt will only increase in the coming quarters, since credit officers at commercial banks, which hold $173 billion, or 20 percent of total outstanding multi-family debt, are spending more time calculating portfolio write downs than assessing new risk. And of course, the CMBS, CDO and ABS markets, which had been approaching $250 billion a year in new origination volume, now look unlikey to match even half that in 2008.

Indeed, of $18 billion increase in multifamily mortgage debt outstanding between the fourth quarter 2007 and first quarter 2008, Government Sponsored Enterprises underwrote $10 billion, or 54 percent of the total increase. Agency and GSE-backed mortgage pools increased their holdings by $3.4 billion and commercial banks increased their holdings by $4 billion. Nobody would be surprised to learn that the CMBS, CDO and ABS categories saw the biggest drop in their holdings of multifamily mortgage debt: a decrease of $9 billion.

In spite of the implosion in the CMBS,CDO and ABS markets, these figures show that at least one segment of the commercial real estate mortgage market is holding up well, possibly even thriving, and they are demonstrative of one of the underlying, basic truths of commercial real estate: Assets that produce reliably monthly income will survive, and so will the mortgages that support them.

Disclosure: None

The Trouble With TruPs

After looking at some potential apartment acquisitions in Ohio last week, American Airlines flew me back home through the lively metropolis of St. Louis. During the layover, I had a chance to read the St. Louis Business Journal, which featured on its front page a story about bad loans and their effect on local banks. It was entitled "Bad Loans Intensify Bank's Pain." Lively indeed!

First Bank, a firm headquartered in St. Louis, sounds like a real basket case: loan charge offs in the latest quarter were up 202% and profits were down 90%, to just $2.5 million from $25 million a year earlier. Its parent, First Banks, Inc., also disclosed that profits were overstated by $11.1 million over three years due to irregularities in its mortgage division.

Non-peforming loans were so common that 25 banks chartered in the region and surveyed by the Business Times reported that cumulative increases in NPLs were up 165% vs the year prior and profits were down more than 35%.

According the the Business Times, bankers there expect it to get worse before it gets better. "I expect the first quarter trend showing greater charge offs to continue through most of 2008", said Mike Flavin, President if the Business Bank of St. Louis.

Falling home prices remain at the center of the problem as these regional banks, which were basically forced out of big real estate and corporate loan syndicates by the ravenous and much cheaper CDO, CLO and CMBS markets, wound up heavily exposed to local housing markets with risky loans to small, local developers.

Not only have these banks been getting burned by loans to developers, but high yielding small loans to rehabbers have also turned south. "The rehabbing business has been difficult," said Rick Bagy, President of the First National Bank of St. Louis. "Everyone went into the rehab business in the last 10 years - doctors, lawyers, housewives - because it was easy money."

And punctuating that point was still another article relating the story of Triad Bank, yet another local lender, that was foreclosing on a local rehabber and seeking up to $1 million in the foreclosure suit. These are big numbers for small local banks and one of the major reasons why the FDIC, OCC and other regulators are stepping up their supervision of local and regional banks and their lending practices.

Forget worrying only about commercial mortgages, there are a number of Mortgage REITs out there, as many of you know, that bought and originated Trust Preferred's as a way of diversifying out of real estate. Many of these TruPs were covenant-lite and therefore poster children of the credit bubble: easy money just didn't get any easier. This was because these particular REITs were turning around and issuing CDOs secured by the TruPs, which was the ultimate OPM game. For those of you who don't know what OPM is, there is a book entitled OPM that was written about a leasing company of the same name. It is great reading, and illustrative of what happens when a lender's interests and a borrower's interests are no longer aligned.

No earnings after issuance? No problem! Busted tangible net worth covenants? Why bother to calculate it, pay that mob of lawyers to get it right in the docs and then monitor it all for compliance? Let's just leave that pesky provision out of the deal, shall we? After all, it's not our money, hey? We're just in it to collect management fees, so it's really no problem if you don't pay us back.

Among the many concerns now facing the banks that coughed up TruPs as fast as the lawyers could replace the ink cartridges on their printers are strong recessionary pressures within the US economy, outsized exposure to residential construction loans and home equity loans, and reduced short-term profitability. Significantly, these are not isolated problems at one or two thrifts, or just one or two wayward mortgage lenders (e.g., IMB). It is spread throughout the country, and it is particularly bad in the Southeast and West, two of the hottest housing markets in 2005 and 2006.

Fitch Ratings, evidencing this increasing pressure, has been notified of the deferral of TruPs payments at 11 banks and the complete default of one since September 2007. These 12 banks issued US$644.5m in aggregate TruPs and subordinated debt through 46 Fitch-rated CDOs. "Further bank deferral and default activity is likely, given current economic conditions," says Fitch senior director Nathan Flanders.

Near-term wholesale defaults appear unlikely, but the breadth of the problem is the issue, as evidenced by my anecdotal reading of just one midwestern business journal on my way through an airport. I'm not sure that anyone could have seen it all coming, except that the lack of covenants should have been a tip off: without covenants, there is no way to declare a technical default and get access to assets before it's too late.

As a result of the observed and expected collateral deterioration underlying bank TruPs, Fitch has revised both its rating and asset performance outlook on US bank TruPs CDOs from stable to negative. This should be no wonder, since by the time they are able to declare a monetary default, holders of the TruPs will be practically last in line for any recovery.

Fitch is also currently reviewing bank TruPs CDOs with deferral and/or default exposure or other high-risk exposure and expects to place materially affected transactions on rating watch negative in the near future. "The magnitude of underlying collateral currently in deferral or default will likely be the most significant determining factor in Fitch's analysis," adds Flanders.

Not wanting to get caught with its blinders on, Fitch says that its deliberations on ratings will also give consideration to individual exposures that Fitch believes will create increased risk, such as banks facing heightened regulatory scrutiny, banks which have recently reduced or eliminated dividends on common equity, or those with an above average level of exposure to high risk real estate. Given what's been happening in the market, this would seem to include just about everybody.

Additionally, Moody's has downgraded 53 tranches issued by 10 CDOs with significant exposure to residential mortgage REIT Trust Preferred Securities (Trups) and homebuilder securities. It said that the rating actions were prompted by continued credit deterioration and defaults in the residential mortgage REIT and homebuilder sectors.

Four of the affected CDO series include Attentus CDO (series I to III), Kodiak CDO (series I), Taberna Preferred Funding (series II to VII) and Trapeza CDO (series X). Moody's said that these CDOs have significant exposure to these sectors, ranging from approximately 25% to 50% of their aggregate portfolio balances. The rating actions also reflect uncertainties over final workout values, which are expected to be low (hence my rant on covenants before).

Not surprisingly, Moody's outlook for REIT TruP CDOs is also negative for 2008. The Taberna series were essentially issued by RAS, since it made its ill-fated purchase of Taberna and is now stuck with the mess. I don't mean to imply that a few isolated downgrades of these CDOs will be a huge problem for REITs like RAS. However, taken cumulatively with other problems, these downgrades - and the trouble they signify for the underlying TruPs collateral - could be the tipping point for those in the REIT menagerie that are struggling with a whole smorgasbord of other problems. These would include forced liquidations of assets, subsequent trouble satisfying IRS REIT income requirements and general head scratching in the board room when it comes to declaring dividends after all the defaulted scrip has been siezed or sold off.

Always looking for ways to have fun in this abysmal market, I have actually written about one such REIT in this very article. Long time readers may have noticed that having fun has not included kicking those that are down and out, but this is too important, as there is real money to be made with the survivors. Some of the more troubled REITs may also survive, but probably not as REITs, and definitely not with those head scratching dividends.

For a clue, look no further than the first letter of each paragraph.

Nuff said!

Disclosure: None

Update: Please take a look at the WSJ article which appeared today (Wednesday, June 25th) entitled "Small Banks Face a Looming Hit From Builders' Interest-Reserve Loans". The article contends that small banks are more heavily exposed to construction & development loans than bigger superregional and money center banks, and that the FDIC and OCC are examining in loans in asset-level detail to determine their performance status.

Apparently, some of these banks are using the interest reserve escrow accounts to maintain "current" status on loans secured by assets that are anything but. The article says that banking analysts worry that 150 small banks could fail in the next "few years" because of big bets on these construction loans. The FDIC has issued "cease and desist" orders to banks ranging from National City (subject of another, earlier WSJ article) to HomeTown Bank of Villa Rica, GA.

Please don't bet the "ranch" on AFN; it seems that many of their TruPs obligors may have already done so.

Mark to Market Losses Starting to Reverse?

In the first quarter of 2007, subprime mortgages provided the first sign of trouble in the credit markets as falling housing prices began to hit borrowers hard. But in the first quarter of 2008, home-equity lines of credit became the new canary in the coal mine. Lenders such as National City have frozen existing home equity lines of credit, and as housing troubles show no signs of abating, these commercial banks are rushing for the HELOC exits with hedge fund-like alacrity.

Indeed, as real wages continue to fall with the recent increase in oil and food prices, the gap between home prices and median income continues to be way out of whack - despite the continuing decline in home prices. Folks, the bottom in housing is simply nowhere in sight.

Amplifying the point was Financial Security Assurance Ltd., which last month said that loss projections for these home equity loans rose in the first quarter. Embattled FSA increased its loss estimate by $355 million in the first quarter, as losses were particularly high in eight of its insured securities backed by home-equity lines of credit.

As everyone knows, these loans consist of lines of credit secured by home equity, which has been disappearing faster than high paying jobs on Wall Street. So far, FSA has paid $104.2 million in net claims on the transactions. Robert P. Cochran, chairman and chief executive of FSA, said that "since the beginning of 2008, these transactions have experienced much higher default rates than ever observed in the past."

Moody's then corroborated FSAs public trouble with a news release of its own, disclosing that losses in some of its insured home equity loan transactions had also risen rapidly. Moody's Investors Services boosted its average loss expectations for securities backed by subprime second mortgages to 17% for 2005 vintage subprime pools, 42% for 2006 vintage pools, and to 45% for 2007 loan pools.

As I wrote earlier, these delinquency figures broken out by vintage illustrate the absolute imperative of investing in Mortgage REITs that have been around the block a few times. Those REITs that started up in the halcyon days of 2005 and 2006 simply have a huge hurdle to overcome: portfolios that are now stuffed full of weak, demand-driven paper. Their workout teams had better be good and well rested, because it looks like they will be busy into the next decade.

Indeed, Ambac cited one transaction where it said delinquencies topped 81% of loans. Significantly, both Ambac and MBIA said they were looking into some loans to see if they lived up to the standards of the securitization agreements. Since many of the underlying loans in question were originated by Countrywide Financial Corp (CFC), one must wonder how carefully Bank of America (BAC) read the investor put provisions in these deals before agreeing to purchase the Company.

Luckily for FSA, it avoided one of the most risky areas of the CMBS market: writing credit default swaps on CDOs backed by all these imploding mortgage loans. However, FSA did write credit default swaps on corporate risk and took a negative market value adjustment of $317.9 million in the first quarter.

In my two earlier articles on mark to market accounting, Mr Market Trips on Mark to Market and the more detailed follow-up How Markit Turned Mr. Market into Mr. Magoo, I emphasized that unlike realized losses, these market value losses only reflect decreases in the market value of the securities in question, not actual cash losses. Consequently, those losses have the potential to reverse if the market moves in the other direction. Thus, in FSA's case, their $317.9 million negative mark could potentially be erased, or even become a future gain, if credit spreads tighten.

And here is the story within the story: according to FSA CEO Cochran, that has already begun happening. Credit spreads have "tightened significantly since the end of the quarter," which would mean that FSA could end up recording a positive market value adjustment on its balance sheet in the second quarter. "It is hard to give a number where we stand now, but no doubt it would be positive," Cochran said.

As the CMBX and ABX continue to tighten, and LIBOR and TED spreads get back to normal, positive market value adjustments (which would be reported as non-cash gains) will become more common. This will be particularly true for seasoned mortgage REITs that stuck to their knitting and resisted temptation with disciplined credit standards. Combined with the additional clarity arising from the adoption of FAS 159, book values will start looking a little more appetizing in the next few quarters.

Good news does not sell nearly as well as bad news, so I guess the traditional news outlets don't focus on it as much. It sure is fun to write about it though, and it's just as important as the opposite truths we've been hearing so much about. REIT Wrecks has your back!

CMBS Prices Reflect Irrational Fears

"MARKET FEARS AND THE LIQUIDITY CRUNCH HAVE DRAMATICALLY DISTORTED THE VALUE OF CMBS, CREATING ONE OF THE BEST ENVIRONMENTS IN HISTORY FOR INVESTING IN CMBS."

The Commercial Mortgage Securities Association (CMSA) yesterday presented new data on the pricing of commercial mortgage-backed securities (CMBS) compared to their fair value and returns relative to risk profile. The study predicts CMBS will perform well in a deteriorating recessionary environment.

It concluded that current spreads for most CMBS vintages are still far wider than their fair value, an irrational market reaction that presents significant arbitrage opportunities for investors."There are no skeletons in the CMBS closet," said Jun Han, Ph. D., the author of the study.

The study performed multiple stress tests on CMBS bonds based on three historical and worst-case recession scenarios. It analyzed all 19,583 commercial mortgage loans in the 675 CMBS bonds that make up the four CMBX indices, which account for approximately 39% of fixed rate conduit CMBS outstanding.

The study concludes that investors have strong reasons to be optimistic. Among the findings revealed were:

• Fixed-rate, investment-grade CMBS perform very well in the study's stress-tested analysis, with minimal defaults, credit losses or yield degradation. No CMBS rated AA or higher are expected to incur any loss under the study's recession scenario, while 99% of A-rated CMBS should be free of losses and the remaining 1% should incur only a small loss.
  

• The risk of CMBS downgrades is very limited. For example, 98% of AAA-rated CMBS and 94% of A-rated CMBS are at no risk of downgrade in a recession scenario.
  

• Current CMBX index spreads unreasonably imply a "doomsday scenario," with such spreads implying that future defaults and losses would be many times the levels of historical experience. Incredibly, when applying the spreads at which the CMBX 4 index has recently traded, the implied annual collateral default rate was over 100% for AAA-rated CMBS on March 20, compared to a historical CMBS average of less than 1%.

"Just how off-target is the CMBX market? We can actually put a dollar value on it," Dr. Han comments. "When applying a worst case 1986 stress test scenario, spreads on the CMBX 4 index of almost 1,200 basis points over T-bills, were almost twice as high as would have been expected at fair value."

"This demonstrates the kinds of distortions and limitations of ceding the determination of value of the nearly $1 trillion CMBS market to an untested and volatile derivatives index during an unprecedented credit and liquidity crisis."