TARP Torpor Torpedoes REITs

No wonder the original plan what plan? was only three pages long. It turns out that there was no plan. When I heard the news that Treasury had reversed course on the Troubled Asset Recovery component of the Troubled Asset Recovery Plan, that and writing an article with the above title were the first things that popped into my head. Sadly, those two things were also all I could think of while I was cowering under my desk, without food and water, waiting for it all to end. REITs of course got absolutely crushed, and now it looks like many REITs are now headed for the dreaded ".BB" designation. I keep hoping in vain to someday drown in dividends, but that's unlikely to happen if REITs are swimming in the Pink (sheets that is).

The story of the insanity in commercial mortgages that ensued after the about face now been covered everywhere, including the Wall Street Journal, the Washington Post, and Bloomberg, which was the most strident in blaming it all on Paulson. Sadly, spreading blame won't help; only spreading money will (and maybe some Prozac too, if I could only afford to see the doctor).

What follows is a relatively cogent article consisting of the most juicy bits from those three above articles.

"A lot of very foolish loans were originated between 2005 and 2007, and many of those loans begin to mature in 2010," said Mike Kirby, director of research at Green Street Advisors, a commercial real estate research firm. "You have a significant amount of debt maturing at that time and yet you don't have a market to replace that debt."

The price of commercial real-estate-debt securities has fallen so far that it has set off a debate among investors as to whether now is the time to get back into the market. Triple-A commercial mortgage-backed securities are trading at roughly 70 cents on the dollar, meaning they would produce a 20% return if held to term.

The default rate on commercial mortgages remains near its historical low, although it is increasing. Overall, the number of commercial mortgages packaged into securities that are 30 days or more past due rose to 0.64% in October from 0.39% at the end of last year. That is the highest delinquency rate in two years but still far from the kind of carnage that occurred during the commercial real-estate collapse of the early 1990s. Back then the cumulative default rate on loans made in 1986 reached 36%.

The trading levels of CMBS bonds imply a cumulative loss rate of as much as 40% on top-rated bonds, which means that at least 70% of the underlying loan pool would have to go into default, [emphasis added] said Richard Parkus, head of CMBS research at Deutsche Bank Securities Inc. But he, like other market observers, views that as an unlikely scenario. ...

The spreads between the CMBX, a credit market index that tracks the values of commercial real-estate bonds, widened to another record level Thursday. And CMBS bonds with triple-A ratings now yield more than 14 percentage points above yields on 10-year U.S. Treasury notes, according to Trepp, a New York company that tracks the commercial real-estate-finance market. That compares with a 1.5 percentage point spread one year ago and an 8.3 percentage point spread just one week ago.

At current prices, all the loans could default within 18 months and a buyer wouldn’t lose money, according to Lisa Pendergast, an analyst at the Greenwich, Connecticut-based unit of Royal Bank of Scotland Plc. That’s assuming foreclosure recoveries of 37 percent, compared with the typical 60 percent.

“The default levels implied by where these bonds are trading mean we will all be living in boxes,” said Eric Johnson, president of 40/86 Advisors Inc. in Carmel, Indiana.

“There is evidence that short-sellers are targeting this market because they know they can push it around,” said James Grady, managing director in New York at Deutsche Asset Management, which has about $240 billion of fixed-income assets under management.

“Recent speculative conditions reminds us of the summer when oil was $140 a barrel, and many parties were calling for $200,” Darrell Wheeler, of Citigroup wrote. “Commercial real estate conditions are deteriorating, but we cannot justify recently cheap levels.”

Let's hope so. I have bills to pay.

Big CMBS Loans Near Default; CMBX Soars, REITs Tank

The BBB-5 CMBX is above 3250, do you know where your money is? These are record levels for the index, and they are seemingly indicative of even greater trouble in the CMBS market. If one were to use the stock price of many Mortgage REITs however, it would seem that the soaring Markit index is actually behind the times for a change:



Part of the reason for the distress in the index and also the basement-dwelling stock prices of many Mortgage REITs is that two very large loans that were securitized into CMBS, including one loan secured by two Westin hotels, appear to be nearing imminent default. Of course, this distress is also due to the forced selling of anything that hasn't already been seized by the county sheriff.

The $209 million Westin loan is backed by two hotels located in Tucson, Arizona, and Hilton Head, South Carolina. The slowing economy has hurt hotel operators as consumers and businesses have cut back on travel. The second loan nearing default is a $125 million loan for The Promenade Shops at Dos Lagos, which is located in Corona, California. Southern California has been dealt a particularly heavy blow by the worst housing crisis since the Great Depression.

Credit Suisse analysts reported that the Weston loan is split between two JPMorgan-issued CMBS deals. J.P. Morgan Chase Commercial Mortgage Securities Trust 2008-C2, the more recent of the two deals, is heavily exposed. That trust's portion of the defaulting Westin loan represents 8.9% of the total collateral pool. Unfortunately, the bad loan on the Promenade Shops is also the largest loan in the same pool, representing fully 10.7% of the collateral. This means two of the top-ten largest loans in the pool, representing almost 20% of the collateral, are about to default. Investors in all but the most senior tranches of this issue are now facing huge losses as remaining cash flows are diverted to those who occupy higher ground (see the post "What is Securitization" for more detail on how subordination impacts Mortgage REITs).

It is not surprising that hotel and retail loans would come under pressure, particularly a retail loan made in Southern California, which was practically the belly of the beast. Hotel occupancies and retail sales have been especially hard hit as consumers and businesses snapped wallets shut when the credit crisis started making what Ross Perot could only have described as that "giant sucking sound".

The real interesting aspect of these latest defaults is that everyone involved should have known better. Yet the pressure to produce, rate and sell still seems to have trumped the mirrors in front of our faces.

All of the mortgage loans in the pool were originated between June 27, 2007 and April 30, 2008, and the securitization closed on May 8, 2008, well after the Bear Stearns collapse and Ralph Cioffi scapegoat perp walk was led away in handcuffs.

Nevertheless, the Westin loans were interest-only for 36 months and had underwritten debt service ratios (DSCR) at closing of less than 1.25%. This would have been considered risky even in 2006. The loan agreements on the Promenade Shops were interest-only for 60 months and had underwritten DSCR of just 1.10%. The Promenade loan also allowed additional subordinated debt provided that the combined LTV did not exceed 85% and the combined DSCR did not fall below 1.00%. This is the equivalent of allowing someone to rent an apartment that will consume 100% of their monthly take-home pay (assuming a landlord would let anyone do such a thing). More than 75% of the loans in the pool were interest-only or partial-interest only. Other large loans in the pool include the Las Vegas headquarters of Station Casinos good luck and several other large retail and hospitality properties.

One would have thought, given the media and political spotlights around shoddy underwriting and hopelessly conflicted ratings agencies, that underwriting standards would have improved and that CMBS investors would be taking a much harder look at the bonds being furiously shoveled in their direction.

So is it really any wonder that Mortgage REIT stocks are in the tank when two of the top-ten largest loans in a May 2008 CMBS deal, representing almost 20% of the collateral, have gone up in smoke in just six short months?


Disclosure: None at the time of this writing

Controlling Class Smack Down For Mortgage REITs?

I went for a ride on my mountain bike last week. Is it any wonder that all I could think of during the long, steep, uphill grades was REITs? The analogy is apt, as making money in this sector is almost as strenuous. This afternoon, however, after I wiped the vomit from my shirt luckily I can't afford to eat much that day seemed like a decade ago. Earlier in the day today, General Growth Properties (GGP), an equity REIT that owns and operates shopping centers announced that it may be unable to refinance its debt. Even pedestrian REITs like AIMCO (AIV), an owner of apartments will you take food stamps? took it in the shorts to the tune of 30% as confidence completely evaporated from anything related to real estate and mortgages.

But didn't our lame, ignorant congress finally get a clue as to the damage a full-fledged banking crisis would cause? For those libertarians that are still ambivalent about the whole thing, if those gerrymandered economic neanderthals hadn't finally passed the TARP bill, the United States would probably be facing the same fate as Iceland: imagine logging into your online brokerage account and being unable to trade or transfer cash. Such is the state of affairs legally blonde in Reykjavik at the moment.

But we do finally have TARP and the treasury had better get at it - and soon. The GGP debt is precisely the kind of stuff the TARP plan was meant to address. Nobody wants it, and nobody needs it. But what if the Treasury does purchase, for example, GGP debt. What will they do, if anything, for the equity?

If Bear Stearns, Indy Mac, Fannie Mae, Freddie Mac, Washington Mutual, Lehman, Wachovia and others are any clue, the answer is plainly nothing. I'm not sure if this matters for largely match-funded REITs like NCT, RSO and crazily enough, even loss crippled CRZ. Especially when the government socialization of private mortgage losses (purchasing broken CMBS debt) at above-market prices and suspending mark to market accounting allows everyone to believe in fantasies giselle bundschen cooks me breakfast whilst naked namely, that there is a market for this stuff in the first place, which there ain't.

But there is no market and it pays to remember that with all this "rescue" talk the Fed has not been kind to equity holders, even PREFERRED EQUITY holders. So for those of you who are marveling at the deals to be had in the REIT preferred space, given the perceived "safety" relative to the common, think again. The preferred holders in Fannie Mae and Freddie Mac were wiped out just like the common, and the TARP bill contained a special provision just to bail out the regional banks that held this junk. But there was no such luck for the individual tax payers who were stuck holding this now worthless scrip, even though they will help pay the Treasury's tab for bailing out the hapless banks.

So how will the TARP program treat those REITs that are investors in Controlling Class CMBS, which is pretty darn close to equity? This was the question on my mind as I pedaled my way up the hill, after spending the morning watching the likes of Anthracite (AHR) and JER (JRT) get knocked back to the Stone Ages. Last week, after these two REITs get disproportionately sold, it seemed that the market was counting on the treasury to penalize those who knowingly invested in the lowest rung of the CMBS food chain.

But today, after listening to Bernanke address the National Association for Business Economics about the need to restart the CMBS and securitization markets, I was less convinced. Controlling class CMBS is an essential cog in the CMBS wheel, and without it there will be no market. Unfortunately, as in Iceland at the moment, there is simply is no market for anything and cash truly is king. But these juicy REIT dividends are no compensation for margin calls and 50-75% losses of principal. I had no idea how big the mother of all bailouts would be when I wrote this post, and it's safe to say neither did Helicopter Ben. All that ivy must have obscured his view.

Disclosure: I am accepting bids on Ebay

Mortgage REITs Bearing CMBS "Tail" Risk

The Mortage Bankers Association today reported a 98% year-over-year decline in CMBS new issuance, which has continued to leave Mortage REIT portfolios at the mercy of the thinly traded CMBX in terms of valuations. Pricing pressure on CMBS (as evidenced by the CMBX) has abated recently, but the index is still indicating levels of distress far higher than the current fundamentals:


The relentless climb of the CMBX is partially the result of pure speculation. However, there is another factor at work as well. While the problems in residential mortgages are already manifest, there's a notable difference between CMBS and their residential counterparts. Losses on RMBS typically decline as the loans age (or "season"), but losses on CMBS are largely driven by tenants' ability to pay rent, and that can be undermined at any point by a slowing economy. The graph below shows that historical CMBS defaults typically peak seven years after issuance. This is "tail" risk, and tail risk for CMBS is rather long:



CMBS delinquencies are now rising, as the graph below depicts. To be fair, most of the delinquencies have been led by multi-family sector, which is partially tied to the single family market via failed condo conversions, and another large component of the increase in that sector can be traced to just one borrower. But the slow rise in defaults in CMBS generally is nevertheless causing a great deal of hand wringing.



That CMBS defaults will rise is not in dispute, simply because they have been at historic lows for much of the past year. Estimates of how high defaults could rise vary widely though, and obviously that affects estimates of how high they may or may not travel up the CMBS capital stack. And "tail" risk is no secret; Mortage REIT portfolio managers account for it in their loss assumptions.

However, while fundamentals are holding up and remain firm, there still is a pervasive sense of fear among CMBS investors and real property investors alike. Costar, in its August 26 article entitled A Dud of a Thriller? Commercial Real Estate Drama Lacks a Killer quoted Philip Conner, of Prudential Real Estate Investors, who compared the market to the Samuel Becket play "Waiting for Godot".

In a report entitled "Waiting for Distress" (I don't have a copy), Connor wrote that "though signs of distress remain largely confined to highly leveraged deals consummated at the peak of the investment cycle, in late 2006 and early 2007, there is an undeniable and growing sense of anticipation among investors that U.S. commercial property values are poised to fall and that widespread distress is just around the corner."

However, Connor noted that in the Samuel Beckett play, Godot never actually appears onstage. "His off-stage presence, whether real or imagined, and his expected arrival largely dictate what does and does not happen in the play."

Connor contends that most of the distress is likely to remain "off stage" in the capital markets. However, capital markets is very much "on-stage" for Mortgage REITs, and just as the abundance of ready and available credit pushed asset prices above their fundamental value, so too will the lack of it push prices below their fundamental, intrinsic value. And when the bottom is finally notched, Godot won't be there to ring a bell for us either.


Disclosure: This play is more interesting.

Graphs courtesy of Markit; Morgan Stanley

What is a Securitization?

Securitization is the process of taking groups of loans and splitting them into different classes of securities, and then selling the different classes of securities to third party investors. Many Mortgage REITs buy CMBS paper, which are securitizations of commercial mortgage loans. Other mortgage REITs buy mainly "whole" loans, which are loans that have not been securitized.

Before the credit crisis, residential and commercial mortgages were widely securitized, but securitizations have also been done for a wide range of cash-flow producing assets, such as residential mortgages, commercial mortgages, credit card receivables and college tuition loans. Securitization confers a huge advantage to lenders in that it allows the lender to transfer all of the risks around making loans to third party investors.



However, FASB has proposed changes to FAS 140, including the elimination of the QSPE rules which previously allowed for a "true sale" and the complete transfer of risk the lender to the investors (for more on that, see the REIT wrecks post on changes to FAS 140). As the video mentions, the securities were usually "tranched" into different classes, which enhances the credit rating of the resulting securities beyond that of the underlying assets. This is known as Credit Enhancement.

Essentially, issuers take the loans and split them into "tranches" which have different levels of risk (referred to as "subordination"). So, if the entire group of securities would have a credit rating of BBB, and you cut it into several tranches, the highest tranche with no subordination, could have a credit rating of AAA, because it gets paid first, and the only way it would not get paid would be if a huge group of the underlying loans were unpaid (i.e. the highest tranche has the lowest risk). Issuers can also "over-collateralize" the pool.

Tranching is important because different Mortgage REITs invest in different classes, or tranches, of the CMBS pool. Anthracite Capital, for example, invests mainly in the "controlling class" (so-called because AHR can take "control" of the defaulted assets) portion of CMBS deals. This is also known generally as the "B Piece". Aside from the equity, which is unrated, the "B piece" is the highest risk and lowest rated portion of the securitization. If large numbers of mortgages default in a CMBS issuance, the controlling class has the most subordination and is the first to take a loss. Therefore, if a Mortgage REIT like Anthracite owns the controlling class securities of a securitization with extremely high rates of default, the REIT's entire investment in that CMBS issuance can be wiped out. If you want to learn more about tranching and over-collateralization, see the REIT wrecks post on CDOs.

Disclosure: None at the time of this writing

Earlier Vintage CMBS "Grossly" Mispriced

In an earlier article ("Mortgage REIT Yields Still Look Safe, But Stick to the Seasoned Veterans"), I wrote that high yield Mortgage REITs with relatively "seasoned" portfolios offered much better safety and value than those with portfolios stuffed full of more recent vintage CMBS. Now, analysts at Barclays Capital also say that the pricing on some earlier CMBS are not fully reflecting the safety of the risk-free treasury securities that replaced the original collateral on many of those earlier vintage pools.

Later vintage CMBS is now under a very bright popular media spotlight on news that a $225 million loan for a New York City apartment complex is heading toward imminent default ("How Could My Big Beautiful Loan Go So Bad, So Quickly"). That loan suffered from egregiously aggressive 2007 underwriting standards and had virtually no hope of being repaid. As a result, "headline risk" is again high and many CMBS traders and portfolio managers are once again shooting first and asking questions later.

However, not only were underwriting standards much stronger in earlier vintage CMBS, but many pre-2005 CMBS loans have also been "defeased" by the original borrowers. Defeasance occurs when highly rated collateral, always AAA-rated US government securities, are deposited into an escrow account for the benefit of the lender. The treasuries are sufficient to make all remaining principal and interest payments under the loan, and the lender's security interest in the underlying real estate is replaced by a security interest in the treasury bonds.

Why does this happen in the first place? Because of the highly restrictive provisions on repayments contained in every loan destined for CMBS pools, borrowers are "locked out" from paying off the loans for at least five years. After that, prepayment is subject to terms that protect the lender (and ultimately the CMBS investors) from "re-investment risk", which is what happens when you get a pile of money back in an unfavorable (low) interest rate environment. Nevertheless, owners of property purchased in earlier years that had been financed via the CMBS market needed to have some way to pay off the loans and cash out when they sold, particularly in the ebullient years of 2005-2007.

This was accomplished by defeasing the loan, a practice that got off the ground for CMBS in 1999 (it was already widespread in other markets). Defeasing CMBS loans grew in popularity, and by 2002 the business had taken off. Many, many earlier vintage CMBS loans were defeased and are now backed by AAA rated government securities, instead of beaten up shopping malls full of Bennigan's and Steve and Barry's.

While the effect of higher credit enhancement is widely recognized, the Barclays analysts think that the market is nevertheless "grossly mispricing" heavily defeased CMBS. They contend that the 2005 to 2007 surge in defeasances left many older vintage collateral pools with over 25% in risk-free government collateral. Such risk-free assets should command a premium in today’s uncertain environment, although they say current market spreads do not reflect that or maybe the Chinese are just dumping every treasury-related security they can lay their hands on.

Pricing on high defeasance paper is roughly five to 10 basis points tighter depending on the vintage — but the analysts think that bonds with high defeasance should command an additonal a 20 to 40 basis point premium compared with non-defeased senior tranches as a result of the more favorable risk profile.

Clearly value does remain in CMBS and the collateral; the real question hovering around the room late at night is what is the value of the real estate supporting it? Analysts agree that cash flows are holding up, but that investors are simply continuing to pay less and less for those cash flows. And that whistling sound you hear in the background is just a lot of people in the graveyard, wondering how much longer that will go on.

Disclosures: None at the time of this writing

Anthracite Gets Hot Again!!

"The Taliban used to hang the victim's body in public for four days. We will only hang the body for a short time, say 15 minutes. Adulterers will still be stoned to death, but we will use only small stones." Afghan judge Ahamat Ullha Zarif on a kindler, gentler Afghanistan

....And a taxable loss, dear believers, is still a taxable loss.


First, some housekeeping: This is a follow up post to the reader comments I republished in "Anthracite Post Generates Some Heat!" Those comments were originally written in response to the article entitled "High Risk, High Yield Strategy Keeps Anthracite Under Pressure", or something like that. This post is also rather lengthy (but informative, I believe), so come back later if you're almost empty.

The purpose of this post is to address those reader comments in more detail, first because their very premise is incorrect (that the REITwrecks article is inaccurate and must be "subjected to a high degree of scrutiny" due to the characterization of Controlling Class CMBS as BB-rated). And second, despite the forest-obscuring discussion of proprietary loss severity models and the not-to-be-trifled-with Math PhDs in the comments, the primary article's main thesis remains the same and is fully intact: This weakening credit environment is simply no time to go out on a limb at the bottom end of the credit spectrum.

Having said that, the comments were greatly appreciated and I think a lot of people learned from them. So I do not wish to discredit the writer. I would simply like to set the record straight.

First, there are four investment-grade tranches (disregarding, for the moment, the various plus and minus flavors) in a mortgage securitization, they are the tranches rated AAA, AA, A and BBB. The tranches below these four are non-investment grade. These non-investment grade bonds are rated BB, B and CCC, the latter known among some as the dreaded "triple hook". Last but not least are the bonds that are completely unrated. In the CMBS industry jargon, the below investment grade bonds (anything below BBB) are collectively known as the "B-piece". The mix of these bonds and their individual rights are generally the same but vary specifically deal by deal.

It is the "B-piece" to which I was generally referring in the original article, and it was my glib refence to these bonds as BB-rated that gave the comments credibility. The B piece, frankly, gets all the attention because it is the hardest bit to sell. The reason is that the B piece investors are first in line for any losses, thereby insulating the more senior, investment grade tranches from all but the biggest of disasters.

Avoiding losses in respect of CMBS (or any structured debt) is completely analagous to homesteading on the beach for the afternoon. The higher the ground you occupy, the less likely you are to ruin your new Gucci's when the tide comes up.

Why bother to go through all the trouble of carving the loans up in the first place? In theory, the borrowers get a better interest rate because the loan is split into various pieces which are then tailored to fit different investor constituencies, and that optimizes the price.

With respect to whether Controlling Class CMBS is rated or unrated, it was suggested that I take some remedial time to read the company's reports so I could learn again? how these securities work. So I did, and naturally it didn't take long to find the following: (edited for clarity) the things I do for you

Now, with respect to loss estimates, AHR clearly does purchase these securities at a discount to par, but they do not assume 100% loss of invested principle. In fact, "As part of its underwriting process hey joe, would you take a look? , the Company assumes a certain amount of loans will incur losses over time. In performing continuing credit reviews on the 39 Controlling Class trusts, the Company estimates that specific losses totaling $851,920 related to principal of the underlying loans will not be recoverable, of which $399,403 is expected to occur over the next five years. The total loss estimate of $851,920 represents 1.46% of the total underlying loan pools."

Continuing credit reviews are important, because historically low CMBS default levels in the years before the boom convinced many investors that CMBS structures were "over-enhanced". These investors believed that recovery levels for junior note holders would remain higher than forecast, just as they had for subprime. Naturally, competition in the B piece world increased as a result, and buyers had to bid up the bonds in order to be successful.

The "B" piece buyers had always been a limiting factor in overall CMBS issuance. Not only were there not that many of them, but they also had veto power over any individual loan that could decrease their chances of getting fully paid out. As more yield-hungy investors clamored for more "B" notes, they began to exercise their veto rights less often. Underwiters and issuers, who were only in it for the fees and cared not about repayment, were then able to stuff more and more junk into the pipeline, and CMBS issuance ballooned. (please read "How Could My Big Beautiful Loan Go So Bad, So Quickly", including the comments)

This volume increase resulted from a combination of huge demand and a commensurate decrease in underwriting standards, including (among other things), a relaxing of traditional loan-to-value criteria. Moody's estimated that the gap between the Moodys LTV and underwritten LTVs reached record in the first quarter of 2007 (nearly 45%). The Moody's estimate of actual LTV also reached a record of 106.5%. Who needs equity when lenders will give you more money than the property is worth?

Moody's warned that "Junior classes have become exceedingly thin, exposing them to the risk that if one of the larger conduit loans defaults, several classes at a time may be entirely wiped out." It was in this environment that AHR was stepping up its purchases of Controlling Class "B" piece CMBS:

Now, some investors may take comfort in the fact that AHR alone gets access to the "top-secret" loan-level files. Presumably this gets combined with their own "top-secret" proprietary models, and they are thus able to divine the future by virtue of their uber geek Math PhDs who needs smack dealers, anyway? But having originated, structured and sold hybrid debt and equity (via conduits and securitizations, among other structures), and having bid on the wreckage as a principal after reality hits, I can tell you that it's just not that easy.

If you've ever called the guy (or gal) who owns the controlling class and is in charge of the "work out", you'll discover that they often want to talk. This is because they know very little, and they need to know what you know. In one phone call, when I discussed the details of an obviously flawed underwriting on a mortgage behind a set of B notes, I was met with an incredulous "you're kidding??" They then asked how I could possibly know about such micro-level minutiae, and I had but one very simple, honest answer: all I did was read the prospectus.

Disclosure: None at the time of this writing

How Could My Big, Beautiful Loan Go So Bad, So Quickly?

"It's surprising that you'd have a New York City multifamily [default] happening so quickly," said Manus Clancy, senior managing director at Trepp Research.

Surprising, that is, unless the mortgage payment is more than double the monthly net income. Impossible you say? Not really, this was the beginning of 2007, and almost anything was possible. "Our job is to create loans for securitization," said an official from Wachovia Corp. a few years earlier. "We’re trying to manufacture the product that the investor base wants." And so they did.

Data: Commercial Mortgage Alert

On the surface, this deal looked pretty good. The pro-forma loan to value was 66.18%, and pro-forma debt coverage was a very safe looking 1.73%. It was a "value-add" deal, and the borrowers, Stellar Management and Rockpoint Partners, planned to pump almost $30 million into improvements and then raise the rents. Pretty simple.

That led to the $225 million first mortgage, topped off with a $25 million mezzanine loan from Deutsche Bank. The first mortgage also became one of the top 15 loans by value (about 3.4% of the initial mortgage pool balance) in a nearly $6 billion CMBS deal issued in March of 2007.

Consequently, one would think that this loan would have received a lot of attention from the underwriters, bond traders and CMBS portfolio managers looking at the securitization. Presumably, these sophisticates could evaluate the loan economics more closely, particulary the rather precarious day-one debt coverage ratio of .39x, which meant that the loan had absolutely no hope of being paid through existing cash flow ('let's see now, the guy's income is less than half the amount of his monthly nut....')

But this was 2007 and the property, known as Riverton Apartments, is no ordinary piece of real estate. It is a massive 12 building, 1,232 unit complex sitting on 7.6 acres of prime East River (Manhattan) waterfront property. I wouldn't know, but I guess that this beach-front location and the "air rights" were what justified the $250 million in debt, even though the property was purchased just 12 months earlier for about half that amount ($135 million) just sayin'. The new loan allowed the borrowers to walk away with over $40 million in cash thanks, the keys are in the mail!

At closing, over 90% of the units (1,143 to be exact) were regulated, rent-controlled apartments. The premise of the loan was that these units would be converted to fair market, such that by 2011, more than half of them would be deregulated and rented at full market.

Unfortunately, this is also New York City, and the only thing more coveted than a long weekend in the Hamptons (or perhaps a phat Congressional seat) is a rent-controlled apartment. Consequently, the conversion did not go as planned, and that .39% day-one debt coverage ate up whatever was left in just eighteen months.

Putnam Investments Sees "Free Lunch" in CMBS

This article, published yesterday in American Banker, pretty much sums it up. BBB CMBX spreads, which have been climbing throughout July and August (Markit Group Says "Bienvenido!"), are now about 2500 basis points over Treasuries, which would equate to just about a 30% (!) yield.

Despite the credit crisis—or perhaps because of it—there has never been a better time to invest in fixed-income products, particularly triple-A commercial mortgage-backed securities, according to portfolio managers at Putnam Investments.

The Boston unit of Power Financial Corp. acknowledged that advisers are facing a great deal of uncertainty and a tough economic climate that could take a long time to level off. Nevertheless, Putnam says fixed-income products, such as commercial mortgage-backed securities, municipal bonds, and high-yield bonds, remain very attractive.

Triple-A commercial mortgage-backed securities are attractive because they are protected from losses and "are the best levels we have seen in 20 years," Bill Kohli, a Putnam fixed-income portfolio manager and team leader of portfolio construction, said in a conference call Tuesday. "This is an area that 10 to 20 years from now we are going to look back on at the historic type of values in these securities."

The securities are "well-protected and fundamentally sound," Mr. Kohli said. "We would need an event five to six times worse than the worst market ever before you would experience any type of fundamental loss."

Unlike equity products, commercial mortgage securities will not be able to maintain their low prices for long, he said. "There is a massive liquidation going on today in terms of firms selling their fixed-income assets. Prices this cheap will disappear."

These products are "plain vanilla, very liquid, relatively straightforward to analyze, and well-diversified," Mr. Kohli said. "This is as close to a free lunch as you can get right now."

Putnam expects a potential price return of 7% from triple-A commercial mortgage-backed securities, 7% from investment-grade bonds, and 13% from high-yield bonds.

"When you look at all of these sectors, the spreads are as attractive as we've seen … in our investment lifetime," Mr. Kohli said.

Analysts and industry observers said that during a difficult economic crisis, investors are interested in using fixed-income products to shelter assets.

But W. Christopher Maxwell, a managing partner at the Rock Hall, Md., wealth management firm Conestoga Capital Advisors LLC, said that despite this notion, many investors and advisers are very suspicious of ratings right now and are wary about investing in any commercial mortgage securities, even if they have a triple-A rating.

"There are a lot of smart people out there that are trying to make astute judgments and trying to buy fixed-income products at a discount, but it can be quite difficult to find those values," he said. "The difference between a successful triple-A-rated CBMS and one that is not so successful is not that big."

Mr. Kohli said it is critical to maintain a well-diversified portfolio that includes a variety of fixed-income products.

"The fixed-income landscape is much more complicated than it was 10 to 20 years ago," he said. "Companies need a certain degree of specialization to understand the dynamics. It is hard for a generalist or anyone who takes a general approach to grapple with all the issues in the fixed-income landscape."

Putnam had $166 billion of assets under management as of June 30, including $75 billion of fixed-income assets.

Mr. Kohli said in addition to triple-A commercial mortgage securities, Putnam believes that there are opportunities to invest in high-yield bonds, municipal bonds, and even alternative-A mortgages.

Even though many analysts and industry observers have turned their back on the alt-A market, Putnam has been buying such assets over the past few weeks, he said.

"We are doing our homework," Mr. Kohli said. "We are getting to know the underlying pools and the geographic distribution. We are not just buying plain vanilla alt-A. … We are dipping our toe in the water. We are really just starting to get involved."

Geoffrey Bobroff, an analyst with Bobroff Consulting Inc. in East Greenwich, R.I., said that the alt-A market is a dangerous place to play right now, because it can be "difficult to distinguish the good from the bad."

Burton Greenwald, a Philadelphia analyst with BJ Greenwald Associates, said Putnam is taking a "calculated gamble" by investing in alt-A products to stand out and improve their profile after several years of outflows caused by the poor performance of the company's equity funds.

"Putnam has gone through more than three years of getting hit in the face every time they stick their head out of the trenches," Mr. Greenwald said. "Their equity hasn't shown signs of a turnaround, but they are recognized for having a strong fixed-income record. Now they want to really allow that to shine."

Thailia Meehan, a Putnam portfolio manager and team leader of its tax-exempt strategy, said that municipal bonds remain an attractive investment option, because they are inexpensive when compared with Treasuries.

There is a tremendous buying opportunity when it comes to A-rated and triple-B-rated municipal bonds, Ms. Meehan said. A lot of investors were underweighted in municipal bonds heading into the credit cycle, she said, and this could be a good opportunity to balance a portfolio.

"This is a terrific opportunity, and we are taking advantage of it," she said. "We are buying high-quality munis at attractive levels. We haven't dipped down to lower-quality munis on the curve."

Mr. Kohli said that it remains a very tumultuous economic market, and that it is difficult to make predictions, but he is confident fixed-income products will remain attractive options for advisers and investors.

"I'd love to tell you that three months from now or three weeks from now we will have the most attractive levels," he said.

He added: "But I am comfortable saying that over a three-year or five-year horizon, the growth opportunities are phenomenal. They are off the chart."

Blackrock: Back up the Truck on CMBS

Last week, traders reported volatility over CMBS and CMBX as headlines of bank downgrades and quoted predictions of summer oil at $170 a barrel influenced investor confidence. CMBX spreads widened and dollar prices dropped across all tranches of all series during the past week, according to JPMorgan research. Spread widening has continued this week amid persistent rumors of more trouble at Lehman.

However, according to Reuters, Blackrock's President, Robert Kapito, was unfazed. While he thinks that there will be a much bigger slowdown in 2009, citing slowing growth in emerging markets and tightening pressures on the U.S. consumer, he sees big value in commercial mortgage backed securities.

"We think there's going to be a global slowdown," he said at a lunch sponsored by the Securities Industry and Financial Markets Association in New York. BlackRock is the largest publicly traded U.S. asset manager with about $1.4 trillion in assets under management.

Using a baseball reference, Kapito said the credit crisis is in the fourth inning, indicating he believes the crisis is nearly halfway over.

"Inflation is up, housing is down," he said. "The consumer is hurt. I can't think of one positive thing for the consumer here."

"BEST TIME" FOR BONDS

But amid the poor economic outlook, Kapito said there are bright spots for investors.

Declines in residential and commercial mortgage-backed securities since last year have created some of the best buying opportunities for fixed-income money managers in history, he said.

"If you take a look in the marketplace, and step back from what's going on, this is the best time that we've ever been in to add value to a portfolio," he said.

Challenges remain, however, since homeowners are still defaulting on loans and house prices are falling. But money managers who have the ability to do the proper credit research can "ferret out" good opportunities, he said.

Kapito said securities backed by loans on properties such as office buildings, retail stores and hotels were especially attractive, in addition to residential mortgage bonds that do not carry the guarantees of Fannie Mae and Freddie Mac, the two government-sponsored enterprises.

"I am a big believer in backing up the truck and buying CMBS," he said, referring to commercial mortgage-backed securities.

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.

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.

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."

PIMCO Still Piling into Mortgages

In April I posted Bloomberg's report that had PIMCO more than doubled the mortgage holdings in its flagship Total Return Fund from 23% of assets in March of last year to almost 50% of assets in March of 2008.

Now the FT is reporting that PIMCO has continued to build its position. Bill Gross, the manager of the world's biggest bond fund, has now almost tripled his mortgage debt holdings to more than 60% of the fund.

According to the FT, the Total Return Fund fund pulled sharply ahead of rivals in the past year after Gross predicted a housing downturn and sold out of housing-related securities and corporate bonds. The fund has returned 12.6% over 12 months, beating 99% of its peers, according to fund tracker Morningstar.

Mr Gross said his decision to raise exposure to mortgage debt in recent months was based on the US government's implicit guarantee of Freddie Mac and Fannie Mae, the government-sponsored mortgage agencies. "Government policy is moving to sanctify the status of the government-sponsored agencies . . . it became a question of which institutions would be sheltered by the government umbrella," he said.

So far, the bet appears to be paying off. In the first four months of this year, the fund returned 3.8%, twice the return of its benchmark index and its best start to the year in at least eight years. Mr Gross said Pimco was buying primarily mortgage agency debt and "not the subprime garbage". The Total Return fund is now invested about 61% in mortgage debt. Such debt comprises only 43% of one of the fund's benchmarks, the Lehman Aggregate bond index.

Mr Gross, who is also Pimco's co-chief investment officer, is known for his macro-economic style of investing, which has seen him take big bets on bond classes depending on where he thinks financial markets might be moving. Mr Gross was heavily overweight US Treasury bonds in the early 2000s but is now scornful of them and the fund is using derivatives to gain from any downturn in Treasuries.

He called Treasuries "the most overvalued asset". "If there was a bubble, the popping has produced a counter-bubble in quality securities. The safe haven has been way overdone. Treasuries are yielding 2 to 3%, there is no real return on that at all," he said. "This is an asset class that is held by sovereign wealth funds and central banks . . . but that is not any reason to follow them."

There may be no reason to follow the herd into Treasuries, but apparently there is still plenty of reason to take a closer look at the disconnect between price and value in Mortgage REITs.

Good News for High Yield Mortgage REITs: Commercial RE Debt Markets Are Stabilizing

Is the Credit Crunch Over? Maybe, But Opportunities Still Abound in the REITwrecks World.

REITwrecks is back! And with good news. Not only is the Indian Ocean still a great place to recreate, but according to indications in the CMBS and CMBX markets, and recent reports by all three of the major ratings agencies, there are increasing signs that the commercial real estate debt markets are stabilizing. As REITwrecks reported earlier, the CMBX and CMBS cash markets were just completely divorced from the fundamentals in commercial real estate (and several astute readers posted comments consistent with this price vs. value disconnect).

Back then, seemingly a hundred years ago, there was no need for a ticket to Vegas: if you were an investor in this sector, all the adrenaline your heart desired could be had sitting right in front of your computer.

Indeed, when nobody was looking and the kids were safely tucked in bed, you could have picked up RAS at $6.75, NRF at $8 and AHR and $6.50. But as everybody knows, it was no time for the faint of heart, and REITwrecks lost a lot of donuts employing this price/value thesis on the likes of SFI and NCT.

But that was then and this is now. Despite widening in both the CMBS cash market and the CMBX last week, the market seems increasingly optimistic that the worst is behind it, and some established players are suggesting that the wild swings in volatility seen since September of 2007 are almost gone for good.

"The yet-to-be-finished de-leveraging process is still likely to exert technical pressure in the market, and volatility could persist for a while as was evident in (CMBX) widening," Citigroup researchers said in their Bond Market Roundup. "But it appears that the market should now be fairly close to fully redirecting attention to the actual and projected performance of the underlying collateral, as this performance, rather than technical forces, should determine bond value going forward."

Recent successful executions of new issue bonds by Lehman Brothers/UBS and JPMorgan/CIBC are also pointed to as examples that the market is returning to something more similar to its former self.

"People say they are comfortable with the fact that CMBS is not connected to residential subprime," one dealer said. "This hadn't been the case until recently."

Indeed, although delinquencies on residential mortgage loans continue to skyrocket, that’s not occurring among U.S. CMBS. Securities backed by commercial real estate loans have deteriorated only modestly. The Fitch Ratings’ CMBS delinquency index rose by three basis points, to 0.33%, in March, the second monthly increase in a row, but still low by historical standards.

“At this point, there is not cause for alarm,” Susan Merrick, managing director and CMBS group head, said in an interview. Although the delinquency rate is expected to rise to about 1% over the course of this year, Ms. Merrick said it will still be “just a bit above the historic average.”

Meanwhile, as the CMBS market sorts itself out and mark-to-market accounting fades from the headlines, borrowers are finding capital elsewhere. According to a new report by S&P, borrowers continue to find parties willing to refinance their CMBS loans, despite reduced liquidity for real estate funding and tighter lending standards.

"Debt financing for commercial real estate is available - albeit at a higher cost - from balance sheet lenders and other market participants, who see a window of opportunity for achieving attractive pricing even on conservatively underwritten loans," the report read.

The report noted that two of the three floating-rate loans with final maturities in the first quarter were refinanced and fully paid off. The third, the highly publized and much-worrisome Macklowe/EOP loan included in the COMM 2007 FL14 transaction did not pay off at its schedule final maturity. However, S&P suggested that the full retirement of the Macklowe COMM 2007-FL14 debt did take place on April 14. S&P said it viewed the Macklowe deal as highly positive given the transaction's size, complex debt structure and the number of parties with varying economic interests.

Fitch also noted an uptick in loans underlying the CMBS that are not refinancing precisely at their maturity date, thus putting them in non-performing status. The number of loans in this category increased to 11.6% of the Fitch delinquency index in March, compared with 2.9% a year ago.

However, Fitch noted that the majority of the fixed-rate "non-performing" matured loans have paid off in full or extended their terms within 60 days of being transferred to delinqu