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

The Markit Group Says "Bienvenido!"

“When Citi is cheaper than Colombia, which is on the verge of a war, it wakes you up,” Andrew Phillips, managing director and co-head of U.S. fixed income at BlackRock (BLK), in the March 2008 edition of Pensions & Investments, referring to the historically wide spreads on Citi's (C) corporate debt.

Or to put it another way, when Liberty Plaza is on the verge of becoming cheaper than Plaza de Bolivar, maybe it really is time time to throw in the towel on U.S. commercial real estate:

Let's take the donkeys and head to Bogota, shall we?

Throwing in the towel is exactly what Lehman Brothers ass whooping! (LEH) may be doing. The New York Post reported on Friday that Lehman is exploring the sale of about $30 billion of commercial mortgage loans, including CMBS. Insiders say Friday's NY Post report was the result of an intentional leak designed to test the market's reaction to Lehman's capitulation potential deal.

However, given that the CMBX was climbing relentlessly throughout July, would it be naive to suggest but we planned the leak! that they still can't figure out their hedges and simply got squeezed by a pack of ravenously short hyenas?

Hoocoodanode?

In what could be one of the biggest strategic blunders since the French built the Maginot Line ein, zwie,...drie!! Lehman decided to partner with Tishman Speyer Properties in early 2007 to buy Archstone-Smith, an apartment REIT. They paid $22 billion, which is the largest deal for apartment-buildings ever. The $22 billion price tag reportedly produced a "3 cap" on current income, which means that it essentially had an unlevered yield of 3%. Assuming that this makes sense for even a moment, it doesn't when you consider that the majority of the deal was financed with debt (leverage) at an average cost that far exceeded the 3% unleveraged yield, it's really not that hard to figure out what happens next.

That deal was soon underwater, as was the first-loss junior debt that Lehman underwrote to help finance it (and can no longer sell at par). Now, people outside the firm if you're not inside, you're outside! say Archstone is quietly shopping every single property outside of those located in New York the new Buenos Aires and San Francisco.

"We're not going to move curious absence of more precise verb noted [commercial real-estate assets] at fire-sale prices," said former Lehman Brothers Holdings Inc.'s finance chief, Erin Callan, during a conference earlier this year, adding, "We're going to move them curious absence of more precise verb noted yet again at prices that make sense to us." an attempt to revive central planning??

Remind me, what was that old joke about Wall Street beginning at a river and ending in a graveyard?

Disclosure: Despair

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."

Dividends Under The Bridge? Markit Responds to CMSA

In responding to the Commercial Mortgage Securities Association's ("CMSA") letter regarding increased transparency on CMBX trading, the Markit Group (the administrator of the CMBX indices) has apparently responded with a modern-day version of "Frankly my dear, I don't give a damn."

Evidently, Markit is contending that since the CMBX trades on the OTC derivatives market, Markit does not have access to trading data (either volumes and/or number of daily trades).

They also pointed out that trading volumes have never been published for other OTC derivative products (e.g. rates, FX, commodities), except for general surveys by ISDA, so it's unlikely that precise CMBX volume and trading data would ever be known. This would be good news for the speculators who make a living off of playing the index, and who now appear to be unloading their short positions.

I wrote about how all this is creating a the mother of all dislocations for REITs and financials in the recent article How Markit Turned Mr. Market into Mr. Magoo and much earlier in a March article entitled Mr. Market Trips on Mark to Market.

With respect to mark-to-market accounting, Reuters reported that Fed Chairman Ben Bernanke recently threw his policy-making heft behind the "if it ain't broke don't fix it" crowd in declining to recommend changes to mark-to-market.

According to Reuters, when asked about the issue in a question and answer session, 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.

Dottie Cunningham, CEO of CMSA, expressed the same concern in the CMSA's original letter to the Markit Group. "In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals," she said. "Some market participants may be relying on what we believe is a distorted value that perpetuates the current cycle of no issuance, erroneous spread widening and additional mark-to-market write downs."

So what can Markit expect next from the CMSA? Perhaps it will be a modern-day version of "I'll get you my pretty". Fortunately, for far-sighted investors who can stomach the turmoil and almost daily drumbeat of bad news, it really doesn't matter. As Bernanke said, mark to market has been good for long-term investors.

In an act of self-healing triage, the market has put itself on sale, and this will almost certainly cause liquidity and prices to recover. It will take some time, but at this point and with these discounts, the recovery may shift into higher gear sooner rather than later. In the meantime, you get paid to sit and watch the show.

CMBX Shorts Start to Unwind, Yields Dropping

Gobs of Fed Grease Moving To Mortgages, Offering Lubricious Relief

Hedge funds that had been aggressively shorting the CMBX market on the basis of the superficial similarities with the ABX (subprime housing related index) unwound some of their short positions last week. Spreads on all the CMBX indices continued to come in, and analysts at Citi contend that as more market participants start to focus on how CMBS is actually performing (low delinquencies, low defaults), and the health of the commercial property sector generally, those CMBX shorts may continue to unwind.

The speed and volatility in this market continues to burn even professional mortgage traders, however. The head of the mortgage desk at a top five investment bank with large mortgage exposure said last week that “we got hammered on the way in and hammered on the way out” as they hedged and rehedged their portfolio against the volatile CBMX. When those shorts reversed unexpectedly and CMBX spreads dropped, they were unable to unload their hedges quickly enough.

That same trader said that last week was the first time in months that the cash market (trading in actual CMBS paper) started to show signs of returning to life, after being almost completely frozen since August of 2007. Still, he said that two thirds of the investor base had been wiped out (e.g., SIVs, CDOs), and it would be a long while before replacements were found.

There is also conspiratorial talk at the highest levels of these firms regarding the hedge funds that brought down Bear Stearns. They are determined not to let it happen again, and senior executives from several firms are now quietly discussing the trading activities of those funds with various regulators.

That debacle led the Fed to intervene in the market in historic proportions. I thought it would be important to review the magnitude of those actions in their totality, because together they are incredibly important for REITs and Mortgage REITs in particular.

If you haven't arleady seen them, it may also be helpful to review excerpts from Bernanke's 2002 speech on asset deflation to understand why his Fed won't let things get any worse, and why saving Bear Stearns was so important in the first place.

The Fed's actions started in earnest on the same weekend that Bear Stearns failed, when the Fed established a Primary Dealer Credit Facility (PDCF). This facility was meant to provide assistance directly to the major investment banks, and for the first time ever it offered direct overnight loans through the Fed’s discount window to that beleaguered group.

Until the PDCF was developed, the access for cash through the discount window was only open to depository institutions with reserve accounts at the Fed. The new Fed facility also allows a much wider range of collateral, including investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities. If a price quote is available, the Fed will take it.

Essentially, the PDCF provides investment banks with access to cash using formerly illiquid mortgage assets as collateral. The liquidity provided by that facility will obviously be very good for the many REITwrecks out there, and it should help reduce the odds of another liquidity crisis in the investment banking sector following the Bear Stearns problems.

Two days after that, the Fed cut the short term rate once again, which cumulatively brought Fed funds down by 300 basis points between last September and March of this year. The last time the Fed undertook such an aggressive action (from 5.25 percent to 2.25 percent or a 57.1 percent cut) was between April and November 2001 (from 4.5 percent to 2.0 percent -- a 56.5 percent cut), in the midst of the previous recession and the aftermath of September 11th.

Just one day later, the Bush administration reduced the amount of capital Fannie and Freddie are required to hold, allowing them to buy or guarantee more mortgages. Combined with OFHEO’s ealier lifting of the portfolio caps on February 29th, and an increase in the conforming loan limits, two major sources of both commercial and residential mortgage capital are now back in full operation. At the same time, Fannie and Freddie agreed to raise more capital (perhaps through stock offerings) providing assurances that capital levels will exceed requirements.

And just one day after that, the New York Fed announced a modification to the Term Securities Lending Facility (TSLF), which was already so new the ink hadn’t even dried yet. Until the modification, the TSLF allowed primary dealers to obtain Treasury securities (not cash) for 28 days in exchange for a broad range of assets, including agency debt, agency residential mortgage-backed securities (RMBS), and AAA private-label RMBS – but not commercial mortgages.

The new, new TSLF (the first auction was held on March 27) now allows agency collateralized mortgage obligations and top-rated commercial mortgage-backed securities (CMBS) as collateral as well.

As the trader at the big 5 firm indicated, these efforts are starting to get the markets for all mortgage-backed securities moving again. Even the incredible, unbelievable, unkillable Thornburg (TMA) announced last week that it would begin lending again “within weeks, if not days.”

While all this was going on, commercial banks, insurance companies and even more conservative pension funds were quietly stepping in to fill the capital markets void in commercial real estate.

Just last month, the San Francisco Employees' Retirement System disclosed that it had increased its investment in CMBS through a $25 million commitment to the Fidelity Real Estate Opportunistic Income Fund LP. The fund will invest primarily in high yield real estate debt securities and instruments backed (directly and indirectly) by commercial property. While this investment is a drop in the bucket individually, it is a great example of a market wide trend that Fitch took note of in its March 25 report on maturing CMBS loans.

Fitch Ratings found that 99% of all CMBS loans maturing since the credit crunch began in August had been successfully refinanced. In the report, Fitch Managing Director and head of U.S. CMBS Ratings wrote that "the diversity of property type and geographic distribution of recent refinancing activity shows that debt capital is still widely available for commercial real estate."

So the commercial real estate debt market continues to function, even in this stressed credit environment, and all that activity in the synthetic CMBX indices looks to be the result of pure speculation - or worse: pure manipulation.

As this massive dose of Fed dollars continues to sluice through the mortgage market, the CMBX shorts continue to come off, and the murky REIT accounting issues begin to clear, more investors will reverse course and begin to sift through these REITwrecks rationally, assessing the true value of their cash flows.

By then it will be too late, so stay the course. The headwinds in the financial services sector are turning to tail winds, and the eye of the storm has passed. I am looking forward to writing more about the micro accounting issues this week, but unfortunately I am so endlessly fascinated by this story and just can’t write fast enough! As I wrote once before, ignore “Mr. Market”. Be careful. But let him serve you, not guide you.

High Yield Mortgage REITs Still Look Safe, But Stick to “Seasoned” Veterans

This may be no country for old men, but it’s definitely no market for little boys.

The headlines on February’s mortgage delinquency numbers were either negligible or somewhat alarming, depending on who reported them and the comparisons they were using. The biggest surprise in all the data was the increase in multifamily delinquencies, which is traditionally the safer and less volatile of the four real estate “food groups”. Here is a look behind some of the data.

A majority of the increase in multifamily delinquencies are linked to just one borrower, New Orleans-based MBS Companies. MBS has a checkered past and was attempting a comeback in Texas. The Company aggressively overpaid for its assets and then severely under-managed them.

Market participants involved in the sale of some of these defaulted loans indicated that MBS was almost inept. Despite some well-located properties, they said that some on-site property managers were accepting cash rent payments and under-reporting occupancies to MBS management (so they could line their pockets with said cash) and maintenance was not even an afterthought.

As of the end of 2007, MBS had over $900 million in multifamily loans that were either delinquent or in foreclosure. The Company raises equity from individual investors (OPM) and generates earnings through fees and carried interests. Thus, their earnings are decoupled from asset cash flows and not aligned well with either investors or lenders.

Most of the loans were originated by PNC Bank’s Midland Loan Services unit, and then securitized. Midland remains the “special servicer” on many of these loans. Because Anthracite Capital (AHR) reports a close relationship with Midland in its SEC filings, this could be something to watch for with respect to AHR.

Given the size and diversity of AHR’s portfolio however, MBS is likely not much more than a fly on its elephantine behind. Other investors that own the below investment grade tranches on these loans are JER Investors Trust (JER) and Centerline (CHC) – though Centerline is not a REIT, and neither is as exposed as Midland.

Meanwhile, the first three months of 2008 ended with only $6 billion of domestic CMBS issuance, the lowest first-quarter volume in a decade. Given current lending volumes, it is unlikely CMBS issuance will even reach half of 2007 volume and some are predicting less than $60 billion for the year.

A liquidity vacuum still exists in this market, despite current BBB CMBX spreads of 1100 of 1200 basis points. Believe it or not, these spreads are actually in from about 1500 basis points before the Fed bought Bear Stearns and dropped rates yet again, all in the same day and on a weekend, no less.

It’s only a matter of time before these incredibly high, unprecedented spreads combine with the Fed's largesse and the fundamentals of the commercial real estate market to over take short-term speculators in the CMBX.

With respect to delinquencies, according to the research firm Real Point, the delinquent unpaid balance for CMBS rose to a trailing 12-month high of $3.48 billion through February 2008, up from $3.16 billion a month prior. On its own, this is an alarming number, but doesn't fully represent the breadth of what is a really a fairly placid and benign market, at least in terms of delinquencies

While it’s true that delinquent balances jumped 57%, from $2.21 billion to $3.48 billion, there is almost $815 billion in CMBS debt outstanding. Thus, even with a 57% rise in delinquencies, troubled loans still represent less than half of 1% of the total market, and CMBS delinquencies overall remain at historic lows.

The real story in the Real Point report is that the increased delinquency rate came primarily from two of the most recent, less seasoned vintages of CMBS. According to their research, over 40% of delinquent unpaid balances through February 2008 came from transactions issued in 2005 and 2006. Nearly 22% of all delinquencies came from the 2006 vintage alone. Almost seven percent of all delinquencies came from the 2007 vintage.

What is the significance of all this for Mortgage REIT investors? Stick to the seasoned veterans. Those who came late to the game have been hit the hardest and will take the longest to recover (if some of them ever do) because they bought at a time when underwriting standards suffered badly, and they stuffed their portfolios full of weak, demand-driven paper.

Chris Milner, Anthracite’s CEO, punctuated the point in his Q4 earnings release: “The dislocation in the capital markets continued to worsen in the fourth quarter, causing CMBS spreads to reach unprecedented levels. While this development clearly has resulted in negative price changes in our portfolio, the relatively better performance of our non-U.S. and seasoned vintage U.S. CMBS assets muted the overall impact.”

In Wall Street's latest game of grown-up musical chairs, it would be wise not entrust your investment dollars to those little boys who sat down last.

Disclosure: Long AHR

Lack of CMBX Transparency Draws Industry Scrutiny

International Trade Association Requests Release of Daily Trade Volume; Calls for Greater Transparency in Trading Data.

Last week, in move that may be at least partially responsible for the nearly 150 basis point drop in the AAA CMBX Index, the Commercial Mortgage Securities Association (CMSA), requested that trading data on the CMBX Index, including total volume and number of daily trades, be made publicly available in order to increase market transparency.

The CMSA made the request in a formal letter to Markit, the administrator of the CMBX Index, a synthetic credit default swap derivatives index introduced in March 2006.

“Public disclosure of derivatives trading data in the CMBX Index would provide an invaluable service to investors in the commercial real estate capital market finance arena,” said Leonard W. Cotton, Vice Chairman of Centerline Capital Group and President of CMSA.

“We believe the volatility in the CMBX index caused by momentum traders, rather than fundamental traders, distorts the true picture of the value of CMBS bonds, which are backed by the cash flows from loans on income-producing commercial real estate.”

“Given the role the Index has come to play in determining the ‘mark-to-market’ value of securities held by financial institutions in the current market environment, greater transparency on CMBX trading volumes and the number of daily trades would aid investors in assessing the merit of values as indicated by the Index,” Cotton added.

Dottie Cunningham, CEO of CMSA, expressed concern that the Index is not indicative of the underlying fundamentals of the investment product. “In a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals,” she said.

“Some market participants may be relying on what we believe is a distorted value that perpetuates the current cycle of no issuance, erroneous spread widening and additional mark-to-market write downs.”

“The commercial real estate securities marketplace is a responsible, healthy and vital contributor to the overall economy,” said Cotton. “What we’re asking for are additional transparent practices that will allow the market to better evaluate the significance of the spread levels resulting from CMBX index trading.”

See the earlier post "Mr. Market Trips on Mark to Market" for general background on how the accounting impacts REITs, and for background on hedge fund speculation in the CMBX index see Is Commercial Real Estate Really Dead?

Is Commercial Real Estate Really Dead?

In September 2007, hedge fund manager Andrew Lahde of eponymous Lahde Capital, which had previously earned huge returns by heavily shorting the ABX, launched a new fund to short commercial real estate via the CMBX. The ABX was becoming too expensive to short, and tying up all that capital reaching for the final 10% of the trade wasn’t worth it.

At the time, he predicted a “100% likelihood” of a US recession that would cause commercial property to also tumble and that his “commercial fund [would] act as a hedge for all of the carnage still to come”.

His thesis relies heavily on exploiting the leverage often used to finance real estate. Using an analogy he says is from Peter Schiff, he explains that one should picture the commercial real estate market as a beach ball, with an arm holding the ball. If the arm is taken away, that ball will fall to the ground. He says many foolishly believe that somehow if you take cheap financing (the arm) away, the ball will remain afloat.

Despite a relatively placid commercial real estate market thus far, Lahde still fervently believes that the “losses will materialize”. Though he admits he doesn’t have any idea how severe the losses will be, nor does he have a model that can correctly predict all the variables (who does?).

He says he is sure of one thing though: “It is safe to assume a market is dead when deal volume falls to zero, as was the case with CMBS issuance during January 2008.” He goes on to say that “risk premiums for this type of debt have skyrocketed as exhibited by the CMBX. If you dramatically increase the risk premium for an asset class, especially one that is so heavily financed, the value of that asset class must fall. End of story”.

But is the CMBX really an accurate gauge of risk premia these days, or just plain paranoia? Worse, has it become an easy way to create a self-serving and self-fulfilling short prophecy on a popular trade? Particularly if it is one of the few vehicles available to speculate on that strategy?

Interestingly enough, the Markit Group, which runs the index, will not provide daily trading information, despite requests from the CMSA to do so. Obviously, low volume could make it subject to manipulation and price swings that do not actually reflect the current healthy fundamentals of commercial real estate.

Lahde knows this (he is clearly a smart guy), and what he also purposely fails to mention - his shareholder letters are all over the internet - is that although the CMBS market is truly quite dead, that doesn’t also mean the commercial real estate market has died along with it. Before the CMBS came market along, real estate financing was the almost exclusive domain of pension funds, insurance companies and regional banks, the very financiers that are now stepping in to refinance that “dead” CMBS market.

Fitch Ratings decided to look into this very issue and issued a March 25 report examining the default rate of maturing CMBS deals (they all have balloons that must be refinanced on maturity). Fitch found that ninety-nine percent of recently matured U.S. CMBS loans have been successfully refinanced.

Broken down further, a total of 3,354 U.S. CMBS fixed rate loans with a balance of $21.4 billion have been refinanced successfully since the credit crunch began in August. The lenders were mostly insurance companies and regional banks.

Lenders continue to finance assets like these because they produce reliable monthly income, not consume it. The arm analogy was a handy way to promote a niche short strategy, but far to simplistic for the real world.

Indeed, the beach ball is still there, and so are all the old lender’s arms, clamoring for a piece of it.

Update: "Lack of CMBX Transparency Draws Industry Scrutiny"