The rise, fall and rebirth of the CMBS market
The commercial mortgage-backed securities (CMBS) were issued as early as 1983, modern securitisations grew out of the savings and loan crisis in the US. Following the overbuilding, weaker underwriting standards and generally lax market discipline that characterised the 1980s commercial real estate boom, the market found itself in a vicious cycle of declining liquidity and price depreciation. With portfolio lenders unwilling or unable to provide financing, investors recognised the value of tapping the public capital markets.
Resolution Trust Company and Federal Deposit Insurance Company
The Resolution Trust Company (RTC) and Federal Deposit Insurance Company (FDIC), in particular, faced the daunting task of disposing of tens of billions of commercial and multifamily mortgages seized from failing institutions turned to securitisation to facilitate their sale.
The RTC/FDIC programme helped to establish CMBS as a viable product with a broad investor base. Between 1991 and 1997, 74 deals were brought to market with a total principal balance of more than $45 billion. Of these, 40% were backed by commercial and multifamily collateral. Although nearly $13 billion of private-label CMBS had been issued before 1990, these transactions tended to be small private placements by commercial banks and insurance companies – on average, $100 million of initial principal. Balance was split among fewer than ten loans. Structures were generally simple, consisting of one or two tranches. The RTC programme was the first to bring more significant deals to market, including many with an original balance of over $500 million split among dozens of loans.
The programme also introduced more complex structures, often with four tranches of rated pass-through certificates – including both fixed and floating classes – as well as residual interests and additional credit support via a reserve fund to cover losses.
Over the next few years, the CMBS market matured dramatically. Securitisations, which accounted for only 1% of commercial mortgage debt in 1990, represented more than 12% of the market by the end of the decade.
Conduit lenders, sourcing loans under an originate-to-distribute model developed more standardised underwriting processes, while investors gained access to extensive collateral performance data via third-party reporting systems. At the same time, expanded secondary trading of CMBS greatly improved market liquidity and enabled better deal execution.
Why did the market grow?
The market grew because securitisation offered economic advantages to all parties involved:
As the market developed and the investor base broadened, deals were categorised by collateral characteristics and diversity. By 2003, six distinct types of CMBS transactions were being issued with some regularity:
Conduit/fusion transactions continued to dominate issuance, particularly in the US. Approximately half of CMBS issued domestically between 1997 and 2003 (measured by original principal balance) fell into this category, versus 18% international, 13% floaters and 9% single asset/borrower. Conduit collateral became more diversified as the market expanded, including eight distinct property types – but primarily focused on the retail, office and multifamily sectors. By 2003, US domestic CMBS supply totalled approximately $80 billion. Beginning in 2004, a rapidly expanding credit bubble in the US drove a dramatic acceleration in issuance. US domestic, commercial mortgage debt grew by 50 per cent in just three years, as borrowers relied more and more heavily on the capital markets for financing.
At the peak in mid-2007, nearly half of all commercial real estate debt in the US was securitised. Approximately $230 billion of domestic CMBS was issued that year, almost triple the amount issued four years earlier.
Competition to source collateral for new transactions caused underwriting standards to deteriorate rapidly. At the peak, almost 90% of conduit loans were interest-only for at least part of their term, and more than half did not amortise at all. Issuers also increasingly relied on Pro-forma financials, often utilising extremely optimistic assumptions regarding rent growth and occupancy trends to justify inflated property valuations.
Therefore, while underwritten loan-to-value (LTV) ratios were relatively stable between 2004 and 2007, real leverage levels were rising rapidly. Rating-agency-stressed LTVs, which use stabilised cash-flow estimates to derive more realistic property valuations rose from 87% in 2004 to 110% in 2007, while debt service coverage ratios (DSCRs) declined from 1.4 to 1.1.
Contributors of change
There is no singular culprit for this dramatic expansion in lending. Instead, several factors collaborated to fuel surging issuance and to hasten declining collateral quality:
Just as originators grew more aggressive in their lending practices, rating agencies loosened their credit enhancement requirements. Going into the market's peak, subordination levels declined simultaneously as leverage rose and underwriting standards deteriorated. Credit enhancement to the AAA part of the capital structure dropped from an average of 19.5% in 2002 to only 12% in 2007; the subordination of BBBs fell from 8.3% to 4.3% over the same period.
By late 2007 to early 2008, the train was veering off the tracks. Amid declining home prices and signs that commercial real estate had peaked, demand evaporated. BBBs, which as of June 2007 were routinely pricing inside of a 150 bps spread to swaps (S +150), were launching as wide as S +1500 bps in the second quarter of 2008 (and traded wider than S +8000 bps by the end of that year).
Extensive use of leverage in the boom years had left financial institutions themselves undercapitalised and overly reliant on short-term funding. As a credit crunch set in and the financial crisis accelerated, the securitisation markets – including CMBS – essentially collapsed.
In the recession that followed, CMBS collateral performance was directly related to underwriting quality. By the end of 2010, for example, the severe delinquency rate – defined as more than 60 days delinquent, including foreclosed and real estate-owned property – for loans written closer to the peak of the market (the 2006 and 2007 cohort, or vintage) was more than double those originated in 2004. Because these loans were underwritten to more aggressive standards, which frequently relied on strong cash-flow growth to justify property valuations, they were less resilient in times of economic stress.
Beginning in late 2009, the market reopened, and deals were getting done. At press time, the economic recovery has driven sufficient spread compression and demand for commercial mortgages to support the resurrection of CMBS. Total issuance in the first six months of 2011 stands at approximately $20 billion, which is rough twice the previous year's total.
The securitisation process
The first step in any securitisation is sourcing loans. CMBS collateral is originated by commercial banks, insurance companies or mortgage finance companies and consists almost exclusively of first-lien commercial mortgages. In addition to issuing the loan, the originator is responsible for assessing loan financials and the borrower's creditworthiness.
The three most important loan characteristics considered are:
These loans are typically warehoused for two to four months until the underwriter or issuer has established an initial collateral pool. Currently, it typically takes 10 to 12 weeks to bring a conduit transaction to market. The first 4 to 6 weeks are spent on due diligence, as potential B-piece buyers and rating agencies evaluate the collateral quality, as well as initial document preparation and servicing bids. During this phase, B-piece buyers can request that certain loans are removed from the pool. After eight weeks or so, the B-piece buyer is selected and signs off on the final collateral pool composition.
Then, the bond structure is set according to final subordination levels received from the rating agencies. Marketing generally begins in the eighth week and lasts up to a month. The term sheet, which contains details on the deal structure and top mortgage loans, serves as the focal point for this process. Over the next week, the issuer conducts investor roadshows and takes indications of interest from accounts. Once the deal is launched, it typically takes two to four business days to price. A final offering circular is prepared, and the transaction settles the following week.
Overview of a typical securitisation
The majority of modern securitisations are organised as real estate mortgage investment conduits (REMICs). Electing REMIC status allows certificate holders to avoid double-taxation (at a corporate and personal level) of income received from the collateral pool.
There are three primary requirements:
Since the market reopened in 2009-2010, these have almost all been private placement 144a transactions. This primarily limits liability exposure for issuers, which helps to motivate greater transparency and disclosures than would be feasible for public deals. It also reflects issuers’ hesitance to invest in registering securities – either by revamping existing shelves or starting new ones – under a cloud of regulatory uncertainty.
There are, however, downsides to private placement: some argue that public transactions would attract a broader investor base, which could improve liquidity and execution for new issues.
Risks in CMBS investing
As with any financial asset, CMBS expose investors to a range of risks. Some are straightforward and reminiscent of other credit products, such as corporate bonds. Others, however, are specific to the asset class, arising from the way deals are structured and the lumpy and idiosyncratic nature of the collateral.
Given the structural complexity of these kinds of financial instruments, risk factors can vary from deal to deal; however, the following ones are the most common:
Important differences between legacy CMBS and more recent transactions
Underwriting Standards
A significant improvement in underwriting standards relative to old ("vintage") loans from 2006 and 2007 represent one of the most important differences between new issue CMBS and legacy deals. These "seasoned" loans have a much lower risk of default as they have been issued long enough. Most importantly, originators and rating agencies now focus on in-place cash flow rather than Pro-forma financials. Many of the mistakes of the "boom" years can be traced back to overly optimistic cash flow growth expectations, which inflated property values and underestimated leverage. Combined with bottom-of-the-cycle underwriting, which is more conservative, new issue collateral is significantly levered than later-vintage legacy deals. In addition to lower overall leverage, originators are making significantly fewer interest-only loans than they did at the peak. In 2007, approximately 60% of CMBS collateral did not amortise at all, and nearly 90% was interest-only for at least part of the term.
By contrast, recently issued transactions are, on average, backed by approximately 80% fully amortising collateral, and only 8% is interest-only for the full term. Amortising, in particular, carries less refinancing risk because they de-lever the term;
Credit enhancement
New issue deal structures are also more conservative than legacy transactions. As the market has reopened, rating agencies have required more enhancement at a given credit rating than they did at the end of the previous cycle.
Control rights
To provide more protection to investors, control rights have also been revised. Because they can direct and replace the special servicer, the majority owner of controlling class certificates (or directing certificate holder) can greatly influence loan workouts. Before, this control rested with the most subordinate outstanding class of certificates. However, it has recently become clear that this arrangement can lead to a conflict of interest. Following a sharp decline in prices, the controlling class could effectively have no economic interest in the transaction but maintain control. At the same time, troubled loans work their way through the delinquency pipeline. This is particularly true if the special servicer is also the directing certificate holder – which was commonplace at the market's peak. In such a scenario, they could seek to maximize cash flow and fee income to the detriment of more senior bondholders.
In recent transactions, this was remedied by allowing the controlling class to be 'appraised out', which in the Real Estate world means that if the principal balance net of appraisal reductions ever falls below 25% of its initial value, control shifts to the next most junior class of certificates. This helps to ensure that the directing certificate holder has an economic interest in loan workouts and avoids potential conflicts of interest.
Conclusion
Since the early 1990s, CMBS has been a significant provider of liquidity to commercial real estate investors. Despite the securitisation markets having been severely disrupted by the global financial crisis of 2008-2009, the CMBS market has since reopened.
There are also signs that the market has begun to learn the lessons of the credit crisis. Despite a clear deterioration in underwriting quality over the past year or so, standards remain quite conservative relative to historical norms. At the same time, the investor base is more actively engaged in policing issuers, for example, forcing Goldman Sachs to restructure its most recent deal to include a junior AAA class when credit enhancement levels were seen as insufficient. In contrast, many chose to outsource due diligence to the rating agencies.
A more balanced market in which investors enforce discipline on underwriting and structuring should go a long way towards preserving a still-high credit quality product. Familiarity with the asset class should provide more diverse financing and investment options, representing a competitive advantage in the future.
AUTHORS:
Francisco Marques
Luísa Lourenço
Teresa Rodrigues
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