Hedge funds see opportunity in beaten-down commercial mortgage-backed securities
Author: Rivington
Commercial mortgage-backed securities (CMBS) are making a comeback after dying a death in 2008 when overleverage led to indiscriminate selling. The revival is driven by a new generation of leaner, meaner products and better than expected performance by legacy CMBS.
Those willing and able to exploit the opportunities created by an inefficient market with high barriers to entry and conservative ratings can benefit from attractive risk return metrics.
Between 2002 and 2007 issuance of CMBS in the US quadrupled to $229 billion and European issuance trebled to $65 billion. In 2007 total CMBS issuance was $300 billion. Some of the biggest trophy properties went down this route.
In their drive to quote competitively, providers offered increasingly aggressive terms. Underwriting and credit ratings relaxed and leverage increased as loan to value (LTV) ratios rose to 80%-100%.
When the financial crisis hit, selling by highly levered investors became endemic and indiscriminate. European and US spreads blew out significantly. This was most exaggerated in the US, peaking at nearly 1,600 basis points (bp) in October 2008.
By November 2008 loss severity and delinquency rates were on a sharp upwards trajectory. The CMBS market all but dried up.
In late 2009 better than expected performance on vintage CMBS and the advent of CMBS 2.0 sowed the seeds of a comeback.
Two key changes had occurred: ratings and LTV ratios were much more conservative.
Previously, rating agencies had been too aggressive in their assumptions. The pendulum has now swung the other way. "They appear conservative and are also feeling empowered to withdraw or not rate deals," says Ravi Stickney, portfolio manager at $6.8 billion Cheyne Capital. "Investors should look at CMBS for the simple reason that they are getting a truly outsized return for taking a conservative level of risk."
LTV ratios have also come down, attracting new money into the market, including insurance companies in Europe. "They can get a nice juicy margin refinancing at 50%-60%, which is a good way to get a return," according to Stephen Ashworth, manager of Reech CBRE's $135 million Iceberg Alternative Real Estate Fund.
Consequently, the CMBS comeback picked up speed. Between September 2010 and February 2011, Markit's CMBX indexes showed price increases across the board with the most exaggerated gains in the lower-rated AJ (the most subordinate of the AAA-rated tranches) and AM tranches (those that sit between the CMBX.NA.AJ and CMBX.NA.AAA tranches in the capital structure and were originally rated AAA).
"The concerns about CMBS in 2008 and 2009 have by and large proven unfounded. Borrowing has become cheaper as long-term swap rates hit an all-time low. Liquidations of assets have come down and refinancing has been quicker than anticipated, which increases the realised return," says Stickney. "When we underwrote CMBS in 2009, we did so assuming a 13% IRR [internal rate of return] and a high level of defaults, significant losses and lengthy loan extensions. CMBS has, therefore, exceeded our expectations."
Cheyne's £303 million Real Estate Debt Fund is 67.9% exposed to CMBS (52.2% UK, 37% Europe) and is up 8.1% at August 31 compared with a negative 4.7% for the iTraxx Crossover Total Return Index (European high-yield credit) and a drop of 17.6% for the EuroStoxx 50.
By May an S&P report showed loss severity rates down significantly at 37%, after hovering between 50%-60% in 2009 and 2010. It pointed to lower future rates based on improving property fundamentals, expanding debt issuance, speedier loan resolutions and the expectation collateral cash flows would continue improving.
Then came summer.
CMBS weakened in line with credit markets, causing many to make mark downs. From June toAugust the price trend for the Markit CMBX indexes reversed, with the AJ and AM series booking 9% and 24% declines respectively.
In July investor confidence was badly hit when S&P pulled ratings on several deals because it discovered "potentially conflicting methods" in its rating system. Goldman Sachs and Citigroup were forced to cancel a $1.5 billion CMBS deal.
"Over the past few months, capital markets participants have become concerned over the viability of CMBS to provide commercial mortgage financing after witnessing the "priced" Goldman/Citi new issue being withdrawn", says Darrell Wheeler, CMBS strategist at Amherst Securities Group. "The resulting volatility has been very hard on the market with many participants looking back to 2008 conditions and wondering what could stop the falling knife of 2011."
By the end of August one in six European CMBS loans was in special servicing and one in eight was in default.
Barclays Capital reported a decline in the delinquency to "cure" rate from 6% to 3% in September. "The decline in the cure rate is partly because refinancing is harder to secure, which is partly because real estate prices have come down so borrowers have less equity to post and fewer new loans are quoted by conduit lenders," according to Julia Tcherkassova, mortgage-debt analyst at BarCap.
As European banks continue to suffer, 32 loans will mature in October according to S&P figures, the highest concentration in 2011. One-third are already showing signs of pressure.
Read more about Cheyne Capital or find the full article at HedgeFundsReview.com
Those willing and able to exploit the opportunities created by an inefficient market with high barriers to entry and conservative ratings can benefit from attractive risk return metrics.
Between 2002 and 2007 issuance of CMBS in the US quadrupled to $229 billion and European issuance trebled to $65 billion. In 2007 total CMBS issuance was $300 billion. Some of the biggest trophy properties went down this route.
In their drive to quote competitively, providers offered increasingly aggressive terms. Underwriting and credit ratings relaxed and leverage increased as loan to value (LTV) ratios rose to 80%-100%.
When the financial crisis hit, selling by highly levered investors became endemic and indiscriminate. European and US spreads blew out significantly. This was most exaggerated in the US, peaking at nearly 1,600 basis points (bp) in October 2008.
By November 2008 loss severity and delinquency rates were on a sharp upwards trajectory. The CMBS market all but dried up.
In late 2009 better than expected performance on vintage CMBS and the advent of CMBS 2.0 sowed the seeds of a comeback.
Two key changes had occurred: ratings and LTV ratios were much more conservative.
Previously, rating agencies had been too aggressive in their assumptions. The pendulum has now swung the other way. "They appear conservative and are also feeling empowered to withdraw or not rate deals," says Ravi Stickney, portfolio manager at $6.8 billion Cheyne Capital. "Investors should look at CMBS for the simple reason that they are getting a truly outsized return for taking a conservative level of risk."
LTV ratios have also come down, attracting new money into the market, including insurance companies in Europe. "They can get a nice juicy margin refinancing at 50%-60%, which is a good way to get a return," according to Stephen Ashworth, manager of Reech CBRE's $135 million Iceberg Alternative Real Estate Fund.
Consequently, the CMBS comeback picked up speed. Between September 2010 and February 2011, Markit's CMBX indexes showed price increases across the board with the most exaggerated gains in the lower-rated AJ (the most subordinate of the AAA-rated tranches) and AM tranches (those that sit between the CMBX.NA.AJ and CMBX.NA.AAA tranches in the capital structure and were originally rated AAA).
"The concerns about CMBS in 2008 and 2009 have by and large proven unfounded. Borrowing has become cheaper as long-term swap rates hit an all-time low. Liquidations of assets have come down and refinancing has been quicker than anticipated, which increases the realised return," says Stickney. "When we underwrote CMBS in 2009, we did so assuming a 13% IRR [internal rate of return] and a high level of defaults, significant losses and lengthy loan extensions. CMBS has, therefore, exceeded our expectations."
Cheyne's £303 million Real Estate Debt Fund is 67.9% exposed to CMBS (52.2% UK, 37% Europe) and is up 8.1% at August 31 compared with a negative 4.7% for the iTraxx Crossover Total Return Index (European high-yield credit) and a drop of 17.6% for the EuroStoxx 50.
By May an S&P report showed loss severity rates down significantly at 37%, after hovering between 50%-60% in 2009 and 2010. It pointed to lower future rates based on improving property fundamentals, expanding debt issuance, speedier loan resolutions and the expectation collateral cash flows would continue improving.
Then came summer.
CMBS weakened in line with credit markets, causing many to make mark downs. From June toAugust the price trend for the Markit CMBX indexes reversed, with the AJ and AM series booking 9% and 24% declines respectively.
In July investor confidence was badly hit when S&P pulled ratings on several deals because it discovered "potentially conflicting methods" in its rating system. Goldman Sachs and Citigroup were forced to cancel a $1.5 billion CMBS deal.
"Over the past few months, capital markets participants have become concerned over the viability of CMBS to provide commercial mortgage financing after witnessing the "priced" Goldman/Citi new issue being withdrawn", says Darrell Wheeler, CMBS strategist at Amherst Securities Group. "The resulting volatility has been very hard on the market with many participants looking back to 2008 conditions and wondering what could stop the falling knife of 2011."
By the end of August one in six European CMBS loans was in special servicing and one in eight was in default.
Barclays Capital reported a decline in the delinquency to "cure" rate from 6% to 3% in September. "The decline in the cure rate is partly because refinancing is harder to secure, which is partly because real estate prices have come down so borrowers have less equity to post and fewer new loans are quoted by conduit lenders," according to Julia Tcherkassova, mortgage-debt analyst at BarCap.
As European banks continue to suffer, 32 loans will mature in October according to S&P figures, the highest concentration in 2011. One-third are already showing signs of pressure.
Read more about Cheyne Capital or find the full article at HedgeFundsReview.com
Tags:
barriers to entry,
ltv,
insurance companies,
pendulum,
new money,
portfolio manager,
mortgage backed securities,
basis points,
risk return,
rate deals,
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