RECOVERING CMBS MARKET HITS ROUGH PATCH [Mortgage Banking]

Although volatility in the capital markets over the summer - especially following the downgrade of U.S. Treasuries on Aug. 5 - has spooked commercial mortgage-backed securities (CMBS) market participants, this financing source is definitely back, say experts, while not as strong as anticipated earlier in the year. I In 201 1, new CMBS issuance may not top $30 billion, far below estimates of $30 billion to $50 billion early in the year. Still, anywhere from $5 billion to $8 billion was in the CMBS pipeline as of the end of August. However, after October, that pipeline will be sparse until the end of the year, possibly picking up after that, says E.J. Burke, executive vice president, group head, at KeyBank Real Estate Capital, Cleveland, who also serves on the Mortgage Bankers Association's (MBA's) Commercial Real Estate/Multifamily Finance Board of Governors (COMBOG). Burke is also MBA vice chairman. I "The CMBS market provides an important source of capital for commercial real estate," says Dan Fasulo, managing director at Real Capital Analytics Inc. (RCA), New York. He adds, "We have seen a significant recovery in commercial real estate transaction activity and we will probably do $200 billion in deals in 2011." I This is the biggest volume since the beginning of the financial crisis, and it would be comparable with deal volume in 2004, he says. (The volume for the first half of 2011 was $90.6 billion - a 104 percent increase over the first half of 2010, according to RCA research.) I "With this volume, we are getting close to the point where the market cannot continue to expand without the help of the CMBS sector, because pension funds and insurance companies have finite pools to invest. We need the public markets to expand," says Fasulo.

And there are other reasons that the CMBS market is needed, says Fasulo: "As long as interest rates are low in major Western economies, investors need a higher-yielding asset class so they can put their money to work." He expects to see about $35 billion in new CMBS issuance for all of 2011.

Still, because of fears about the larger economy, in the United States as well as Europe, says Tom Fink, senior vice president, managing director at Trepp LLC, a New York-based commercial real estate research firm, spreads on conduit loans (which began to widen in late summer) are expected to stay wide for a while.

As a result, "people are having trouble doing loans that make sense for securitization," he says. While wider spreads may entice investors, the higher coupons could discourage borrowers, says Fink. At the same time, volatility in the market makes it hard to hedge interestrate risk. All of this together could be cutting into demand for CMBS loans, he says.

And there are other factors cutting into the demand for CMBS, says Darrell Wheeler, senior managing director at Amherst Securities LP, New York.

"The reality is that there will not be a lot of mortgage maturities until 2015, so the CMBS market will be much smaller than it had been before the crisis for the next couple of years. Mortgages have to mature before originators can do new originations," he says.

"We get new mortgages from people selling properties, but the major driver is refinancing and the majority of refinancing will not happen until 2015," notes Wheeler.

CMBS vs. other lenders

"CMBS has a smaller proportion of commercial real estate originations than at the height of the market in 2007, when it accounted for over 50 percent of the volume of new originations," says Ben Carlos Thypin, director of market analysis at RCA.

"In 2011, as of the end of August, CMBS made up about 21 percent of commercial real estate origination volume - slightly down from 26 percent for all of 2010, but higher than in 2009 when it accounted for only 10 percent of commercial real estate originations."

CMBS competes with a variety of lending sources, including foreign and domestic banks, thrifts, life insurance companies, and Fannie Mae and Freddie Mac, with the last two sources only competing in the multifamily arena.

In first-quarter 2011, CMBS held the second-highest volume of commercial real estate debt outstanding, or 26.3 percent, according to MBA. Only banks and thrifts had more with 33.4 percent. The high percentage of outstanding CMBS debt is, of course, largely due to the strength of the CMBS market before the financial crisis.

In the multifamily arena alone, Fannie Mae and Freddie Mac have led all other types of lenders since the financial crisis began. But today, that is starting to change.

Fannie and Freddie's new multifamily originations went from about 30 percent in 2007 to 85 percent in 2009, says Jamie Woodwell, vice president of commercial real estate research at MBA. But its share was back to about 63 percent in 2010 as other lender groups began to recover. Fannie and Freddie have a natural advantage, he says, because of their ties to the federal government and their attractive lending terms.

As of the end of August, the long-term fate of Fannie Mae and Freddie Mac remains in limbo, as the government-sponsored enterprises (GSEs) continue in conservatorship. Numerous bills focusing on Fannie Mae and Freddie Mac reform have been introduced in Congress this year but, as of Sept. 9, none had made it out of full committee.

In spite of their attractive rates, Fannie and Freddie faced competition from the life companies at midyear, says Burke. Life companies had "developed an appetite for multifamily recently," because they recognized that rents in multifamily properties and the value of those properties had been recovering more quickly than other commercial real estate sectors, he says.

But since the end of July, life companies have widened their spreads because of the volatility in the market, making them less competitive with Fannie and Freddie than earlier in the summer, says Burke.

"For the bigger deals, other than those in the multifamily sector, international banks and insurance companies are winning a lot - and in New York, at least, many community banks are strong lenders," says Fasulo. "CMBS [lenders] can't compete for borrowers in the primary markets very well, because they have had to raise their prices," he says.

"Deals financed by CMBS are less likely to happen in primary markets, because there is more competition for loans in those markets," adds Thypin. "Players like big insurance companies, and foreign banks are less inclined to go out of major international cities like New York and San Francisco, so they offer more favorable terms in those markets to attract borrowers - terms that are better than what CMBS can offer," he says. "As a result, CMBS is restricted to smaller assets in primary markets and strong assets in secondary and tertiary markets."

And the CMBS market is limited in other ways. "Despite the CMBS market having made a comeback, it hasn't come back enough to allow for very large loans that get distributed across several different bond issues," says Thypin.

"Now, people are concerned that the market could freeze up or slow down, so it isn't operating consistently enough for a conduit lender to be able to make such large loans," he says. "The issue here is that there are not many large CMBS loans being made on single properties, because the risk is so concentrated in that single property/' adds Thypin.

"However, some large CMBS loans are being made on large portfolios," says Thypin. "For example, Wells Fargo, Deutsche Bank and Barclays recently teamed up to provide $1.4 billion in debt for a portfolio of 107 shopping centers owned by Blackstone, $1 billion of which was securitized," he says. "A CMBS lender can make such a loan and turn it into a single CMBS bond issue. These types of loans are being made today because collateral is spread out and so is the risk," says Thypin.

Credit enhancement a wave of the future

"There has been an increase in risk aversion among investors," which influences spreads, says Joseph Franzetti, senior vice president, capital markets, in the New York office of Horsham, Pennsylvania-based Berkadia Commercial Mortgage LLC.

"While each lender has a different approach, we are seeing them quote coupons [in the 6 percent range], rather than the low 5 percent range, where they were before July," he said at the end of August. While the widening began in July, it has continued and gotten dramatically worse since then, Franzetti said in early September.

"Quoting coupons rather than spreads is an indication of a market not operating properly," says Franzetti.

"When lenders quote a coupon rather than a spread, that means that there is more than enough spread to attract investors, but if there isn't a market for a CMBS deal, they don't mind holding the loan on the balance sheet at a higher return," he says.

At the same time that spreads are widening, CMBS investors are demanding greater credit protection, says Franzetti. "Some lenders won't quote a transaction today because they don't know how much credit enhancement investors will require to buy triple-? bonds," he says. "At some point, the borrower will sit on the sidelines unless [he has] a gun to his head," says Franzetti. If not, they may not be able to refinance their properties, he says.

In early August, Frankfurt, Germany-based Deutsche Bank AG and Zurich, Switzerland-based UBS AG surprised the market when they came out with one of the most conservative CMBS offerings in recent years, in terms of credit enhancement.

The deal, worth $1.4 billion, was priced at 200 basis points over the 10-year AAA Treasury bond, which, as of the end of August, was probably the widest pricing of 2on, says Wheeler. It also featured 30 percent credit enhancement: 70 percent of the bonds were rated AAA, while 30 percent were designed to be purchased by socalled B-piece buyers, who take the riskiest portion of a deal.

"Investors held the transaction hostage," says Wheeler. "Issuers may not like it, but in the long term, investors don't trust rating agencies" to give an accurate picture of credit levels, he adds.

Super-seniors, as deals structured like the aforementioned are known, may give more comfort to investors, but they stick in the craw of rating agencies like Moody's Investors Service, New York.

"The introduction of the super-senior structure is a credit negative for CMBS underwriting because it can diminish so much of the credit risk for senior investors that they no longer exert much-needed discipline on the underwriting process," according to an Aug. 8, 2011, Moody's Investors Service special report entitled U.S. CMBS Q2 201 1 Review: Conduit Leverage Steady, Other Key Credit Metrics Slip.

"We don't know if volatility in the stock market, which also affected the CMBS market, is over," says Wheeler. "When investors sell stocks, they also sell CMBS bonds," he says. "When pricing for CMBS is falling, that affects the prices for raw [new] commercial mortgages."

Depending upon how they hedge, investment banks could have losses as high as 7 percent of the dollar volume of mortgages they hold, because a lot of product could sell for less than the investment banks paid for them, says Wheeler. The losses would probably not exceed 7 percent, thanks to hedging, he estimates.

CMBS risk-retention requirements still in limbo

At the same time that CMBS issuers are trying to attract investors, they are uncertain about how the proposed credit risk-retention requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act will play out. The legislation calls for securitizers of all asset-backed securities (ABS) to retain 5 percent of the credit risk of the assets in the pool, but just how that 5 percent will be held depends on how final regulations, which are still being considered, are written.

Proponents for the CMBS market believe that CMBS issues can be adequately protected by B-piece buyers alone, who purchase the riskiest slice of a deal. Because their own money is at risk, these proponents believe that the B-piece buyers will do enough due diligence to safeguard the whole CMBS pool.

According to the Dodd-Frank legislation, CMBS alone, among asset-backed securities, may be able to transfer the 5 percent risk to a third party, usually the B-piece buyer, but only if B-piece buyers meet certain underwriting standards, such as re-underwriting each loan on the deal that they intend to purchase.

Although this requirement may give some in the CMBS market pause, the proposed risk-retention requirement that Burke is most concerned about is a premium capture cash reserve account, which would be in addition to the 5 percent risk retention. This "premium capture" mechanism is designed to prevent a securitizer from structuring an asset-backed securities transaction in a way that would allow the securitizer to effectively negate or reduce its retained economic exposure to the securitized assets by immediately monetizing, or profiting from, the excess spread created by the securitization. The excess spread is simply the difference between the gross yield on a securitized pool less the cost of financing those assets, chargeoffs, servicing costs and any other trust expenses.

In a July 11, 201 1, letter from MBA to the federal regulatory agencies responsible for the risk-retention requirements - including the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC) and the Securities and Exchange Commission (SEC) - objections were raised to the proposed requirements.

Addressing the premium capture cash reserve account, the letter stated, "As proposed, we believe it will be exceedingly disruptive to the CMBS market (which relies on the interest-only [10] tranche for expense recovery and a return on capital), and effectively would remove the financial incentive to issue CMBS, potentially eliminating CMBS as a potential source of permanent mortgage capital for commercial/multifamily real estate borrowers."

Unlike the risk-retention requirements that Burke thinks the CMBS industry could live with, the premium capture cash reserve account "gives us heartburn," he says.

Operating adviser plays a significant role in CMBS

Another proposed risk-retention requirement related to the Dodd-Frank legislation would mandate that any CMBS sponsor that meets the risk requirement via a third-party purchaser, who has control rights not shared with all other classes of bondholders - such as special servicing rights - appoint an operating adviser. That person's job would be to advocate for all bond holders, but especially for those holding AAA bonds.

Objections to this proposed requirement were raised in the July 11, 2011, MBA letter mentioned earlier. As an example, it said: "While the MBA recognizes the reasons for including an independent party to balance certain conflicts among the first loss and other investor classes, we have strong concerns about the operating advisor role as set forth in the proposed rule and recommend an alternative framework governing its role and that of the special advisor."

Among the recommendations the MBA letter cited were to "strengthen disclosures on the activities of the special servicers - and the accessibility of such information - to inform all CMBS investors of information related to non-performing loans when such information can be disclosed."

Most CMBS issues done in 2010 and 2011 have operating advisers, says Wheeler, although it is not a legal requirement presently. "The job of the operating adviser is to police the trust, to ensure that disposition or modification of any loan doesn't have inordinate third-party fees and has been fairly marketed to maximize value," he says.

Operating advisers have become a necessary part of the CMBS environment, because special servicers have changed, says Wheeler. Until a few years ago, they were more likely to be institutional and they had a more stable investor base with a standard compliance department, he says. "Today, some special servicers are owned by hedge funds, which may have objectives which appear counter to investors' interests," he says.

As an example, in August, New York- and Irving, Texas-based C-III Capital Partners LLC, which is led by property investor Andrew Farkas, bought McLean, Virginia-based JER Partners' special servicing business, and last year New York-based Fortress Investment Group LLC purchased Bethesda, Maryland-based CW Financial Services.

A few special servicers have exercised fair value options in distressed property dispositions, "which means they may have properly used an option to buy delinquent loans, although in these cases, investors still want an independent review of these dispositions," says Wheeler.

The proposed regulations for operating advisers give them more power than they presently have. As an example, the operating adviser can recommend removal of the special servicer at any time, if he or she believes that it is not living up to its contractual obligations, according to one proposed requirement, and the only way the special servicer would be able to remain is to get a majority of investors voting to keep it. In contrast, today the operating adviser is usually dormant until the B-piece buyer has lost its investment.

While the B-piece buyers/special servicers say they can live with what is in current CMBS contracts, they want to be in full control when they are "in the money," which is to say they still have their investments. But if they lose their positions as special servicers while they still hold their investments, which would be the case if the proposed requirements for operating advisers are adopted, someone else would be making decisions about workouts. Given that being an investor is all about controlling risk as much as possible, this is a situation that B-piece buyers ardently want to avoid. MB

With the prospect of commercial real estate transactions reaching $200 billion in 2011, the market may not be able to expand further without help from commercial mortgage-backed securities (CMBS) as a lending source. Even so, capital markets volatility became an issue in late summer, clouding the outlook for the rest of the year.

In first-quarter 2011. CMBS held the second-highest volume of commercial real estate debt outstanding, or 26.3 percent, according to MBA.

At the same time that spreads are widening, CMBS investors are demanding greater credit protection, says Franzetti.

Operating advisers have become a necessary part of the CMBS environment, because special servicers have changed, says Wheeler.

Hortense Leon !s a freelance writer based In Miami. She can be reached at [email protected].