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Slow thaw for CMBS: there are small signs that the commercial mortgage-backed securities market is beginning to come back. The federal government is playing a major role in helping to unfreeze the market.

There is little indication that the commercial mortgage market will make a strong comeback anytime soon. But activity is picking up. As an example, new issuances of commercial mortgage-backed securities (CMBS) are expected this fall, in addition to a $1.1 billion issue from Freddie Mac, which came out the week of Sept. 28. * In other positive news, the Internal Revenue Service (IRS) smiled on real estate mortgage investment conduit (REMIC) borrowers, making it easier for them to talk to their servicers before default is imminent. * The main catalyst for new CMBS is the Federal Reserve's Term Asset-Backed Securities Loan Facility (TALF) program. In August, the TALF--which is designed to make low-cost financing available to investors buying super-senior CMBS bonds and other structured securities--dispersed roughly $2.1 billion in loans for the purchase of existing, so-called legacy CMBS and another $1.4 billion in September. * In addition, Beachwood, Ohio--based Developers Diversified Realty, a real estate investment trust (REIT), was expected to issue a $400 million CMBS in November, with help from TALF, according to the Oct. 2, 2009, issue of Commercial Mortgage Alert (CMA), a newsletter covering real estate finance and securitization. Shortly after that, Vornado Really Trust, a New York-based REIT, is expected to follow with its own new issuance with TALF assistance, according to an earlier issue of CMA.



"The popular view is that there is $4 [billion] to $6 billion in the [new CMBS] pipeline," says Jeffrey DeBoer, president and chief executive officer of the Real Estate Round-table, Washington, D.C. "Whether or not they come to the market remains to be seen."

"I have a high level of confidence that these transactions will come together," says Michael Berman, CMB, chief executive officer and president of CWCapital, Needham, Massachusetts, and chairman-elect of the Mortgage Bankers Association (MBA).

"But the TALF is a new program, and anytime you have a new program, especially if government is involved, it is more difficult to put deals together," says Berman. Plus, the fact that these TALF deals involve a public-private partnership adds more complexity, he says.

At some point, says Darrell Wheeler, head of securitized products strategy at Citigroup Inc., New York, "If there start to be long-term, stable spreads [in CMBS bonds], banks will start to do new mortgage originations without government help." That probably won't happen until early 2010, he says. "The immediate benefit of the TALF will be [to facilitate origination] of new single-issuer CMBS transactions," he says. "Multi-borrower pools will lake longer to develop."

"CMBS transactions backed by a single loan and secured by a single large property or a pool of properties, were common before 9/11," says Pat Quinn, co-chair of the capital markets department of Cadwalader, Wickersham & Taft LLP, a law firm based in New York.

Once these first TALF deals are done, these transactions may encourage lenders to make loans to hold in their portfolios pending securitization, says Michael Gambro, also co-chair of Cadwalader's capital markets department.

Insurance companies in TALF's shadow

The TALF program's influence on commercial real estate finance today is widespread. One need look no further than the life insurance industry. In 2007 and 2008, according to Real Capital Analytics Inc. (RCA), New York, insurance companies stepped in to help bridge the gap in financing. During this period, their share of commercial real estate financing nearly doubled. But in 2009, their share has dropped markedly, according to RCA.

In fact, there was a spike in commercial real estate mortgage commitments in second-quarter 2009 up a whopping 76.9 percent from the previous quarter, when the industry had only $2.6 billion worth of commercial mortgage commitments. By contrast, there was $4.6 billion worth of commitments in second-quarter 2009, but that is a small amount compared with the nearly $11.7 billion in fourth-quarter 2007.

According to one anonymous insurance company executive, the life companies are doing a lot less commercial lending today than they had expected to do, for a number of reasons. First, there have been few commercial real estate transactions of late. Secondly, "the life companies are focused on high-quality assets and sponsors, and the good candidates for commercial mortgages have decided to go with the TALF," he says.

The good news for the life insurance industry, according to RCA, is that of the $140 billion of troubled properties RCA has tracked in the United States over the last couple of years--a rolling total--insurance companies had the lowest proportion of troubled loans of all the lender groups. This is partially because they had the lowest proportion of loans of all lender groups and they have high lending standards, says Dan Fasulo, managing director of research at RCA. According to RCA, over the past five years, insurance companies are represented in just less than 10 percent of acquisition loans for commercial real estate.

Delinquency rate still high

While the TALF may be stimulating the CMBS market to some degree, the delinquency rate for loans in U.S. CMBS conduit and fusion securitizations had reached 3.64 percent as of the end of September 2009--an increase of 41 basis points over the month before and 342 basis points higher than the low seen in July 2004, according to Moody's Investors Service, New York.

The typical conduit CMBS deal is comprised of a diverse pool of loans with relatively high leverage and average loan sizes. Fusion deals, by contrast, start with loans typical to a conduit transaction and then add loans with larger amounts and lower leverage.

A few hopeful signs

In spite of the high delinquency rates noted here, New York-based Goldman Sachs started a new program to originate fixed-rate commercial mortgages of $25 million or more in late summer, one of several firms to initiate new mortgage origination programs in the third quarter, and a positive sign for the market.

Although Goldman Sachs' new program was initially designed for the sale or syndication of five-year mortgages in the whole loan market, "The loans are eligible for securitization, and that is one of the exit strategies we will consider," says Michael DuVally, vice president of media relations for Goldman Sachs. He declined to say if the company would try to make use of the TALF program.

Another sign that the CMBS market is at least beginning to heal was evident in late summer, when a number of financial service companies announced plans to hire new staff to work in their commercial real estate departments. Cantor Fitzgerald, a New York-based financial services provider, has plans to hire 130 people for the company's commercial real estate department, according to CMA's Sept. 18, 2009, issue.

TALF not a panacea

The TALF program will not have a big effect on the CMBS market, says RCA's Fasulo, even though some investors will take advantage of it.

Still, says Fasulo, the commercial real estate market is at the bottom, so the only direction left for it to go is up. "It is an easy bet that significant activity will pick up by the end of the year, because there is going to be pent-up demand from sellers and buyers [of CMBS collateral]. People who own buildings die every once in a while. We haven't even seen those kinds of transactions recently," he says.

"Investors are driving down yields for existing CMBS, so at some point it will be just as attractive for them to buy new CMBS as existing ones," says Fasulo. For now, though, he says that a lender with $100 million to lend is best advised to buy existing CMBS debt that will bring an approximately 10 percent yield, rather than make new loans with yields of only about 7 percent.

Meanwhile, more lenders are making loans for refinancing and even acquisitions today, although at this point the deals are small because the debt is mostly coming from local and regional bankers, says Fasulo.

"I think everybody is hopeful that the TALF and PPIP [Public-Private Investment Program] programs will help investors get the CMBS market started," says Nick Levidy, managing director for the commercial real estate finance group at Moody's Investors Service. The PPIP is sponsored by the Department of the Treasury and is similar to TALF, but has different criteria for bonds it accepts and targets only legacy CMBS, not new issuance.

"At this point, the new TALF deals that have been submitted to us for rating have been single-borrower transactions sponsored by REITs. REIT deals tend to have lower leverage, which makes them more likely to be rated AAA," he says. "A typical conduit transaction has loans with higher leverage, so not as much of the deal will qualify for the TALF" program, says Levidy.

Before the crisis hit, the largest share of commercial mortgage-backed securities originations involved conduits, says Levidy. At this point, there are virtually no conduits being contemplated without TALF help, he says.

But there is still hope, as the markets continue to heal and pricing on the bond side tightens, that a blended rate that flows through to the conduit borrower will become competitive.

The good news, says Levidy, "is that bond spreads have tightened from the historic wides of earlier in the year--especially for super-senior AAA bonds--in part because of the TALF."

The bankers, borrowers and the Federal Reserve all want to see the CMBS market come back to life, says Levidy. The CMBS market accounts for about one-quarter of commercial real estate debt, which was loaned over the last to years, he says. "Commercial real estate debt held by banks will need to be refinanced over the next several years, and could become an even bigger charge against bank balance sheets without a robust CMBS market," says Levidy.

The TALF funding, which will be in place for five years, will not accept just any kind of bond, says Bose George, senior vice president of research at Keefe, Bruyette & Woods Inc., a financial research firm based in New York. Everything TALF has accepted so far has been super-senior AAA debt, of which there are several levels, he says.

Plus, there are a lot of other rules and restric tions that limit the amount of assets that qualify for the program, says David Loeb, senior research analyst and managing director with Robert W. Baird & Co., Milwaukee. TALF, which was originally designed to help new issuance, will take care of only a single-digit percentage of the problem of massive numbers of maturities coming due for CMBS collateral, he says.

"You've got this tsunami coming toward the coast, with a little seawall, so the water will wash over the beach," predicts Loeb.

"This will be the news for the next five years," says Loeb. "There are a few buyers out there, circling. But there are way more assets available for sale than buyers, and all are looking for blood. They are looking for today's prices, not yesterday's, and worry that tomorrow's prices will be lower. While people will realize their losses over the next few years, those assets have to find a home."

In his July 9, 2009, testimony before Congress' Joint Economic Committee, the Real Estate Roundtable's DeBoer said an estimated $300 billion to $500 billion in commercial real estate loans are coming due this year to be followed by, on average, $400 billion in maturing loans each year for the next decade.

REITs get into the act

Fourteen mortgage REITs filed initial public offerings (IPOs) with the Securities and Exchange Commission (SEC) last spring and summer, according to the Sept. 25, 2009, issue of Commercial Mortgage Alert, in an effort to raise money to buy up distressed commercial real estate debt. But only one REIT, which is sponsored by Greenwich, Connecticut-based Starwood Capital Group, met with great success, raising $810 million in its August IPO--far more than its proposed S500 million.

People know the track record of the principals involved in this REIT, which is one reason it was so successful, says George.

But several other REITs were a lot less successful in raising capital. For example, Apollo Commercial Real Estate Finance Inc., a New York-based REIT, halved the size of its public offering, as did Colony Financial Inc., a Los Angeles-based REIT, due to weak response from investors.

At least one other REIT pulled its proposed $500 million IPO from the market after its sponsor reportedly was discouraged by the lack of success of several other mortgage REIT IPOs.

This is an unfortunate situation for the REITs, says George, because they have limited alternatives to IPOs given the fact that they are no longer able to access funds through the repurchase market, where banks and other firms lend securities in exchange for short-term cash.

Furthermore, says George, "An argument could be made that the REITs are having a hard time because the bond market is too successful." The recovery in the bond market has been strong, partly because of TALF, he says, but even on the residential side, without TALF, residential mortgage-backed securities (RMBS) have done well, says George.

Mortgage REIT IPOs, as a whole, are not doing well, says George, because of the presence of the TALF and PPIP programs. Thanks partially to these programs, the prices for CMBS AAA debt have soared in recent months before the REITs were able to raise capital, he says. Also, with the rise in AAA CMBS bond prices, the unlevered return on equity will be lower for the mortgage REITs than when prices for AAA CMBS were lower, according to George.

Bond price rally

These bond prices are reflected in New York-based Markit's CMBX indexes, which contain credit default swaps on 25 U.S. CMBS bonds. CMBX.NA.AAA4 is one of those indexes that reference bonds issued in 2007. The index was priced at about 56 percent of par at its low point last year, which was Nov. 20, 2008, compared with a price of 80 percent of par on Oct. 13, 2009.

These price escalations are ironic, because in July 2009, Standard & Poor's (S&P), New York, downgraded certain classes of bonds. After that, CMBS securities originated from 2005 to the present, became hard to use, so bond buyers began to favor the older, pre-2005 CMBS bonds, which have a better chance of being accepted by the TALF program and less of a chance of being downgraded by the rating agencies, says George.

The TALF and PPIP programs won't accept downgraded AAA bonds, says George, and the government doesn't have to give investors a reason for not accepting certain debt. For an investor to buy mezzanine debt now would be risky, because a lot of those bonds are being downgraded.

The market at the end of 2008 priced AAA CMBS bonds as if there would be another Great Depression, says George, but since that didn't happen, prices for these bonds have moved up since the end of last year. But that doesn't mean that 2007 bonds will be accepted by TALF, especially given the recent downgrades, says George. Nonetheless, they still have value.

IRS to the rescue

Meanwhile, in early September, the beleaguered CMBS market became the beneficiary of a change in IRS rules allowing more flexibility in modifying commercial mortgages. The most important part of the change is that borrowers will be able to contact their servicers before default is imminent. Before the rule change, REMICs would lose their tax-free status if discussions of modification took place before default was imminent.

While the ruling does allow for more flexibility, "It does not modify contractual CMBS limitations on workouts, so a special servicer must still determine if the modification is in line with servicing standards and if it is good for senior and junior bondholders," says Cadwalader, Wickersham & Taft's Quinn. "The servicers tend to view securitized loans as whole loans, rather than loans divided up into tranches," he says.

These changes won't result in many modifications that wouldn't be made under the old rules, says Quinn, but the servicers can deal with problem loans earlier than in the past, he says. Before the IRS ruling, according to Quinn, there was a sense that even initial conversations between borrowers and servicers were premature if default was not imminent.

There are two points of view about modification, says Quinn. The senior bondholders want to get repaid sooner rather than later, whereas junior bondholders are concerned about foreclosure, because when the lender takes over a property, junior bondholders are first in line to suffer losses, unlike senior bondholders, he says.

Some servicers may be overrun by inquiries from borrowers, says John B. Levy, president of John B. Levy & Co., a real estate banking firm based in Richmond, Virginia. "Many special servicers may not have enough staff" to handle the deluge, he says. Also, the more loan extensions there are, the more risk, adds Levy.

When all is said and done, says Quinn, modifications must make economic sense. If the value of the property cannot support the debt, the special servicer has to decide if a loan extension will cause the value to increase. Just extending the maturity date may not be enough, says Quinn. The lender might require some amortization of the loan or ask for more reserves to enhance credit quality when an extension is granted. This kind of request would work with properties sponsored by bigger, better-capitalized companies.

Securitization likely to survive and change

Because of all the turmoil in the commercial mortgage securities markets, "Some people are suggesting that securitization is dead," says Levidy. "But it is not dead. When the CMBS market comes back, it will be a smaller and different market with less complexity. That is how it started more than 10 years ago. No one is predicting we will be back to 2007 numbers," he says.

CMBS will survive, says Levidy, because the need for debt is too big for insurance companies to fill. "We still need CMBS executions" he says.

The CMBS market for new issuance is dead, but it will come back to life slowly, says Berman. "If you look at CMBS originations in the early 1990s, we saw homogenous pools, starting with multifamily deals"--much like the single-borrower deals being put together with the help of the TALF today, he says. In contrast, in 2006 and 2007, deals could have properties from all commercial real estate sectors, says Berman.

In the new world of CMBS after the TALF, says Berman, at least in the beginning, one likely scenario will include investor clubs that will invest in CMBS bonds. These groups will pre-commit to the pricing and credit quality of the bonds they want to invest in, before the loans are made, he says. They will also commit to the part of the capital stack they want. These deals will start with lower leverage and tighter credit standards than were seen in 2006 and 2007, says Berman.

When the CMBS market does come back to life in the next few years, normalized volume will be in the $75 billion to S100 billion per year range, Berman expects. Part of the reason the market grew to $200 billion per year in the past is the different kinds of leverage that were allowed, he says. But with a more conservative market, the total dollar volume of CMBS originations won't be that large, says Berman.

Berman thinks there may be a few new CMBS originations without the TALF in 2010. But the first step toward achieving that goal is to have a stabilized economy, he says. In the second half of 2010 and into 2011, the CMBS market may restart in earnest, he believes.

In the near term, however, the TALF is the main catalyst for the CMBS market. "Usually it takes a long time to originate commercial mortgages and structure them," says Stav Gaon, CMBS analyst at Citigroup. The fact that the TALF program will soon expire could be a problem and could limit the risk that originators will accept, because until they sell off their loans, they have origination risk, he says. Unless market conditions improve significantly, the Federal Reserve and the Treasury Department, which have authority over the TALF, will probably need to extend the program, he says.

The Federal Reserve did say it would consider conditions in the market when TALF is about to expire and may consider extending it, says Gaon. There will probably be a compromise between market needs and what the Federal Reserve wants to provide, he says. "I don't think that it is necessarily the end of the story for the TALF program" when the currently scheduled expiration date arrives, says Gaon.


Hortense Leon is a freelance writer based in Miami. She can be reached at
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Title Annotation:Commercial / Multifamily; commercial mortgage-backed securities; Federal Reserve Board. Term Asset-Backed Securities Loan Facility
Comment:Slow thaw for CMBS: there are small signs that the commercial mortgage-backed securities market is beginning to come back.
Author:Leon, Hortense
Publication:Mortgage Banking
Geographic Code:1USA
Date:Nov 1, 2009
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