Worries over systemic risk in CMBS

By Aline van Duyn

Published: June 23 2009 03:00 | Last updated: June 23 2009 03:00

Even as conditions in many parts of the credit markets have improved, a big question mark hangs over one large part of the market that is still dysfunctional: the market for securities backed by commercial mortgages.

Behind the scenes, regulators are acutely aware that the commercial real estate market is one of the few potential remaining sources of systemic risk if the financing problems cannot be fixed.

William Dudley, president of the Federal Reserve Bank of New York, highlighted this earlier this month: "The revival of the commercial mortgage-backed security (CMBS) market is essential to stabilising the commercial real estate market.

"If the availability of funding for this market is not restored, the downturn in commercial real estate valuation and the losses for the holders of these assets will be greater," he added. "This will, in turn, likely further constrain credit availability. That's the vicious cycle we want to lean against."

The clock is ticking with some of the $3,400bn of loans made to property developers for anything from urban office tower blocks to shopping malls across the US due for payment.

At the moment, it is near-impossible for developers to refinance these maturing commercial mortgages though the commercial mortgage-backed securities (CMBS) sector, which makes up 25 per cent of the real estate financing sector.

Even properties that are not in distress - the ones where the value of the property is still larger than the financing behind it - are in danger of defaulting if this problem is not fixed.

The Federal Reserve is in charge of fixing this. It had planned to provide investors with funding to buy securities backed by commercial mortgages last week. In the event, the deals were not ready. They are supposed to kick off in July instead, and all eyes will be on whether the term asset-backed securities loan facility (Talf) - a $1,000bn credit facility aimed at easing the pain of a credit crunch - will deliver.

If the Fed cannot unblock the market for securities backed by commercial mortgages, there are concerns that another wave of losses could be unleashed on the fragile US banking system.

Analysts at Goldman Sachs warned as early as February 2008 that losses on commercial real estate debt could be on a par with those from subprime mortgages but the pain would be felt over a longer timeline. Goldman currently estimates losses of $234bn from US commercial real estate loans raised between 1995 and 2008.

Rating agencies are also warning about the bleak outlook for European loans. "Some of the largest loans in European CMBS are scheduled to mature in the next two to four years and it remains questionable as to whether markets will have improved enough by then to allow for orderly refinance," says Euan Gatfield, Senior Director, Fitch Ratings.

Although the CMBS sector faces a series of downgrades - bringing echoes of the subprime mortgage-backed securities - there are important differences.

First of all, only a quarter of commercial mortgages are securitised - the proportion was much higher for subprime mortgages. Also, there was not the same amount of derivatives and securities created linked to commercial mortgages.

The subprime mortgage collapse was so damaging because billions of dollars of securities were linked to their value through derivatives. The commercial mortgage issue is vital for US banks, which have much reduced capacity on their balance sheets, meaning they are not as able to roll over and refinance maturing loans. In addition, there are concerns about losses once properties that are not in a good state have to be refinanced.

In other words, there will be properties where the value is far less than the loan, and additional equity has to be found.

(EQUITY INFUSION)"At least two-thirds of the loans maturing between 2009 and 2018 ($410bn) are unlikely to qualify for refinancing at maturity without significant equity infusions from borrowers," says Richard Parkus, analyst at Deutsche Bank.

"Bank and life companies, which make up approximately 50 per cent and 10 per cent of the [$3,400bn commercial real estate] market, respectively, must also be considered," said Mr Parkus. "The same combination of deteriorating underwriting standards and excessive price inflation were operating in bank and life company lending [as in the CMBS market]."

The Fed's initial plans are aimed at funding new securities backed by new mortgage loans. The complication is that the decision to lend new commercial mortgages, unlike credit card or auto loan backed securities, is very closely linked to the interest rates available on existing CMBS. The collapse of the sector and the departure of numerous buyers of CMBS led to a huge increase in interest rates, and these remain high.

The Fed is also planning to provide investors, such as hedge funds, loans through the Talf to buy existing CMBS, but the plans are complicated by the fact that Standard & Poor's has said it may downgrade many recent CMBS from triple A. The current Fed plans specify that it will only finance CMBS with triple A ratings.

Although many market participants expect the Fed could tweak these rules, the growing risks in the sector highlight the political balance of wanting to offer finance to property developers and others and protecting taxpayers from losses which those developers and others would otherwise potentially incur.

Because the market for existing securities remains blighted, it complicates the creation of new mortgages. Within the real estate market it is believed that one or two deals are being readied for Talf financing. But because the exposure cannot be hedged so easily the Talf may only work when an entire deal is financed through it.

Against this backdrop, it is clear why Mr Dudley stressed recently the CMBS market was the biggest test of the Talf programme.

"The rollout of Talf to the CMBS market this summer will be important in determining the overall success of the programme," he said. It could also be important in determining whether those waiting for another shoe to drop - the commercial mortgage market - are right or not.

Additional reporting by Anousha Sakoui in London and Nicole Bullock in New York