GSP’s principals have spoken to the heads of several Wall Street real estate lending divisions, bond traders, life company senior directors, commercial bank credit officers, sales brokers and investors. We devote this week’s FINfacts to a discussion of the current turmoil in the debt markets.
Few would have predicted that credit problems in domestic subprime residential mortgages could spread like a contagion throughout the global capital markets. But spread they did and the results are not pretty. Bond investors have gone on strike. The resulting lack of demand has sent bond spreads soaring. Even worse, CMBS lenders cannot determine their cost of capital. As a consequence, uncertainty looms in the market.
How did we get here?
During 2005 and 2006, both residential and commercial loan underwriting standards weakened substantially because of fierce competition amongst lenders. Aggressive residential loan terms included: under qualified borrowers, high leverage, minimal documentation and low teaser rates with subsequent resets at higher rates. In the commercial market, fixed rate lenders competed for loans by offering interest only notes, minimal impounds and reserves and aggressive underwriting.
Most residential and commercial fixed rate loans are pooled, tranched into bonds with different priorities, rated and ultimately sold to bond investors. The securitization markets for all types of real estate loans were extremely liquid, with heavy demand from bond investors and rapid turnover as lenders repeatedly cleared their balance sheets and continued lending.
The first market disruption occurred in February 2007 as subprime residential mortgage delinquencies spiked as reset provisions kicked in while home values leveled off or declined, putting borrowers under water. This caused panic in the residential mortgage bond markets as bondholders began to take losses on investment grade bonds. Shortly thereafter, a large aggressively underwritten CMBS pool went to market. The pool’s 10 largest loans had an average in place DCR of 0.65. In an unprecedented move, prospective buyers of the most highly rated AAA bonds kicked out of the pool several of the most aggressively underwritten loans. Investors became nervous that the losses suffered in the subprime market would spread to commercial real estate despite good market fundamentals. Bond buyers insisted on higher bond spreads to compensate them for the increased perceived risk. Spreads widened from approximately Treasuries+85 bps (85 bps = 0.85%) to Treasuries+120 bps (1.20%) in short order resulting in significant losses for lenders.
To make matters worse, many of the first loss “B piece” buyers suffered a liquidity crunch as increased spreads made it more difficult to securitize their investments. Without the ability to securitize their investments, the B piece buyers lacked liquidity to buy new issuances. The reduction in the number of B piece buyers threatened to stall the issuance of subsequent CMBS pools. Those B piece buyers that remained in the market could essentially name their terms. B piece buyers flexed their muscles by kicking out the most aggressively underwritten loans. Lenders had to immediately tighten their credit standards for fear that future loans would be kicked out. Interest only loans, for instance, began to disappear from the market. In a classic case of closing the barn door after the horse had left, the rating agencies announced new subordination levels to reflect the formerly aggressive underwriting practices.
During late July, certain bond buyers, particularly hedge funds seeking to flip bonds, left the market place at the same time that several large multi-billion dollar CMBS pools came to market. Other bond investors moved to the sidelines because of fears that spreads would continue to widen. Several hedge funds that had invested heavily in subprime mortgages announced substantial losses and stopped investor withdrawals. Demand for bonds languished and lenders found themselves holding large portfolios of unsold bonds. Spreads for the safest AAA bonds widened from Swaps+44 bps to Swaps+68 bps in one week. And this was after AAA spreads had widened from swaps+26 bps earlier in the year. When a French bank stopped redemptions on one of its investment pools holding subprime paper, European banks stopped making short term loans to each other. After months of rock solid stability, LIBOR soared. The European Central Bank had to pump $130 billion into the European banking system to restore confidence. In the meantime, the Fed pumped $26 billion into the United States banking system and began buying prime residential mortgages. Rising spreads caused some insurance companies to begin selectively buying bonds. The higher spreads made these bonds look like bargains in comparison to those sold earlier in the year. But investors typically have to mark their bonds to market on a monthly basis. Many investors sat on the sidelines fearing that rising spreads would require them to post mark to market losses. Investors waited for stability to return to the marketplace. But by sitting on the sidelines, investors contributed to the instability.
Where are we at today?
CMBS: Lenders cannot sell bonds in CMBS pools and therefore have no way of calculating their cost of capital. Three weeks ago, many lenders refused to quote prices for fixed (or floating) rate loans. Today, most fixed rate lenders are quoting but will provide indicative prices only. The actual price is set at rate lock of closing leaving the borrower at risk for wider spreads.
Typical indicative CMBS pricing today is T+200, proceeds based on 1.20 DCR with 30 year amortization and maximum leverage of 80%. Interest only notes are scarce although some lenders are underwriting 35 year amortization. In addition, lenders will insist upon tighter loan covenants.
Life Companies: Life companies have increased their purchases of CMBS bonds now that the wider spreads make them an attractive alternative to whole loans. Although life companies continue to originate loans, they have become more cautious. Life companies often originate with an eye towards securitization. Therefore most companies are underwriting new loans with lower leverage (65-70% LTV) and higher spreads in the Treasuries+175-185 range with 25-30 year amortization.
Floating Rate Bridge and Construction Lenders: Many finance companies had raised liquidity through a securitization method known as the collateralized debt obligation (CDO). CDOs allow lenders to finance their loans by issuing bonds against pools of mortgages in a manner similar to the CMBS market. The cost of funds for CDO lenders was as low as LIBOR+36 bps in late 2006/early 2007. But CDOs are now tainted because many subprime issuers financed their activities through CDOs. Liquidity in the CDO market has dried up making it difficult for some lenders to finance new mortgages. Those CDOs that do go to market suffer from lower leverage and higher spreads. While some CDO lenders have stopped lending altogether while they deal with their own liquidity problems, others are lending on a selective basis at higher spreads.
Commercial Banks: Commercial banks may be the biggest beneficiaries of the current market conditions. Most banks leave short to intermediate term loans on their own portfolios. As portfolio lenders, these banks do not have to mark their loans to market. As competition from CDOs weaken, banks have raised rates and tightened underwriting assuming that borrowers will pay for the certainty of execution. The larger banks have plenty of liquidity and should steal market share from their competitors. We would also expect some borrowers to opt for bridge financing as they wait out the CMBS market disruption. Spreads for non-recourse bridge transactions range from LIBOR+200-300 bps
Bottom Line: Capital is more expensive across the board. Fixed rate loans are being quoted and closed, but at higher spreads, tighter underwriting and stricter terms. Bridge and construction financing is relatively plentiful as balance sheet lenders take back market share. Expect upward pressure on cap rates as high leverage, cheap financing becomes scarce.
We at GSP have extensive market knowledge and relationships. We know which lenders are still in the market and which ones have closed up shop. We are here to consult with you regarding your capital needs.
