CMBS debate: Participants
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Executive summary
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Market reaction to the US will be contained – but spread widening, particularly at the bottom of the capital structure, will persist
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Levels of debt in the real estate market are not sustainable in the long term and some of the valuations that underlie CMBS transactions lack support
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Volume predictions for CRE CDOs in Europe were overplayed
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The ability to short the market will lead to volatility and contribute to spread widening. But property derivatives can be an imperfect portfolio hedging tool
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New jurisdictions will begin to bear fruit |
RF, Standard & Poor’s Clearly the topic of the moment is sub-prime. We’ve seen US sub-prime take its toll on both US CMBS and US CRE CDOs, with very substantial spread-widening in the second quarter. We’re seeing triple-B spreads backing up above 100 basis points. What is the outlook for spreads for a European structured deal in CMBS?
JD Spreads will widen. They came in too far from where they should be from a natural risk perspective. CMBS spreads should be wider than RMBS spreads because there’s less granularity in the portfolios. At the moment they are wide of where prime RMBS is generally in Europe but they’re now within sub-prime RMBS levels in the UK. Property derivatives and the CMBS index will also lead spreads wider. Spread widening in UK sub-prime has been led by synthetic products, primarily hedge funds shorting CDS against sub-prime, which has pulled out spreads in the cash market. The same will happen in CMBS.
SG, LNR Partners There will be some spread widening due to repricing of risk in the market. It will differ somewhat in the triple-A and double-A segment, which has a different investor base from sub-investment-grade bonds, and it depends on your view. Are you looking at spreads relative to another asset class, such as MBS or other ABS products? Or are you looking at it from a pure, fundamental perspective – relative to equity returns for example? I expect to see spread widening in subordinate notes and below-investment-grade CMBS.
JH, Fortress European CMBS spreads have to widen, and particularly at the triple-B level, for all of the reasons given, but not too far. There is a lot of real-money-funded capacity out there to buy and the arbitrage works, for instance, for CDOs pretty well at 150 to 175 basis points over on triple-B minuses and pretty well at 100bp to 125bp on triple-B flats. Most of those people are sitting on long cash at the moment. That helps support. However, you’ll see much more differentiation at the bottom of the capital structure from deal to deal.
GP, European Credit Management I agree with John and James but I think the development of the derivatives market will increase spread volatility. That’s what we’re worried about.
JD The ability to go short will be there, which means that there will be pressure on the other side of the equation. That will lead to increased volatility and it should lead to spread widening.
RF, Standard & Poor’s Some people have commented that US sub-prime is an example of capital markets throwing money at originators who in turn made inappropriate loans at non-risk adjusted margins. Is there a danger that we’ll see the same in CMBS?
JD The real issue is whether issuer tiering increases as you go along. If it does, there’s a prompt disincentive for banks to make bad loans. And while that disincentive persists, it should act to restrict the volume of inappropriate loans in the market. There has been very little tiering over the last couple of years, and there have been a lot of high loan to value (LTV) loans made as a result that were borderline credits. The recent dispersion of spreads on new issue triple B, triple B minus has been something like 85bp to 225bp across all of the issuance. We’ve not seen that level of tiering for a number of years.
JH, Fortress Many CMBS investors have other options in deploying their money. CMBS as a proportion of the structured finance market in Europe is not as predominant as sub-prime. It is much easier for dedicated structured finance investors to express a dislike of underwriting standards in CMBS by stepping back. One of the problems in US sub-prime was that it’s hard to step back from 90% of the floating-rate market.
RP, Morgan Stanley Most investors in CMBS have the chance to get comfortable with the underlying levels that the originators have used. If someone thinks that a loan is too aggressive from an LTV perspective or a low issuer credit rating (ICR) perspective, they can pass on it.
DN, Natixis I don’t think Europe has got to the level of aggressive underwriting that was prevalent in the US CMBS market, which caused some push-back, both in terms of loans being rejected from CMBS issuances as well as spreads widening. We might see the reaction to what’s happened in the US catching us a bit earlier in Europe, and therefore we won’t see as much volatility and spread widening.
JH, Fortress What has bothered investors is less underwriting standards and more a dirtying of CMBS pools from very transparent, visible, quite simple to underwrite loans, to loans backed by specialist asset classes or with very high leverage with a high degree of lease turnover risk, or to unknown sponsors. Those deals get pushed back more than others because they are harder work.
JD There are few deals where every loan is great or where every loan is bad. It’s very much the case that every single deal has one or two loans within it that you don’t like, and you have to form a view. If one or two of those lower-quality loans do default, maybe it starts becoming too expensive to the cost of the deal as a whole to include them.