ABCP-land is not the only market where arbitrage conduits face a tricky short-term future. CMBS conduits which have been the engine behind the spectacular growth in this asset class in both Europe and the US are also now facing the prospect of a market where the numbers no longer add up.
CMBS conduit programmes pool real estate loans and refinance them in the securitization market exploiting the spread arbitrage between the two. But with triple-A CMBS spreads in Europe having blown out from around 20 basis points over Libor to 65bp over during the summer (and factoring in sterling Libor itself having gone from 6% on June 30 to 6.8% by Sept 14 euro Libor went from 4.17% to 4.72% over the same period), the cheap funding on which the arbitrage relies has long gone. "For [recently written] loans originated at very low margins, a CMBS exit in the current environment would crystallize a very material loss," notes Ronan Fox, managing director at Standard & Poors.
CMBS conduit businesses have proved highly profitable in recent years, and many banks have rushed to pile into the market, driving margins on the underlying loans themselves to historical lows. Many banks are therefore now sitting on large real estate loan books, with their exit options dwindling. Ramping up a conduit deal tends to take about six months, and the first half of 2007 was characterized by healthy lending volumes. Hans Vrensen, head of European securitization research at Barclays Capital in London, reckons that there were between 20 billion and 30 billion of structured and rated CMBS deals ready to go in mid-September, but still sitting on the banks books.
Opinions vary as to how big the various banks exposure will be, and how big a concern the logjam will become. In the US, where CMBS lending accounts for between 40% and 50% of the real estate lending market, banks are likely to be well hedged, as a liquid index in the form of the CMBX has been in existence since early 2006. (Before this, loan books were hedged using interest rate swaps or TRS on CMBS.) Holding on to real estate loans until the market recovers will therefore be a less painful option. In Europe, however, no such index exists, despite numerous efforts to launch one. (An E-CMBX index was due to be launched in the third quarter this year but has now been postponed.) This means that holding on to loans could pose more of a problem in Europe. "In the US every dollar of lending will be hedged," says a banker at a US house. "In Europe there has been less hedging as there is no liquid index, but this means that banks have been reasonably good at keeping a trim balance sheet." However, anecdotal evidence suggests that many of the banks that have been very active in CMBS could be sitting on big positions. Rumour has it that one continental European bank alone is now sitting on 8 billion of real estate loans.
European CMBS spreads
Source: Markit, DBIQ
So what can they do? Option one is to attempt a deal very unlikely in the current market. "Banks in the arbitrage conduit market are pretty much closed for business right now," observes Caroline Philips, head of securitization at Eurohypo. "People will either sit tight or they could print the bond issue and sit on the bonds." One deal did emerge in September, a 1.5 billion trade from Lehmans Windermere conduit, backed by the Coeur Défense towers in Pariss business district. The G and H tranches of the deal were pre-placed and Lehman decided to retain the remainder due to market conditions.
Fox at S&P doubts that the benefit gained by issuing and retaining transactions would be worth the time and expense involved. "There could be a benefit to holding rated bonds rather than the assets under some regulations but it would be marginal," he reckons.
An alternative would be the syndicated loans market. In Europe, CMBS accounts for only 10% to 20% of the commercial real estate lending markets so many banks still have sizeable syndicated loans teams in this area. "The syndication market does make sense for current inventory," says Peter Hansell, managing director at Lehman Brothers, "we are aware of commercial lenders who are looking at this." But again, this might not be an obvious solution. "The syndication market is very difficult for these loans," warns one expert. "Taking on real estate exposure at the moment is very difficult to justify. And for anyone pricing off three-month Libor it does not make a lot of sense."
Sit it out
There is not, therefore, an obvious solution for conduit lenders that need to shift their logjam of loans. But the prospect of cut-price real estate loans being dumped into the market seems fairly remote partly because of decent hedging and partly because of optimism that the market will return. "I suspect that banks will sit it out and manage their overall balance sheet appropriately," says Fox. "Enthusiasm to sell these loans at a loss is low." But one large European lender confirms that it has been offered whole real estate loans at around 90 to 95, so some lenders might already be feeling the strain of postponed deals. And even when the market does return, it will be very different. "SIVs make up a large part of the investor base for triple-A European CMBS," warns Philips at Eurohypo. "The triple-A market will come back, but it will be a while before it does."