We’ve discussed Commercial Mortgage-Backed Securities or CMBS in a number of posts. So, it’s worth mentioning that spreads on AAA CMBX (CDS) increased substantially on Tuesday. At about 550 basis points, those spreads seem to be twice as high as the previous all-time high, which was reached in the late winter of this year, and are seven or eight times higher than on January 1.
It’s much harder to say where spreads on CMBS (bonds) are since they tend not to trade. Historically, they didn’t trade much, and now it is even less frequent. In fact, in June, we had a long post, On Nedges and Sledges and Paving the Road to Hell, on the difficulties of using CMBX to hedge exposure to CMBS. As that post mentioned, the now-defunct Lehman Brothers was one of the firms having difficulty with things that were Somewhat Like Hedges.
If the reader is unsure of the notion of CMBS, know that CMBS is very much like any other mortgage-backed security, except: (1) the number of loans in the collateral pool is smaller; (2) the dollar value per loan is substantially greater (into the hundreds of millions of dollar); (3) the borrowers tend to be much more sophisticated and have better legal representation; and (4) in our opinion, there is more systematic risk, which mean less diversification and higher levels of default during economic downturns.
Like almost everyone else, we’re not sure how the loss given defaults would differ residential mortgages, but we doubt that it would be favorable for commercial real estate. (By the way, readers looking for an illustration of basic MBS should see the last part of Gossamery Arguments for Transparency and Our Reply, in which we describe it in the simple terms of a spreadsheet.)
We ask: what are the odds that the housing market could crash in many parts of the country, residential mortgages defaults would rise, the economy would seemingly slow down, unemployment would increase, and the stock market would decrease substantially AND commercial real estate would not suffer? Yeah, when stated precisely, it seems like a silly question doesn’t it.
So, with CMBS, we’d guess that the really bad times are just beginning.
In fact, we’d speculate that proportionally–given the different sizes of the markets–the bad times may be substantially worse for commercial mortgages than for residential mortgages.
For example, in CMBS Market Begins to Show Fissures, two writers for The Wall Street Journal, describe two large –$209 million and $125 million–and recent (December, 2007 and July, 2007, respectively) mortgages that are close to default and mention that news was the impetus for spreads to increase on Tuesday.
Of course, we wouldn’t be a pedant if we didn’t mention that several of the factors mentioned above were starting to be present in July, 2007, and were certainly evident by December, 2007, when those two loans were made.
In that respect, and given the ongoing collapse of the CMBS new issues market, we wonder how many other bad commercial real-estate loans currently sit in banks’ conduits. As we understand it, the market for new issues has been dead for quite awhile; so, many pipelines likely contain similarly-aged mortgages (that never went into CMBS pools) and now sit in the nether world of loans available for sale (although no one wants to buy them). (Kind of like purgatory, but without hope of heaven. In this case, inside the gates of hell.)
If J.P. Morgan, the originator of those two loans, or other large players made similar loans in expectation of continued good times or a quick rebound, then one should expect larger loan-loss reserves within the next six months or so.
In fact, (1) ithout prior large and public defaults and (2) given the magnitude of losses that many banks have incurred in their other portfolios and (3) given the illiquid nature of the commercial mortgage market that leads to a lack of “marks,” it seems highly unlikely that banks have already aggressively written-down the value of their CMBS or their inventory of commercial mortgage loans.
In that case, one could infer that they–the banks (and their conduits)–were betting that markets would return to normal. Unfortunately, if that was the bet, and if the above-mentioned defaults are followed by others so spread levels stay high, then those banks will be forced to recognize additional losses at the end the fourth quarter and into next year.
We’d hate to be sitting on a large pile of recent, unsecuritized, commercial mortgages. It’s likely that they’re composting. While that might improve the prospect of growth in the future, it probably stinks now.
While I agree that the mark against such loans held/available for sale will likely worsen, that actually shouldn’t effect loan loss reserves unless the institutions have to move them to the held to maturity book. The write-downs would flow through trading or OCI, not the provision line. That’s the left pocket right pocket world that the accountants have created.