Spero Consulting

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.

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