2008 was a rough year. The housing bubble burst, the credit market collapsed, gas prices topped $4 per gallon and a beleaguered president finished his second term of hard fought, but hardly won battles. Not least among the list of deflated personas was the securitized products market. Mortgage Backed Securities, in particular, took the lion’s share of the blame for the systemic economic collapse, and in subsequent years became a four letter word that few were eager to revisit. But in recent years, much of what went wrong in ‘08 has begun to return with renewed strength. Housing prices have surged past pre-2008 levels, gas prices remain in the $3 range, and even the securitized market is reestablishing its mainstream acceptance. With securitizations coming back online after such a devastating fall, there are sure to be some changes in the name of creating safer markets. To understand what is different this time around, and what it means for those of us who access this market, it’s helpful to see the narrative as a whole, starting with a look back on market conditions leading up to the collapse in 2008.
At the time, there was a desire to invest; money was cheap, interest rates were low and an international confidence abounded that money would grow more money. At the same time, there was a willingness and desire to lend. The synergy of this relationship exerted so much pressure to keep money flowing that borrowers could demand unprecedentedly favorable terms. Lenders would compete against each other over the amount of leverage they would allow borrowers to use, and the skin left in the game was at times little more than a hangnail.
The ratcheting up of lending and borrowing pulled ratings agencies into the mix. Securitizations issuers demanded ratings in increasingly higher volume, all the while demanding faster and faster turnaround. Issuers would play ratings agencies off each other to drive down turnaround time and drive up the percentage of AAA ratings their securitizations brought home. As a result, objectivity on the part of rating’s agencies eroded, ratings inflated to new highs, and the push to rate anything and everything gained critical mass.
In a lawsuit following the eventual fall-out from the economic collapse, one rating agency insider was quoted as saying, “It could be structured by cows and we would rate it.” A common joke in the finance community at the time went like this; “Uh-oh, golf courses have made it into securitizations, watch out.” Joking aside, much of the real estate finding its way into securitizations was far from fungible, a symptom of overlooking the incredible correlation in the real estate marketplace. Low default rates in the range of 5% lent a sense of security to wrapping lower-rated tranches of Mortgage Backed Securities into higher-rated Collateralized Debt Obligations, since to the level of default required before obligations at the CDO level could no longer be met was much greater than the current default rate. But the near perfect correlation in commercial real estate meant that if one multi-family housing unit went bad, a whole portfolio of multi-family units went bad with it, and so on for offices, retail space and the like. What followed was swift, systemic collapse that left investors gaping and deflated. The firmly-held belief that property values could not drop was shattered. All but the highest tranches of MBSs stopped receiving payments, and many people said things would never recover.
But the market for securitized products is proving rather resilient. In 2011, spreads were wide; AAA securities were 300 bps over swap rates and investors saw the market stabilizing. CMBS issuance jumped from 3 billion in 2009, to over 30 billion in 2011, with the trend continuing to push past the 80 billion mark last year. In tandem with the spike in issuance, the number of conduit lenders making CMBS loans has risen dramatically, but this renewed confidence is paired with heightened caution.
The upside to pushing financial safeguards past their breaking point is that the aftermath often lays the groundwork for safer, more robust markets going forward. Much of the paring back of the unsound practices that contributed to the collapse are self-enforced. For example, the ratings of loans underlying CMBS are far better at factoring in risk, something that agency models had let slip. Before the crash, it was common for such loans to carry a loan to value in the 70 to 80 percent range. This was due, in large part, to the practice of pro forma, where lenders made loans based on future projections of the net operating income of the property. Now we are seeing LTVs in the 50 to 60 percent range as pro forma gives way to historical NOI.
Other safeguards are mandated. One such area is risk-retention, or “skin in the game,” where securitizers are required to retain a portion of their securitization so that they are not immune or indifferent to poor performance. Section 15G of the Dodd-Frank Act requires that securitizers retain 5% of credit risk, taken either from the equity tranche, or split with a B-piece buyer who would take 2.5% of the equity tranche while the issuer would retain a 2.5% vertical slice of all tranches. This portion must be held through to the maturity of the securitization. A recent revision proposal to the risk retention rule offers flexibility over how the 5% retention is divided and how long it must be held. What shape the rule will eventually take is still up in the air, but in one form or another, expect to see it come into effect sometime in the next two years.
Safer markets are good news for investors and securitizers alike. They can also spell good news for borrowers, as debt sourced from conduit lenders can offer enticing prospects. As a borrower, CMBS loans should be considered carefully. On the one hand, the CMBS loan market is incredibly versatile, offering loans as small as a few million dollars and as large as half a billion. But this flexibility comes with a price. When considering debt sourcing, it is important to think about prepayment in the event you want to sell the underlying asset. Defeasance requirements carried by CMBS loans are the most punitive way to repay debt. By contrast, a prepayment penalty on a traditional floating rate loan is generally far less exacting. Chatham has defeasance and debt management services that can help you think through the important considerations when sourcing and managing debt. As the world of securitized products continues to gain traction and build speed, don’t hesitate to call Chatham for market insight and strategy development.
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