Unsinkable, Titanic II

If you haven’t yet heard of Clive Palmer or his new project, then you’ll probably have to settle for being put on his waitlist. A successful Australian businessman, Clive publicly announced last week that he will recreate something as spectacular as it is foolhardy, but something that captures our imagination and will compel us to follow his project from questionable concept to physical reality. Invoking the name of the world’s greatest maritime disaster, Clive Palmer has set out to give the world the Titanic II – a ship that is faithful in outward design and appearance to the original, but brimming with modern safety features to keep this titanic ship afloat and its passengers safe.

Clive is already being called crazy by the media. He not only will tempt fate with the ship’s instantly recognizable stylings, infamous class separations, and period amenities, but the maiden voyage will also cover the same open sea from Southampton, England to New York that doomed its predecessor. More than a few people think it’s a bad idea. Undeterred, he has some numbers on his side: more than 40,000 people have lined up to book the second “maiden voyage” he is designing.

It is possible that Clive’s inspiration is last year’s 100th anniversary of the Titanic’s demise. But there are other explanations. One is the example of a market that underwent a spectacular sinking of its own – albeit more recently – the US and European markets for bonds secured against commercial real estate. We can imagine Clive watching intently for both inspiration and guidance as CMBS shows more and more signs of proving critics wrong and undergoing a second “maiden voyage.”

Underwater? Commercial Mortgage Backed Securities were a booming business before the Great Recession hit, with private label issuance reaching a lofty $230 billion in the US in 2007 and $79 billion in Europe in 2006 in the respective continental markets. But then, an unimaginable loss of confidence and risk appetite all but sank the CMBS marketplace, creating a cumulative default rate hole that touched nearly 14% in the US, where stakeholders had never experienced much more than 4% in previous storms. European default rates were lower but the effect was the same. The CMBS market sunk 95% in 2008, and hit rock bottom in 2009 with less than $3 billion in new private label issuance. Although European figures are lower as this newer market is recovering more slowly, CMBS is sailing full steam ahead with the goal of remaking the industry via better underwriting standards and credit enhancements. So what exactly is different from the last time? Whether a would-be passenger on the Titanic II, or an investor in new mortgage bonds, a careful review of the changes is warranted.

Safer below the waterline. When the Titanic suffered a horizontal gash across several compartments at once, the ship’s designer instantly knew the she would sink as water filled each compartment and spilled over into the next. The Titanic II could address this with a double hull design to resist flooding and allow more time for safe departure from a wounded vessel. So too, the CMBS market is bracing for a radical new design. Born of the credit crisis, securitization risk retention rules are expected to be finalized sometime in 2013, whereby issuance sponsors (with limited exception) would be required to hold 5% of the structure as a horizontal investment (a piece of one compartment), a vertical investment (a piece of multiple compartments), or a combination thereof under the so-called “skin in the game” rules from Section 941 of the Dodd Frank Act. B-Piece buyers would also be limited in their ability to transfer risk or sell their position over the life of the investment. Regulators are hoping substantial design overhauls like this will align investor incentives and make the securities safer and more reliable in the process. Many market participants are concerned that this could limit the ability of issuers to attract and involve B-piece buyers, who are vital to the market and without whom no “ships” could be built. With significant industry comment to consider, regulators have yet to issue a final rule nearly two years after the proposed rule came out, a sign that all market participants hope means that regulators are trying to get it right in balancing safety with market recovery.

Safer above the waterline. Clearly, technology has improved since the days of sending out young crewmen at night to look for white things floating in the ship’s path. Additional to immeasurably better sensing equipment, a modern crew would enjoy a huge network of other vessels with which it could communicate and thus improve its ability to avoid icebergs or other dangers before-the-fact. There are several analogies to the technology improvements for the next generation of CMBS; in fact, one concerns Chatham’s favorite subject, hedging. Pre-financial crisis, the credit ratings maintained by any hedge provider (i.e. swap or cap counterparty to the issuer eventually protecting the underlying borrower from interest rate risk on a floating-rate CMBS loan) were for the most part fairly strict in certain respects. However, subsequent to the Lehman Brothers example and liquidity concerns among many other financial institutions providing hedges to CMBS, there has been a tightening of standards by the major ratings agencies that go many steps further to protect bondholders. In particular, the amount of collateral that a hedge provider would have to post in the event of a downgrade past a certain trigger (and a failure to replace themselves with a suitably rated alternate hedge provider) is substantially greater than in the past.

Enough Room in the Lifeboats. The Titanic famously did not have enough capacity on all its lifeboats to accommodate all passengers and crew aboard. Titanic II will easily right this historical wrong, and will meet new safety standards for overcapacity. Similarly, the underlying commercial real estate loans that are packaged into new CMBS 2.0 securities have thus far demonstrated a more conservative underwriting standard today than in years past. While earlier loans may have required a debt service coverage ratio of as little as 1.25 and an 80% loan to value to be originated and packaged, the typical loan today may be in the 1.6 DSCR and 64% LTV range. This excess capacity in terms of underlying property cash flows and collateral value gives investors in new issuance more comfort than in years past, and should help these securities withstand future market turmoil that could otherwise sink several earlier vintage securities. Both Moodys and Fitch have expressed concern though that the prospect of too many originators chasing too few deals could drive these indicators back down to earlier underwriting ranges, but the current vintage loans have been brought to market under these conservative standards.

A Changed Environment. The North Atlantic route that the Titanic took on its fateful voyage put it in the path of numerous icebergs, with dire consequences. Today, the Titanic II would be able to sail the same route with less risk, in part due to global warming. There simply aren’t as many icebergs along the route, according to Clive Palmer’s own estimate. CMBS 2.0 has also experienced a changed environment. The CRE Finance Council (CREFC) issued market standards for new CMBS deals in March 2011, which distilled many of the hard-learned lessons from the credit crisis into a series of “best practice” approaches to CMBS. From the Principles Based Underwriting Framework, to the Model Representations and Warranties and Repurchase Mediation Language, the themes of greater transparency, higher quality lending standards, and enhanced communication dominate the industry today. Investors have been generally pleased with the new risk/reward tradeoffs, given both the industry reforms and the attractive yields of new issuance securities relative to US Treasuries. Still, we are far from the heyday of 2007. Who knows where we will be when Clive Palmer launches his Titanic II in 2016, but the hope is that this vital source of real estate lending will steadily return to the market place, and remain a positive example of markets remade.