CMBS Needs Some Skin in the Game

There has been virtually no new issuance of CMBS since the summer of last year. The result has been a reduction in the number of investment sales in New York with prices over $100 million of 85% in 2008 versus 2007. Thus far in 2009, there have been only 2 transactions which have exceeded $100 million. Securitizations are used for smaller loans as well, however, the  majority of this sector consists of larger loans.

Various reports have indicated approximately $180 billion to as much as $400 billion of commercial real estate financing maturing in 2009. Most of this financing is CMBS and a significant percentage is collateralized by assets located in New York. The market does not have the ability to refinance this magnitude of capital without access to the public markets. Even performing, low LTV (even using today’s adjusted values) loans with strong sponsorship will find refinancing challenging if the aggregate amount of dollars needed is too large. It is, therefore, critical to get the CMBS market operating again, in one form or another.

The government is trying to stimulate all credit markets including the CMBS market. The TARP includes TALF 1.0 which is geared towards supporting asset backed securities collateralized by credit card debt, student loans and auto loans. It also has an allocation to purchase newly originated AAA traunches of  CMBS. TALF 2.0, which was born out of the “Geithner Plan”, has an interesting component which will attempt to create a pool of buyers of legacy CMBS as well as other toxic assets. Created via the formation of public/private parnerships, this pool of buyers will consist of competitive bidders for these assets. Leverage will be available at a ratio of as much as 10 to 1. Balance sheets of financial firms could be significantly enhanced based upon the extent to which this process is successful.  

How did the CMBS market deteriorate?   Similar to the mechanism which caused problems with RMBS, no one had any skin in the game……. until the end of the process. Along the way, fees were made and exposure was passed on to the next one in line. Loans were orignated and sold to the secondary market. Pools of loans were securitized and divided into traunches. Rating agencies gave their blessing and when the securities went bad, the investors who purchased them were left holding the bag.

The question is, What will convince investors to purchase these securities in the future? Perhaps something like this could help:

The originator of the loan should be required to keep a first loss position of let’s say 20% on their balance sheet and could then sell 80% of the loan to the secondary market. The lender would then be compelled to make prudent decisions about what loans they are making because they will have skin in the game. The secondary market securitizer should have to keep a second loss position of let’s say 10%, which would make them scrutinize the collateral, layering in another slice of due diligence. The securitizer could then sell the balance of the securities to institutional investors. With a 30% loss position in front of  the investors, a rating agency would no longer be necessary to give comfort to the investors. The percentages of loss positions could vary greatly, but the concept is to have market participants put their money where their mouth is rather than merely processing a financial instrument for a fee and then passing all of the risk on to someone else.

The market desperately needs access to massive amounts of capital and a fix to the CMBS market would be a start.

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24 Responses to “CMBS Needs Some Skin in the Game”


  1. 1 Nathan Isikoff March 11, 2009 at 11:41 am

    Bob – this is a great suggestion! You need to write an op-ed to the WSJ, unless you can get the message to Geithner or Summers directly.

  2. 2 rknakal March 11, 2009 at 11:53 am

    Hi Nathan, Thanks for your response. I met with Senator Chris Dodd, Chairman of the Senate Banking Committee, at the offices of the Real Estate Board of New York on Monday and he seemed interested in the idea. This idea creates a hybrid lender or a “quasi-portfolio” lender which creates accountability and credibility. Secretary Geithner needs to do something impactful and well thought out with respect to this problem sooner rather than later.

  3. 3 joe March 11, 2009 at 4:17 pm

    interesting idea for new loan, but with the hangover banks and investors will naturally be more conservative in underwriting. The issue that needs to be solved are the existing loans and the fact that they can not be financed. Your suggestion could make re-financing the upcoming maturities even more difficult because of the capital allocation issues for first loss pieces and the fact the banks don’t have any capital. The LOSSES need to be taken and we must move on. putting more equity in banks just delays the issue. Some banks need to go under.

  4. 4 rknakal March 11, 2009 at 8:40 pm

    Hi Joe, I agree that some banks have to fail, and they will. 41 have so far in this cycle and there are about 200 more on the FDIC’s watchlist. There are really two issues that your post addresses. The first is the fact that the mark-to-market accounting rules need to be and probably will be changed. Banks currently have more cash than they have ever had but their capital positions are weak because of this mechanism. If we had mark-to-market rules during the early 1990s, thousands of banks would have failed instead of the 853 that did. Secondly, revitalizing the CMBS market will not address the fact that many 2005, 2006 and 2007 vintage loans are at significantly higher amounts than could possibly be refinanced today. Yes, these losses must be taken and will be regardless of whether the lender sells the real estate after a foreclosure or sells the note to get cash today. A functioning CMBS market is, however, necessary to make the market function.

  5. 5 Pete March 12, 2009 at 10:14 am

    This suggestion is not very different from how things previously worked. Say the originator made a new loan for 70% of the capital stack. They would only securitize the first 50% as CMBS, retaining the first loss 20% piece as a B Note on their balance sheet. What you are missing is that these B Notes were then sold to other institutions on the secondary market.

    The reason that there is no new CMBS origination now is the huge disconnect between the interest rate on loans and the spread required on the bonds. You can’t securitize an 8% loan if the AAA bonds require a 12% yield.

  6. 6 rknakal March 12, 2009 at 1:34 pm

    Hi Pete, thanks for your response. What I am suggesting is that the B Note be kept on the originator’s balance sheet. TALF 2.0 is attempting to create a buyer pool that will have an appetite for the AAA piece whether it be through a “subsidy” or other incentives to abate the disconnect. Requiring a 12% yield on AAA bonds represents an unrealistic spread expectation above the risk free rate and, I would hope, should moderate over time.

  7. 7 scott March 12, 2009 at 2:47 pm

    Your idea does not address the “true sale” rules. The point of securitization is to take these loans off the balance sheets of the originators. Requiring them to hold subordinate traunches will mean in many cases that they have to show the entire loan on their balance sheets.

  8. 8 rknakal March 12, 2009 at 4:07 pm

    Hi Scott, thanks for your feedback. Just as I believe the mark-to-market rules will be modified, if it is the case that the lender’s balance sheets will misrepresent their position, those rules should be modified as well. Having a functioning market should supersede accounting rules that do not make sense.

  9. 9 JWB March 14, 2009 at 11:36 am

    How do we put faith back in the rating system to where AAA bonds are not being priced at 12% yields and it makes sense to make securitizable CRE loans again?

  10. 10 rknakal March 14, 2009 at 2:50 pm

    Hi JWB, Given the recent track record of the rating agencies and the general skepticism of fiduciaries caused by Madoff and all of the other scamers that are being uncovered, faith in the agnecies will be slow to regenerate. What is needed is a multi-layered system of diligence such that an agency rating is simply an final designation in a transparent process. Requiring each participant along the way to have some skin in the game accomplishes this objective.

  11. 11 JWB March 15, 2009 at 9:40 am

    Why aren’t we seeing or at least hearing about any reform of these rating agencies though? It seems “greedy” wallstreet banks are taking all the heat.

    I imagine if the rating agencies would not have given pools of junk loans inflated ratings, we would have avoided much of this mess. They crippled the bond market.

  12. 12 rknakal March 15, 2009 at 7:16 pm

    Hi JWB, That is an interesting point. I don’t think we can place all of the blame on one particular market participant. Everyone involved in the process contributed to the result. We can extrapolate all the way back to the early 1990s when the government was advocating for the homeownership rate in the country to rise to 75% from the 62% it was at that time. They encouraged Fannie and Freddie to broaden their platforms and that was the snowball that started rolling down the hill. As recently as 2007, congress had the opportunity to rein in the GSEs and failed to do so.

    With respect to the rating agencies themselves, while they are clearly not alone, they could have and should have done more due diligence.

  13. 13 JWB March 16, 2009 at 8:19 am

    I agree with you about government pressure being the catalyst and creating the market to push liar loans, however, who pays the rating agencies? It’s one thing to have a single appraisal “Made As Instructed”…it’s another to buy a false rating for a securitzed instrument.

    If we can’t rely on the ratings to be acurate, then we have no system regardless of the level of individual diligence. Why else would the bond liquidy pull out of the market across the board just due to subprime loans? At the time, CMBS default rates were a fraction of a percent. Noone has faith in the rating system in general. Until someone gets ahold of these guys, noone will.

  14. 14 Richard (Rick) Herbold March 16, 2009 at 9:37 am

    One area that needs ‘looking into’ is the property condition assessment reports associated with CMBS. The two major standards are issued by Standard and Poor’s and ASTM. There are also data from the GSEs (Fannie, Freddie, etc.). Soem of the data suggests what should be used for “replacement reserves (RR)”. Most of the time the issued reports use recommended reserves amounts. This does not show the true picture of the property assessed. The end user is often left holding the bag: the reserves do not cover real world work to be done. A lower reserve figure does increase the value of the property; it also increases the fees charged by those who get a percentage piece of the action. Immediate Repairs are also underfunded on many reports. Plus, the firms writing the reports are not regulated. One idea is to have all reports written and authored by registered professional engineers or registered architects. This would allow control of the ‘numbers” finding their ways into the reports. If the reports do not show real world costs and work scope, the licenses of the architects and engineers would be on the line. Another idea is to rewrite the standards (ASTM and S+P); make the use or registered / certifed engineers and architects a requirement and make all report authors use real world costs no matter what the impact on the value of a property.

  15. 15 stuartx March 16, 2009 at 12:02 pm

    Bob, tell senator Dodd that this stucture already exists right under his nose. Tell him to take a look at the Fannie DUS program. I have made claim for years. But no one on Wall st has the risk tolerance to do what the Fannie DUS structure calls for. Wall st just uses OPM and OPR (Risk). The best bet is to get groups like Goldman that has an investment in a DUS platform to mirror it’s risk and start to do new cmbs loans with this risk structure. Others will soon follow, but a leader is needed. Also, we need someone in Washington that has real experience in this field not professional politicans who are not focused on the problems but are making new ones.

  16. 16 rknakal March 17, 2009 at 6:16 am

    Hi JWB, As we have said before, the more accurate the rating agencies can be, the better for the market.

  17. 17 rknakal March 17, 2009 at 6:20 am

    Hi Rick, Thanks for your feedback. Clearly, the more accurate the underwriting can be, the better. Additionally, the more standardized the parameters are which are utilized to determine the reserves, the more comfort the market will have with the numbers. Perhaps a contingency reserve would provide another layer of protection.

  18. 18 rknakal March 17, 2009 at 6:23 am

    Hi Stuartx, Your point is well made. What are the percentages of “skin” the DUS program requires? Thank you for your post.

  19. 19 stuartx March 17, 2009 at 2:41 pm

    18% in the first loss position. but if fannie thinks the underwriting is weak or too aggressive it may double. There are alternate way to alleviate the pain by reduced servicing strips etc, but its a starting point.

  20. 20 rknakal March 17, 2009 at 8:59 pm

    Hi Stuartx, I think the first loss position and a second loss position need to be a higher percentage to have the end investors feel comfortable. The market will dictate the correct percentages.

  21. 21 Heartburn Home Remedy April 15, 2009 at 6:28 am

    The style of writing is quite familiar to me. Have you written guest posts for other blogs?

  22. 22 rknakal April 15, 2009 at 9:35 am

    Hi HHR, I write a for my company’s website as well as periodic commentary articles on the market. Feel free to go to the Massey Knakal website at http://www.masseyknakal.com and click on the REEL for my stories as well as others from people at the firm.

  23. 23 PTCP May 6, 2009 at 3:19 pm

    Have you ever worked in the CMBS market? Your ideas need to have a practical application. Your structure would require overall rates to be high enough that each level is properly compensated for their level of risk.

    As for the DUS program, the agencies can hold the risk because of their backing from the government, right? And they are not subject to the same regulations as banks.

    By the way, Replacement Reserves are such a small part of each deal that they are irrelevent to the failure of a loan.

  24. 24 rknakal May 7, 2009 at 6:43 am

    Hi PTCP, thanks for your post. The government has fundamentally changed the way so many things function that they may have to change operating parameter for CMBS participants. The need for access to public capital is so significant that something tangible must be done to stimulate this market. I find it hard to believe that the CMBS market will return, in the short run, the way it was without structural modification. Passing along 100% of the risk in any deal will leave investors fearful given that ratings from ratings agencies do not hold the weight that they did in the past. What would you suggest as ways to revive the CMBS market?


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