New rules regarding treatment of MBS debt on bank balance sheets

A recent ruling by the Comptroller of the Currency, FDIC, and Federal Reserve adopted some new rules for the CRE world and are set to take effect next year. The two major implications of the rule are that more capital must be held in reserve for both banks taking positions in CMBS, and a formula has been enacted to calculate the risk level of a debt security, negating the former method which was based on the rating agencies. For now the formula is only in place for securitizations, corporate debt, and other debt on banks’ trading books but it may spread to include all bank holdings of these securities. 

This formula, which is called the “Simplified Supervisory Formula Approach,” was born because of terms in Dodd-Frank stating that ratings cannot be used to determine credit risk. Under the terms, any bank involved in debt securities must analyze and evaluate data on the underlying loans to determine the credit risk of the holding. One exception to the SSFA rule is the case where a bank already has an approved internal model and will be allowed to continue using that instead of the new formula. The majority of banks do not have this approval though, and will now have until January 1, 2013 to get set up. This could have an adverse effect on CMBS and RMBS pricing performance as well as liquidity in times of turmoil. The real problem is that regulations such as this do nothing to prevent the type of crises that we experienced in 2008 and 2009, while at the same time they vastly increase costs to the bank and at some level this will discourage banks from participating in the mortgage market. 

While it is logical to us as money managers that we want to scrutinize loan-level data when making investment decisions in MBS, regulating as much on a bank is at best unfair from the perspective that they do not have the same requirements in other securities. For instance, if the bank were to buy GE corporate debt (AA- rated), they are not regulated in a manner that forces them to analyze all of its subsidiaries or even GE’s top level financials. In fact, under the legislation there is an investment in the corporate debt of GE Capital (AA-) is treated no different from CIT Group (B+); despite vast differences in their credit quality they each receive a flat 8% “specific risk weighting”. An even better example would be ETFs – the bank could easily invest in a theoretical ETF, whose underlying holdings were solely subprime mortgages or corporate junk bonds, and never have to analyze the ETF’s holdings, whereas buying the bonds directly would require them to adhere to this needlessly onerous regulation.

Eminent Domain is not a solution to the housing problem

During the second quarter a plan to use eminent domain to “condemn” underwater mortgages began making headlines after San Bernardino County California and Cook County Illinois both indicated they were at least evaluating the plan.

The basic idea is that County residents who are underwater, and owe more than their home is worth, but not delinquent or actually under any financial distress, would have their mortgages taken over by the municipality. The municipality would allow them to refinance it at a much lower balance with a new lender. All of this would be arranged by a “helpful” intermediary, which also happens to be the same party that is trying to sell the idea of the plan, which would effectively force the losses on the mortgage lenders, give the homeowners a big free write down on their mortgage and better terms, and give the intermediary a big fee in the process.

The intermediary has been pitching the idea to large pension plans and money managers for over a year now, and has been soundly rejected by most with even a basic understanding of market dynamics.

The most obvious pitfalls of the plan start with the fact that it is not helping struggling homeowners, and in fact is targeted specifically at performing mortgages. It also runs contrary to even the most basic tenets of property, mortgage, and even standard contract law, and would likely result in decades of litigation. Finally, no lender would ever lend in a county that implemented a plan like this in the future without additional assurances that the collateral for their loan was secure.

This would be a devastating "solution" for the citizens as well as the investors in the mortgages, which include all of us as taxpayers, pension holders, and retirement assets in fixed income assets.

Our perspective is that we do not think that this plan will ever actually be executed, but is an example of another poorly thought out legislative “solution” to counter mortgage market problems. These kind of regulatory/legislative risks continue to be a concern.

2011 Insurer Loan Originations Up 55% from 2010

Insurance companies have once again grown their commercial lending operations, this time almost back to pre-crisis levels. Results for 2011 are out (See Figure 1), and show that $51.7 billion of originations were completed by the top 30 companies, up 55% from the 2010 figure of $33.3 billion. At the height of the lending boom in 2007, insurers peaked at $56.6 billion. The surge in lending in the last two years has been instigated by the ability of insurers to offer more secure and competitive interest rates to borrowers compared to CMBS shops. Furthermore, Metlife’s Mark Wilsmann indicated that from a relative-value perspective commercial properties are currently seen as a more attractive investment for them compared to other fixed-income opportunities of the same risk.

Figure 1. Origination Amounts by Top 30 Insurers ($Billions). Source: CMAlert

Maiden Lane III Sale Puts Pressure on the CMBS Market

On April 23, Deutsche Bank and Barclays agreed to buy the $7.5 billion of CDO bonds being marketed by the Federal Reserve Bank of New York (FRBNY). As has happened in the past with other Maiden investment vehicles, these Maiden Lane III bonds are being auctioned off to re-coup an investment made by the FRBNY when it seized assets from AIG in return for a bailout in 2008. It is speculated that the consortium paid between 66 and 68 cents on the dollar for the pool while the second place group bid 65 cents. Barclays and Deutsche had a pricing edge going into bidding because their group already owned the subordinate classes and had an interest-rate swap counterparty position on the CDOs, meaning it would be easier and cheaper for them to deconstruct the CDOs, and sell off the underlying CMBS bonds to the market.

When news first broke of the Maiden Lane III offering, consisting mostly of AM and AJ bonds, pricing slumped and many traders headed to the sidelines to wait out this unusual glut of supply being dumped on the market. Things have returned to normal after the sale, but some volatility may still persist as the winning group sells off small pieces of the deal it did not pre-sell to large investment groups.

Big REITs, Little Stores

Llenrock posted an interesting snippet about the changing tenant dynamics in the retail space, here's an even shorter excerpt...

Despite popular opinion, many local businesses and neighborhood stores, either due to the nature of their products and services or by the sheer convenience of being “right down the street,” are not significantly affected by online retailers like Amazon. As Kimco’s CEO explained to Jim Cramer a while back, local businesses such as dry cleaners and convenience stores offer increased income while filling the small vacancies in REIT-operated shopping centers. Finally, the big guys and the little guys are teaming up.

Florida Retail Loans Undergo Modification

CRENews reported a modification by CWCapital that has become a common workout strategy. The two loans in question were jointly owned by Morgan Stanley Real Estate Fund V and Kitson & Partners with a total balance of over $282mm and 10 separate properties. The properties are mostly centered around Orlando and Fort Lauderdale, as you can see in this map.

•  Kitson paid all of the modification costs, in exchange for a 20% interest in any future proceeds that exceed the new A-notes.
• Kitson remains on the hook for a $8.8mm LOC for TI or CapEx for one mortgage as originally laid out in the docs.
• An existing $4.6mm debt-service reserve will be transferred to a TI reserve account and is expected to be used to cover TI in the near future.
• The coupons remain unchanged.
• The maturity date was extended from this year on one, and from 2017 on the other, to March 2019 in both cases.
• One mortgage was split into an 58%/42% A/B note structure, and the other was split into a 50%/50% A/B note structure.
• In both cases, the expenses are paid first, then to paying down the A note principal, then to replenishing a TI reserve, and then 80/20 to the B-Note and Kitson.

See CRENews.com for the full article - although they require a subscription, this article is offered publicly.

RMBS, CMBS improve, while Treasurys decline

The WSJ reports:

The rotation out of safe-harbor Treasury bonds was mainly driven by some optimism that an official report Friday from China may show the world's second-largest economy fared better last quarter than the 8.3% growth forecast by economists. Commercial mortgage-backed securities whose spreads have blown out this month are snapped back as traders took a rosier view of global growth and stock markets rose. The dealers are focused on commercial-real-estate collateralized-debt obligations, which are a corner of the $47 billion face amount of debt held by the New York Fed portfolio known as Maiden Lane III. They are primarily focused on dismantling the so-called CRE CDOs because the underlying commercial mortgage-backed securities are worth more as individual pieces and could likely generate more trading revenue, the investors said.

Note that the two CDOs in Maiden Lane III are the subject of a previous post.

Potential Auction of Maiden Lane III - $8 billion of CMBS collateral

The Fed announced this week that they may put the Maiden Lane III assets (former AIG assets) up for sale, which include nearly $8 billion of CMBS collateral that is in two MAX CDOs. The CMBS collateral primarily consists of AJs, AMs, and A4s. It is unclear if the CDOs would be broken up or sold in their current form, but we believe it will cause some short-term volatility in pricing.

This would be a lot of supply for the CMBS market to digest, where average daily volume the past year has totaled $1 billion and the largest single day supply was just over $4 billion.