CMBX Shorts Start to Unwind, Yields Dropping

by REIT Wrecks on April 5, 2008

Gobs of Fed Grease Moving To Mortgages, Offering Lubricious Relief

Hedge funds that had been aggressively shorting the CMBX market on the basis of the superficial similarities with the ABX (subprime housing related index) unwound some of their short positions last week. Spreads on all the CMBX indices continued to come in, and analysts at Citi contend that as more market participants start to focus on how CMBS is actually performing (low delinquencies, low defaults), and the health of the commercial property sector generally, those CMBX shorts may continue to unwind.

The speed and volatility in this market continues to burn even professional mortgage traders, however. The head of the mortgage desk at a top five investment bank with large mortgage exposure said last week that “we got hammered on the way in and hammered on the way out” as they hedged and rehedged their portfolio against the volatile CBMX. When those shorts reversed unexpectedly and CMBX spreads dropped, they were unable to unload their hedges quickly enough.

That same trader said that last week was the first time in months that the cash market (trading in actual CMBS paper) started to show signs of returning to life, after being almost completely frozen since August of 2007. Still, he said that two thirds of the investor base had been wiped out (e.g., SIVs, CDOs), and it would be a long while before replacements were found.

There is also conspiratorial talk at the highest levels of these firms regarding the hedge funds that brought down Bear Stearns. They are determined not to let it happen again, and senior executives from several firms are now quietly discussing the trading activities of those funds with various regulators.

That debacle led the Fed to intervene in the market in historic proportions. I thought it would be important to review the magnitude of those actions in their totality, because together they are incredibly important for REITs and Mortgage REITs in particular.

If you haven’t arleady seen them, it may also be helpful to review excerpts from Bernanke’s 2002 speech on asset deflation to understand why his Fed won’t let things get any worse, and why saving Bear Stearns was so important in the first place.

The Fed’s actions started in earnest on the same weekend that Bear Stearns failed, when the Fed established a Primary Dealer Credit Facility (PDCF). This facility was meant to provide assistance directly to the major investment banks, and for the first time ever it offered direct overnight loans through the Fed’s discount window to that beleaguered group.

Until the PDCF was developed, the access for cash through the discount window was only open to depository institutions with reserve accounts at the Fed. The new Fed facility also allows a much wider range of collateral, including investment-grade corporate securities, municipal securities, mortgage-backed securities, and asset-backed securities. If a price quote is available, the Fed will take it.

Essentially, the PDCF provides investment banks with access to cash using formerly illiquid mortgage assets as collateral. The liquidity provided by that facility will obviously be very good for the many REITwrecks out there, and it should help reduce the odds of another liquidity crisis in the investment banking sector following the Bear Stearns problems.

Two days after that, the Fed cut the short term rate once again, which cumulatively brought Fed funds down by 300 basis points between last September and March of this year. The last time the Fed undertook such an aggressive action (from 5.25 percent to 2.25 percent or a 57.1 percent cut) was between April and November 2001 (from 4.5 percent to 2.0 percent — a 56.5 percent cut), in the midst of the previous recession and the aftermath of September 11th.

Just one day later, the Bush administration reduced the amount of capital Fannie and Freddie are required to hold, allowing them to buy or guarantee more mortgages. Combined with OFHEO’s ealier lifting of the portfolio caps on February 29th, and an increase in the conforming loan limits, two major sources of both commercial and residential mortgage capital are now back in full operation. At the same time, Fannie and Freddie agreed to raise more capital (perhaps through stock offerings) providing assurances that capital levels will exceed requirements.

And just one day after that, the New York Fed announced a modification to the Term Securities Lending Facility (TSLF), which was already so new the ink hadn’t even dried yet. Until the modification, the TSLF allowed primary dealers to obtain Treasury securities (not cash) for 28 days in exchange for a broad range of assets, including agency debt, agency residential mortgage-backed securities (RMBS), and AAA private-label RMBS – but not commercial mortgages.

The new, new TSLF (the first auction was held on March 27) now allows agency collateralized mortgage obligations and top-rated commercial mortgage-backed securities (CMBS) as collateral as well.

As the trader at the big 5 firm indicated, these efforts are starting to get the markets for all mortgage-backed securities moving again. Even the incredible, unbelievable, unkillable Thornburg (TMA) announced last week that it would begin lending again “within weeks, if not days.”

While all this was going on, commercial banks, insurance companies and even more conservative pension funds were quietly stepping in to fill the capital markets void in commercial real estate.

Just last month, the San Francisco Employees’ Retirement System disclosed that it had increased its investment in CMBS through a $25 million commitment to the Fidelity Real Estate Opportunistic Income Fund LP. The fund will invest primarily in high yield real estate debt securities and instruments backed (directly and indirectly) by commercial property. While this investment is a drop in the bucket individually, it is a great example of a market wide trend that Fitch took note of in its March 25 report on maturing CMBS loans.

Fitch Ratings found that 99% of all CMBS loans maturing since the credit crunch began in August had been successfully refinanced. In the report, Fitch Managing Director and head of U.S. CMBS Ratings wrote that “the diversity of property type and geographic distribution of recent refinancing activity shows that debt capital is still widely available for commercial real estate.”

So the commercial real estate debt market continues to function, even in this stressed credit environment, and all that activity in the synthetic CMBX indices looks to be the result of pure speculation – or worse: pure manipulation.

As this massive dose of Fed dollars continues to sluice through the mortgage market, the CMBX shorts continue to come off, and the murky REIT accounting issues begin to clear, more investors will reverse course and begin to sift through these REITwrecks rationally, assessing the true value of their cash flows.

By then it will be too late, so stay the course. The headwinds in the financial services sector are turning to tail winds, and the eye of the storm has passed. I am looking forward to writing more about the micro accounting issues this week, but unfortunately I am so endlessly fascinated by this story and just can’t write fast enough! As I wrote once before, ignore “Mr. Market”. Be careful. But let him serve you, not guide you.

REIT Dividends

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