Concerns Grow on CMBS Price Manipulation

by REIT Wrecks on June 23, 2008


In early April, I reported that the Commercial Mortgage Backed Securities Association had written to the Markit Group Ltd., the London-based administrator of the CMBX Index, a synthetic credit default swap derivatives index introduced in March 2006, requesting that trading data on the index, including total volume and number of daily trades, be made publicly available in order to “increase market transparency”.

The move was a clear swipe at the Markit Group and the extent to which its CMBX synthetic credit default swap had come to dominate the cash market for commercial mortgage backed securities, and by extension had also become the playground of various hedge funds attempting to execute self-fulfilling niche short trades in the same market.

As Bloomberg subsequently reported when it picked up the story, rather than dispersing risk and lowering borrowing costs as former Federal Reserve Chairman Alan Greenspan predicted, the contracts have exacerbated the debt crisis. What was intended as a way for lenders to protect against defaults spawned a market where no one knows how much is traded and speculators who bet on deteriorating credit quality can end up forcing that reality.

When the cash markets froze in late 2007 and early 2008, the indices became the only way for firms to value their portfolios in accordance with mark to market accounting requirements. Hedge funds quickly recognized the opportunity to profit by driving pricing of the CMBX indices higher, thereby forcing firms to mark down the value of the underlying cash instruments by a similar amount. Consequently, some credit-default indexes morphed into what Wachovia Corp. analyst Glenn Schultz called “Frankenstein’s monster” because they now often drive prices in the so-called cash bond market, rather than the other way around.

All of this continues to have a dramatic effect on portfolio valuations for those firms subject to mark to market accounting, and possibly even played a role in the downfall of Bear Stearns. “The indices are just trading on their own account, with no relationship whatsoever to an underlying cash market,” said Jacques Aigrain, chief executive officer of Zurich-based Swiss Reinsurance Co.

Fearing a repeat of losses and continued possible manipulation of their books, banks are refusing to support new indexes that would allow investors to wager on everything from auto loans to European mortgages, reining in a market that’s about doubled in size every year for the past decade.

“The last thing the securitization market needs is another no-cash-upfront instrument that people can use to knock the markets about with,” said Andrew Dennis, the London-based head of the asset-backed debt syndication group for UBS AG of Zurich.

Indeed, Wachovia wrote down $600 million of commercial mortgages early this year because of declines in prices indicated by CMBX indexes, and Citigroup Inc., the largest U.S. bank by assets, wrote down its subprime holdings by $18.1 billion after using ABX credit-default swap indexes to help value the assets.

However, as the latest CMBS default figures from Fitch and others indicate, commercial real estate assets themselves continue to perform well and the commercial mortgages underlying the assets have therefore suffered very little deteriotation in quality.


While the ABX Index was the best known offender, pricing in an underlying loss rate that was at least four times that expected by some analysts, the CMBX wasn’t much better. According to Bloomberg, the cost to protect $10 million of AAA commercial mortgage securities jumped 10-fold during one six-month period to $100,000 a year, based on the first CMBX index from Markit. That implies about 13 percent losses on the underlying loans, also more than four times the worst case 2.8 percent loss rate forecast by JPMorgan analyst Alan Todd.

“The ABX, CMBX, any kind of X you like, are totally uncorrelated to any kind of underlying market,” Swiss Re’s Aigrain said.

This is has all led to a great deal of controversy over the merits of mark to market accounting. Even Helicopter Ben saw fit to weigh in on the issue when asked about it recently in a question and answer session. According to Reuters, Bernanke said that on balance mark-to-market has worked well, but “it’s also true in the current context, that mark-to-market accounting has been sometimes destabilizing in that sales of assets into very illiquid markets had led to reductions in prices, which have caused writedowns which have sometimes caused firesales, and you get into an adverse dynamic which has caused problems in some of our markets,”

While he said mark-to-market accounting has been a positive influence for investors, he also said that valuations should be determined during normally functioning, stable markets, not times when assets are illiquid.

It’s a controversial topic, but any changes to mark to market accounting would be unfortunate and detrimental. This latest market dislocation is simply the result of the latest incarnation of the investment bubble, and protecting investors from the market’s healthy aftermath would only encourage even more “irrational exuberance”.

More importantly, it would penalize those investors who had the patience and foresight to avoid the bubble in the first place. For those fortunate few, the opportunities that now exist in the REIT wrecks world have created one one of the best environments in history for investing in Mortgage REITs.

Information on how REITs work can be found in the post REIT Definition.

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