Many commercial real estate loans are heading inexorably toward their 2009 maturities, and straight into a titanic log jam in the capital markets. In the old days of commercial logging, this uncertain situation called for a Jamcracker. The job was extremely dangerous and required the Jamcracker to walk over the log jam and break it up with pike poles or, as a last resort, dynamite.

The commercial real estate loan Jamcrackers of 2009 face an equally dangerous mess, but numerous lenders are postponing the real day of reckoning until 2010. This will make 2010 an even more pivotal year for commercial real estate values, and the Jamcrackers will be jumping by then, not walking.

Because liquidity is now almost non-existent, master CMBS servicers are reporting transfers of more loans with upcoming maturities to special servicing even if they’re performing. Special servicers have the flexibility to work out, modify or extend loans up to a year at a time, whereas a master servicer can only offer a short term extension.

Fitch identified approximately 1,100 of these individual fixed-rate CMBS loans that need to refinance on or before June 30, 2009. The loans total $5.7 billion in value, and they will more than likely be transferred to special servicing due to the continued lack of available capital to refinance. This is on top of 100 floating rate CMBS loans, totaling $12.7 billion that will likely also be extended, and 22 floating rate CMBS loans totaling $1.3 billion that will reach their final extended maturities in 2009. For those latter loans, 2009 is the end of the road. In total, the Real Estate Roundtable estimates that there is $400 billion in commercial real estate loans that need to be refinanced in 2009.

Many of the fixed rate loans would have refinanced a year or even six months ago because they’ve been amortizing and have attractive debt service coverage ratios, but even these loans are caught in the liquidity logjam. Lenders, trustees, banks and special servicers are faced with the choice of having to extend these loans and delay full repayment until liquidity returns, or foreclose on properties in a market that has completely stalled.

The problem is that there seems to be no end to the stalled market, and 2010 looks no better than 2009. Defaults doubled in 2008, albeit from historical lows, and Fitch is predicting that CMBS delinquencies could hit 2 percent by the end of 2009. Office vacancy rates are now reaching into double digits even in “superstar” cities such as New York, Chicago and Los Angeles, and they may reach 20% by year-end. Retail centers and hotels are doing no better.

As the souring economy catches up with tenants and landlords, problem loans are growing at an even more more rapid clip. For the first three quarters of 2008, increases in CMBS delinquencies were almost negligible. However, CMBS delinquencies ticked up by 6 basis points in October, and then by 13 basis points in November. This was the biggest one-month jump of the year. It took all of January through June for CMBS delinquencies to increase just 14 basis points.

For the Jamcrackers, the below data from Real Capital Analytics illustrates the dynamite dilemma. Capital needs to be recycled to get the river flowing again, but with buyers almost completely on strike, collateral recoveries through liquidations are likely to be lilliputian.

This is an unwelcome prospect for the capital-drained banks, pension funds, insurance companies and hedge funds holding these loans and planning on contractual return of capital in 2009. Unfortunately, these institutions cannot hold out forever without some sort of repayment.

If the Treasury finally follows through on the Troubled Asset Recovery component of its so-called Troubled Asset Recovery Plan, don’t look for fireworks right away. Instead, expect a lot of pike poles to be gingerly wielded by the Treasury’s Jamcracker proxies, Blackstone and Pimco, coached by lobbyists at the Real Estate Roundtable, who are extremely busy in Washington right now. But how long this can all go on before the entire river chokes to death is anyone’s guess.

commercial real estate loans
commercial real estate

Both Bloomberg and the Wall Street Journal published stories on Monday warning of increasing trouble in the land of commercial real estate. It’s going to be pretty bad, there’s no doubt about it. But why is it bad and who is it really going to hurt? The Bloomberg headline claimed defaults could triple, but how much you care about that depends on where you sit in the food chain.

REIS, a consulting firm boasting a peripatetic chief economist with the best enunciation I have ever heard, evidently supplied data to Bloomberg showing that commercial loan defaults will rise dramatically if property-level net operating incomes (“NOI”) drop by even 5%. That’s a rosy forecast, given what’s going on with the economy. For the time being however, let’s assume they’re correct because there is really no dispute that NOI will weaken in this environment.

All things being equal, when NOI drops, the value of the underlying property also drops. Let’s say you own a property with $6 million in NOI. And let’s also say the “market” capitalization rate for that property is 6%, which is about where cap rates were, broadly speaking, during the boom. That means you have a property worth $100 million ($6MM in NOI/.06). However, if your NOI drops 5% to $5.7MM, your property is now worth only $95 million ($5.7MM/.06).

Could this really be what persuaded a bunch of New York City real estate tycoons to beg for a meeting, hats in hand, with a Senator from Brooklyn? Unfortunately, it wasn’t, because the above example assumes all else is equal, which is not the case. What if you threw in a few more wildcards, like the collapse of the CMBS market and rising cap rates? Then you’d have a story, and blessed be the prophets, it’s all right here on REIT Wrecks!

So what’s going on with the CMBS market? The short answer is nothing, really, and that’s a big part of the problem. During the boom years, CMBS grew to become a $225 billion source of capital to the commercial real estate market. Some were optimistically predicting that it would crash through $300 billion in annual issuance by 2008. What actually happened couldn’t have been more different, but it did crash.

The CMBS market actually collapsed, and commercial real estate lending volumes continue to contract. In fact, those 2008 deals you see on the chart, all $12.1 billion of them, were largely the result of lenders desperately trying to unload the loans they made in 2007. One of the last of those deals, J.P. Morgan Chase Commercial Mortgage Securities Trust 2008-C2, closed in May of 2008 and 20% of its commercial real estate loans defaulted within just 6 months.

Clearly, huge demand for CMBS led to a decrease in underwriting standards, including (among other things), a relaxing of traditional loan-to-value criteria. Moody’s estimated that the gap between the Moodys LTV and underwritten LTVs reached record in the first quarter of 2007 (nearly 45%). The Moody’s estimate of actual LTV also reached a record of 106.5%.

These poorly underwritten loans are still out there and in a few of short years, many of them will start to mature. Unfortunately, no lender will touch them now because they are practically radioactive. At the same time that a huge source of capital has disappeared from the market, borrowing costs have soared, making whatever capital there is out there relatively expensive. You can enlarge the chart a bit by clicking on it. Nevertheless, the lines going up and to the right tell the story: money is more much more expensive.

This is happening at the same time that cap rates, which were compressed down around that 6% mark, are now correcting. Cap rates averaged 8.3% between 1986 and 2008, but they fell below 6% in the first quarter of 2007.

This is a toxic mix for those New York City real estate tycoons, and the reason they made the trip to see Chuck Schumer from Brooklyn is simple: they are all about to lose a TON of money.

If NOI decreases by 5%, that’s a few less dinners at the Palace Hotel. However, if that happens at the same time that cap rates revert to historic averages and borrowing standards suddenly tighten, they can forget about dinner at the Palace because they’ll all be sleeping outside on the sidewalk.

Here is that $6 million in NOI at a 6% cap rate during the boom years. Everything looks great, and we’ve got our $100 million:

Ok, but what happens now that things have changed? If you still want your 15.6% Levered IRR (and that’s a big if), what would that deal look like today? Cap rates are definitely headed north, most likely back to their 8.3% average, and loan to values are definitely headed south, probably close to 50% for office and retail (Pro Logis recently did project level industrial debt at 50% LTV).

Adjusting for the new reality, that $100 million deal is $36 million in the hole. If NOI drops by 5%, the problem gets a whole lot worse. This is the wall against which many equity investors and developers have backed themselves into, particularly those with near-term debt maturities.

While REIS was emphasizing NOI growth, or lack thereof, in the Bloomberg story, the canary in the coal mine for the Wall Street Journal was Foresight Analytics warning about near-term debt maturities. The Journal’s story emphasised 2009 maturities that could have trouble getting refinanced. However, while there will definitely be demand for refinancing next year, it will start to get really interesting in 2010. About $180 billion in 2005-2007 CMBS loans will start to mature then, and a little more than half of those are variable rate deals. These are the Alt-A’s of the commercial world, and they were underwritten for a completely different solar system.

The good news is that if you’re a lender in the above example with a well-underwritten 70% LTV loan, things aren’t looking nearly so bad. You’re only down about 10%, and you get the asset to play with, while the developer/owner is completely wiped out. This could lead to the ultimate irony for all those that have been burned on Mortgage REITs: those loan defaults aren’t looking so bad after all! Thanks to Piping Rock Partners for compiling and assembling the data in this post

Disclosures: None at the time of publication
apartment reits, commercial real estate, commercial real estate debt, commercial real estate mortgages,reits
commercial real estate loans

No wonder the original plan what plan? was only three pages long. It turns out that there was no plan. When I heard the news that Treasury had reversed course on the Troubled Asset Recovery component of the Troubled Asset Recovery Plan, that and writing an article with the above title were the first things that popped into my head. Sadly, those two things were also all I could think of while I was cowering under my desk, without food and water, waiting for it all to end. REITs of course got absolutely crushed, and now it looks like many REITs are now headed for the dreaded “.BB” designation. I keep hoping in vain to someday drown in dividends, but that’s unlikely to happen if REITs are swimming in the Pink (sheets that is).

The story of the insanity in commercial mortgages that ensued after the about face now been covered everywhere, including the Wall Street Journal, the Washington Post, and Bloomberg, which was the most strident in blaming it all on Paulson. Sadly, spreading blame won’t help; only spreading money will (and maybe some Prozac too, if I could only afford to see the doctor).

What follows is a relatively cogent article consisting of the most juicy bits from those three above articles.

“A lot of very foolish loans were originated between 2005 and 2007, and many of those loans begin to mature in 2010,” said Mike Kirby, director of research at Green Street Advisors, a commercial real estate research firm. “You have a significant amount of debt maturing at that time and yet you don’t have a market to replace that debt.”

The price of commercial real-estate-debt securities has fallen so far that it has set off a debate among investors as to whether now is the time to get back into the market. Triple-A commercial mortgage-backed securities are trading at roughly 70 cents on the dollar, meaning they would produce a 20% return if held to term.

The default rate on commercial mortgages remains near its historical low, although it is increasing. Overall, the number of commercial mortgages packaged into securities that are 30 days or more past due rose to 0.64% in October from 0.39% at the end of last year. That is the highest delinquency rate in two years but still far from the kind of carnage that occurred during the commercial real-estate collapse of the early 1990s. Back then the cumulative default rate on loans made in 1986 reached 36%.

The trading levels of CMBS bonds imply a cumulative loss rate of as much as 40% on top-rated bonds, which means that at least 70% of the underlying loan pool would have to go into default, [emphasis added] said Richard Parkus, head of CMBS research at Deutsche Bank Securities Inc. But he, like other market observers, views that as an unlikely scenario. …

The spreads between the CMBX, a credit market index that tracks the values of commercial real-estate bonds, widened to another record level Thursday. And CMBS bonds with triple-A ratings now yield more than 14 percentage points above yields on 10-year U.S. Treasury notes, according to Trepp, a New York company that tracks the commercial real-estate-finance market. That compares with a 1.5 percentage point spread one year ago and an 8.3 percentage point spread just one week ago.

At current prices, all the loans could default within 18 months and a buyer wouldn’t lose money, according to Lisa Pendergast, an analyst at the Greenwich, Connecticut-based unit of Royal Bank of Scotland Plc. That’s assuming foreclosure recoveries of 37 percent, compared with the typical 60 percent.

“The default levels implied by where these bonds are trading mean we will all be living in boxes,” said Eric Johnson, president of 40/86 Advisors Inc. in Carmel, Indiana.

“There is evidence that short-sellers are targeting this market because they know they can push it around,” said James Grady, managing director in New York at Deutsche Asset Management, which has about $240 billion of fixed-income assets under management.

“Recent speculative conditions reminds us of the summer when oil was $140 a barrel, and many parties were calling for $200,” Darrell Wheeler, of Citigroup wrote. “Commercial real estate conditions are deteriorating, but we cannot justify recently cheap levels.”

Let’s hope so. I have bills to pay.

The BBB-5 CMBX is above 3250, do you know where your money is? These are record levels for the index, and they are seemingly indicative of even greater trouble in the CMBS market. If one were to use the stock price of many Mortgage REITs however, it would seem that the soaring Markit index is actually behind the times for a change:

Part of the reason for the distress in the index and also the basement-dwelling stock prices of many Mortgage REITs is that two very large loans that were securitized into CMBS, including one loan secured by two Westin hotels, appear to be nearing imminent default. Of course, this distress is also due to the forced selling of anything that hasn’t already been seized by the county sheriff.

The $209 million Westin loan is backed by two hotels located in Tucson, Arizona, and Hilton Head, South Carolina. The slowing economy has hurt hotel operators as consumers and businesses have cut back on travel. The second loan nearing default is a $125 million loan for The Promenade Shops at Dos Lagos, which is located in Corona, California. Southern California has been dealt a particularly heavy blow by the worst housing crisis since the Great Depression.

Credit Suisse analysts reported that the Weston loan is split between two JPMorgan-issued CMBS deals. J.P. Morgan Chase Commercial Mortgage Securities Trust 2008-C2, the more recent of the two deals, is heavily exposed. That trust’s portion of the defaulting Westin loan represents 8.9% of the total collateral pool. Unfortunately, the bad loan on the Promenade Shops is also the largest loan in the same pool, representing fully 10.7% of the collateral. This means two of the top-ten largest loans in the pool, representing almost 20% of the collateral, are about to default. Investors in all but the most senior tranches of this issue are now facing huge losses as remaining cash flows are diverted to those who occupy higher ground (see the post “What is Securitization” for more detail on how subordination impacts Mortgage REITs).

It is not surprising that hotel and retail loans would come under pressure, particularly a retail loan made in Southern California, which was practically the belly of the beast. Hotel occupancies and retail sales have been especially hard hit as consumers and businesses snapped wallets shut when the credit crisis started making what Ross Perot could only have described as that “giant sucking sound”.

The real interesting aspect of these latest defaults is that everyone involved should have known better. Yet the pressure to produce, rate and sell still seems to have trumped the mirrors in front of our faces.

All of the mortgage loans in the pool were originated between June 27, 2007 and April 30, 2008, and the securitization closed on May 8, 2008, well after the Bear Stearns collapse and Ralph Cioffi scapegoat perp walk was led away in handcuffs.

Nevertheless, the Westin loans were interest-only for 36 months and had underwritten debt service ratios (DSCR) at closing of less than 1.25%. This would have been considered risky even in 2006. The loan agreements on the Promenade Shops were interest-only for 60 months and had underwritten DSCR of just 1.10%. The Promenade loan also allowed additional subordinated debt provided that the combined LTV did not exceed 85% and the combined DSCR did not fall below 1.00%. This is the equivalent of allowing someone to rent an apartment that will consume 100% of their monthly take-home pay (assuming a landlord would let anyone do such a thing). More than 75% of the loans in the pool were interest-only or partial-interest only. Other large loans in the pool include the Las Vegas headquarters of Station Casinos good luck and several other large retail and hospitality properties.

One would have thought, given the media and political spotlights around shoddy underwriting and hopelessly conflicted ratings agencies, that underwriting standards would have improved and that CMBS investors would be taking a much harder look at the bonds being furiously shoveled in their direction.

So is it really any wonder that Mortgage REIT stocks are in the tank when two of the top-ten largest loans in a May 2008 CMBS deal, representing almost 20% of the collateral, have gone up in smoke in just six short months?

Click here for an updated Mortgage REIT list, including current yields.

Disclosure: None at the time of this writing

I went for a ride on my mountain bike last week. Is it any wonder that all I could think of during the long, steep, uphill grades was REITs? The analogy is apt, as making money in this sector is almost as strenuous. This afternoon, however, after I wiped the vomit from my shirt luckily I can’t afford to eat much that day seemed like a decade ago. Earlier in the day today, General Growth Properties (GGP), an equity REIT that owns and operates shopping centers announced that it may be unable to refinance its debt. Even pedestrian REITs like AIMCO (AIV), an owner of apartments will you take food stamps? took it in the shorts to the tune of 30% as confidence completely evaporated from anything related to real estate and mortgages.

But didn’t our lame, ignorant congress finally get a clue as to the damage a full-fledged banking crisis would cause? For those libertarians that are still ambivalent about the whole thing, if those gerrymandered economic neanderthals hadn’t finally passed the TARP bill, the United States would probably be facing the same fate as Iceland: imagine logging into your online brokerage account and being unable to trade or transfer cash. Such is the state of affairs legally blonde in Reykjavik at the moment.

But we do finally have TARP and the treasury had better get at it – and soon. The GGP debt is precisely the kind of stuff the TARP plan was meant to address. Nobody wants it, and nobody needs it. But what if the Treasury does purchase, for example, GGP debt. What will they do, if anything, for the equity?

If Bear Stearns, Indy Mac, Fannie Mae, Freddie Mac, Washington Mutual, Lehman, Wachovia and others are any clue, the answer is plainly nothing. I’m not sure if this matters for largely match-funded REITs like NCT, RSO and crazily enough, even loss crippled CRZ. Especially when the government socialization of private mortgage losses (purchasing broken CMBS debt) at above-market prices and suspending mark to market accounting allows everyone to believe in fantasies giselle bundschen cooks me breakfast whilst naked namely, that there is a market for this stuff in the first place, which there ain’t.

But there is no market and it pays to remember that with all this “rescue” talk the Fed has not been kind to equity holders, even PREFERRED EQUITY holders. So for those of you who are marveling at the deals to be had in the REIT preferred space, given the perceived “safety” relative to the common, think again. The preferred holders in Fannie Mae and Freddie Mac were wiped out just like the common, and the TARP bill contained a special provision just to bail out the regional banks that held this junk. But there was no such luck for the individual tax payers who were stuck holding this now worthless scrip, even though they will help pay the Treasury’s tab for bailing out the hapless banks.

So how will the TARP program treat those REITs that are investors in Controlling Class CMBS, which is pretty darn close to equity? This was the question on my mind as I pedaled my way up the hill, after spending the morning watching the likes of Anthracite (AHR) and JER (JRT) get knocked back to the Stone Ages. Last week, after these two REITs get disproportionately sold, it seemed that the market was counting on the treasury to penalize those who knowingly invested in the lowest rung of the CMBS food chain.

But today, after listening to Bernanke address the National Association for Business Economics about the need to restart the CMBS and securitization markets, I was less convinced. Controlling class CMBS is an essential cog in the CMBS wheel, and without it there will be no market. Unfortunately, as in Iceland at the moment, there is simply is no market for anything and cash truly is king. But these juicy REIT dividends are no compensation for margin calls and 50-75% losses of principal. I had no idea how big the mother of all bailouts would be when I wrote wrote this post, and it’s safe to say neither did Helicopter Ben. All that ivy must have obscured his view.

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

The Mortage Bankers Association today reported a 98% year-over-year decline in CMBS new issuance, which has continued to leave Morgtage REIT portfolios at the mercy of the thinly traded CMBX in terms of valuations. Pricing pressure on CMBS (as evidenced by the CMBX) has abated recently, but the index is still indicating levels of distress far higher than the current fundamentals:

The relentless climb of the CMBX is partially the result of pure speculation. However, there is another factor at work as well. While the problems in residential mortgages are already manifest, there’s a notable difference between CMBS and their residential counterparts. Losses on RMBS typically decline as the loans age (or “season”), but losses on CMBS are largely driven by tenants’ ability to pay rent, and that can be undermined at any point by a slowing economy. The graph below shows that historical CMBS defaults typically peak seven years after issuance. This is “tail” risk, and tail risk for CMBS is rather long:

CMBS delinquencies are now rising, as the graph below depicts. To be fair, most of the delinquencies have been led by multi-family sector, which is partially tied to the single family market via failed condo conversions, and another large component of the increase in that sector can be traced to just one borrower. But the slow rise in defaults in CMBS generally is nevertheless causing a great deal of hand wringing.

That CMBS defaults will rise is not in dispute, simply because they have been at historic lows for much of the past year. Estimates of how high defaults could rise vary widely though, and obviously that affects estimates of how high they may or may not travel up the CMBS capital stack. And “tail” risk is no secret; Mortage REIT portfolio managers account for it in their loss assumptions.

However, while fundamentals are holding up and remain firm, there still is a pervasive sense of fear among CMBS investors and real property investors alike. Costar, in its August 26 article entitled A Dud of a Thriller? Commercial Real Estate Drama Lacks a Killer quoted Philip Conner, of Prudential Real Estate Investors, who compared the market to the Samuel Becket play “Waiting for Godot”.

In a report entitled “Waiting for Distress” (I don’t have a copy), Connor wrote that “though signs of distress remain largely confined to highly leveraged deals consummated at the peak of the investment cycle, in late 2006 and early 2007, there is an undeniable and growing sense of anticipation among investors that U.S. commercial property values are poised to fall and that widespread distress is just around the corner.”

However, Connor noted that in the Samuel Beckett play, Godot never actually appears onstage. “His off-stage presence, whether real or imagined, and his expected arrival largely dictate what does and does not happen in the play.”

Connor contends that most of the distress is likely to remain “off stage” in the capital markets. However, capital markets is very much “on-stage” for Mortgage REITs, and just as the abundance of ready and available credit pushed asset prices above their fundamental value, so too will the lack of it push prices below their fundamental, intrinsic value. And when the bottom is finally notched, Godot won’t be there to ring a bell for us either.

Click here for an updated Mortgage REIT list, including current yields. Data compilation courtesy of Chris Germain in San Francisco

Disclosure: This play is more interesting.

Graphs courtesy of Markit; Morgan Stanley

Securitization is the process of taking groups of loans and splitting them into different classes of securities, and then selling the different classes of securities to third party investors. The brief video below does a great job of explaining how it all works. Many Mortgage REITs buy Commercial Mortgage Backed Securities (CMBS), which are commercial mortgage loans that have been securitized. Other mortgage REITs buy mainly “whole” loans, which are loans that have not been securitized.

Before the credit crisis, residential and commercial mortgages were widely securitized, but securitizations have also been done for a wide range of cash-flow producing assets, such as residential mortgages, commercial mortgages, credit card receivables and college tuition loans. Securitization confers a huge advantage to lenders in that it allows the lender to transfer all of the risks around making loans to third party investors.

However, FASB has proposed changes to FAS 140, including the elimination of the QSPE rules which previously allowed for a “true sale” and the complete transfer of risk the lender to the investors (for more on that, see the REIT wrecks post on changes to FAS 140). As the video mentions, the securities were usually “tranched” into different classes, which enhances the credit rating of the resulting securities beyond that of the underlying assets. This is known as Credit Enhancement.

Essentially, issuers take the loans and split them into “tranches” which have different levels of risk (referred to as “subordination”). So, if the entire group of securities would have a credit rating of BBB, and you cut it into several tranches, the highest tranche with no subordination, could have a credit rating of AAA, because it gets paid first, and the only way it would not get paid would be if a huge group of the underlying loans were unpaid (i.e. the highest tranche has the lowest risk). Issuers can also “over-collateralize” the pool.

Tranching is important because different Mortgage REITs invest in different classes, or tranches, of the CMBS pool. Anthracite Capital, for example, invests mainly in the “controlling class” (so-called because AHR can take “control” of the defaulted assets) portion of CMBS deals. This is also known generally as the “B Piece”. Aside from the equity, which is unrated, the “B piece” is the highest risk and lowest rated portion of the securitization. If large numbers of mortgages default in a CMBS issuance, the controlling class has the most subordination and is the first to take a loss. Therefore, if a Mortgage REIT like Anthracite owns the controlling class securities of a securitization with extremely high rates of default, the REIT’s entire investment in that CMBS issuance can be wiped out. If you want to learn more about tranching and over-collateralization, see the REIT wrecks post on CDOs.

Click here for an updated Mortgage REIT list, including current yields

In an earlier article (“Mortgage REIT Yields Still Look Safe, But Stick to the Seasoned Veterans”), I wrote that high yield Mortgage REITs with relatively “seasoned” portfolios offered much better safety and value than those with portfolios stuffed full of more recent vintage CMBS. Now, analysts at Barclays Capital also say that the pricing on some earlier CMBS are not fully reflecting the safety of the risk-free treasury securities that replaced the original collateral on many of those earlier vintage pools.

Later vintage CMBS is now under a very bright popular media spotlight on news that a $225 million loan for a New York City apartment complex is heading toward imminent default (“How Could My Big Beautiful Loan Go So Bad, So Quickly”). That loan suffered from egregiously aggressive 2007 underwriting standards and had virtually no hope of being repaid. As a result, “headline risk” is again high and many CMBS traders and portfolio managers are once again shooting first and asking questions later.

However, not only were underwriting standards much stronger in earlier vintage CMBS, but many pre-2005 CMBS loans have also been “defeased” by the original borrowers. Defeasance occurs when highly rated collateral, always AAA-rated US government securities, are deposited into an escrow account for the benefit of the lender. The treasuries are sufficient to make all remaining principal and interest payments under the loan, and the lender’s security interest in the underlying real estate is replaced by a security interest in the treasury bonds.

Why does this happen in the first place? Because of the highly restrictive provisions on repayments contained in every loan destined for CMBS pools, borrowers are “locked out” from paying off the loans for at least five years. After that, prepayment is subject to terms that protect the lender (and ultimately the CMBS investors) from “re-investment risk”, which is what happens when you get a pile of money back in an unfavorable (low) interest rate environment. Nevertheless, owners of property purchased in earlier years that had been financed via the CMBS market needed to have some way to pay off the loans and cash out when they sold, particularly in the ebullient years of 2005-2007.

This was accomplished by defeasing the loan, a practice that got off the ground for CMBS in 1999 (it was already widespread in other markets). Defeasing CMBS loans grew in popularity, and by 2002 the business had taken off. Many, many earlier vintage CMBS loans were defeased and are now backed by AAA rated government securities, instead of beaten up shopping malls full of Bennigan’s and Steve and Barry’s.

While the effect of higher credit enhancement is widely recognized, the Barclays analysts think that the market is nevertheless “grossly mispricing” heavily defeased CMBS. They contend that the 2005 to 2007 surge in defeasances left many older vintage collateral pools with over 25% in risk-free government collateral. Such risk-free assets should command a premium in today’s uncertain environment, although they say current market spreads do not reflect that or maybe the Chinese are just dumping every treasury-related security they can lay their hands on.

Pricing on high defeasance paper is roughly five to 10 basis points tighter depending on the vintage — but the analysts think that bonds with high defeasance should command an additonal a 20 to 40 basis point premium compared with non-defeased senior tranches as a result of the more favorable risk profile.

Clearly value does remain in CMBS and the collateral; the real question hovering around the room late at night is what is the value of the real estate supporting it? Analysts agree that cash flows are holding up, but that investors are simply continuing to pay less and less for those cash flows. And that whistling sound you hear in the background is just a lot of people in the graveyard, wondering how much longer that will go on.

“The Taliban used to hang the victim’s body in public for four days. We will only hang the body for a short time, say 15 minutes. Adulterers will still be stoned to death, but we will use only small stones.” Afghan judge Ahamat Ullha Zarif on a kindler, gentler Afghanistan

This volume increase resulted from a combination of huge demand and a commensurate decrease in underwriting standards, including (among other things), a relaxing of traditional loan-to-value criteria. Moody’s estimated that the gap between the Moodys LTV and underwritten LTVs reached record in the first quarter of 2007 (nearly 45%). The Moody’s estimate of actual LTV also reached a record of 106.5%. Who needs equity when lenders will give you more money than the property is worth?