Tuesday, November 18, 2008

CMBS Hitting the Fan

Stock market investors who find themselves perplexed by the continued weakness in insurers and financials can look for clues in the commercial mortgage backed securities market.  In addition to the residential mortgage debacle, banks and insurers hold huge portfolios of commercial mortgage loans and securities, investments which are currently getting pounded due to increasing fears of impending defaults.  The Wall Street Journal has a great story detailing the rapid deterioration in CMBS.  According to the article, the market for debt used to finance hotels, offices and shopping malls tumbled Tuesday on fears of a wave of defaults in the $800 billion commercial real estate securities market.  Two big commercial mortgages that were packaged into securities in the past year are on the verge of defaulting.  Both of the large loans, a $209 million loan backed by two hotels and a $125 million loan backed by a mall, were "pro forma" loans.  For those unfamiliar with the jargon, "pro forma" is investment banking-speak for "numbers we invented."  You see, if the actual cash flows from the building were utilized, the loans wouldn't really make sense financially.  In order to get around this minor inconvenience, the goons at JP Morgan, who underwrote these specific loans, just assumed that operating income would go up, alot, in the future.  And really, why would they even care?  The loans were just shoveled into a CMBS and passed along to the boob investor who bought the securities because some idiot at the rating agency slapped it with a AAA rating.  Given that this level of underwriting scrutiny was the status quo for several years, can anyone possibly be surprised that spreads in AAA CMBS have widened to record levels?

The overall number of commercial mortgages packaged into securities that are 30 days or more past due rose to .64% in October from .39% at the end of last year, with most of the increase coming in October.  Although fairly low by historical standards, the delinquency rate was the highest in two years.  Clearly delinquencies are set to soar as borrowers are unable to refinance into new loans on terms similar to those they negotiated during the boom.  Furthermore, with the economy weakening significantly, operating income is more likely to decline as office vacancies increase, consumers stop visiting malls, and both business and pleasure travelers cut back on time spent at hotels.  The news in the commercial real estate market is likely to get much worse.  


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