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Only a few short months ago, borrowers routinely obtained full-leverage permanent loans - 75% to 80% LTV - at spreads averaging 115 bps over Treasuries. Suddenly, during late July and August, these mortgage spreads jumped to as high as 200 bps over Treasuries before settling - for the moment at least - at around 175 bps.1 At our recent Quarterly Real Estate Breakfast, a distinguished panel representing the life company, Wall Street, and banking sectors gave their views on what made the spreads widen so suddenly - and where they're headed over the next 12-18 months. We combined their perspectives with our own market knowledge, and offer the following assessment of the situation facing borrowers today.
Let's start by getting some perspective. The chart below shows mortgage spreads going back to January 1, 1996, and points to three events that have pushed these spreads up significantly since then. Note that today's spread of 175 bps is only slightly above the historical average of 160 bps. After our Quarterly Real Estate Breakfast 18 months ago, we reported that the below-average spreads we'd all been enjoying since early 2004 could not continue. We forecasted that one of several kinds of events would eventually push up mortgage spreads. The one that fulfilled our prediction was a "credit and liquidity event" - the recent flight of investors from sub-prime home mortgages.
The problems with residential mortgages during the spring and summer of 2007 infected spreads in the commercial market through the specific funding mechanisms used by CMBS lenders. These lenders, who raise money by packaging mortgages and slicing up the resulting pools for sale as CMBS (Commercial Mortgage Backed Securities), have become by far the largest providers of permanent mortgages. Where they lead, the whole commercial mortgage market follows. Here's what happened in this shake-up:
Buyers of CMBS became worried - with some justification - about the risks of the underlying real estate loans in the pools these investors were buying into. After all, the rating agencies that failed to assess adequately the risks in pools of subprime mortgages were the same ones providing ratings on commercial CMBS. What were the agencies overlooking or ignoring? Faced with uncertainty, the bond buyers can be said to have over-reacted. The commercial mortgages in CMBS pools are, in fact less risky than subprime mortgages. But it's also true that the CMBS lenders had been getting "fast and loose" in their underwriting for some time: using aggressive capitalization rates and thin debt coverage ratios, structuring in long interest-only periods, and waiving funded reserves and escrows. We have noted these trends in successive editions of our quarterly Lender Survey.
CMBS buyers were jolted to the recognition that issuers had oversold them on the risk-reducing benefits of diversification, the main advantage gained through pooling loans. After all, the pools are entirely composed of commercial mortgages, subject to the same general economic factors that could cause defaults to whole groups of loans. Also, even a small number of defaults in a pool would hit hundreds of investors. So buyers became skittish. Meanwhile, in the case of a more arcane technique for selling diversification, investors just bolted. The highest risk ("B piece") bonds in the CMBS pools had been raising funds cheaply through CDOs (Collateralized Debt Obligations), offering yet other investors reduced risk through diversification - investing in a package of high-risk B-pieces rather than just one. After all, those B-pieces couldn't all collapse at once....or could they? By August, CDO funding for CMBS pools had vanished, taking away an important source of liquidity.
As result, buyers of CMBS demanded both higher returns and more stringent underwriting. Investors in the lowest-risk, AAA-rated bonds, were getting yields in September that were 45 bps higher than what they commanded in June. Investors in the CMBS with the mid-range of risk - bonds rated AA to BBB - left the market in droves. Those who remained demanded steeply higher returns, and they combed the loan files in prospective securitizations, insisting on much more conservative underwriting. Finally, as we mentioned a moment ago, the investors in high-risk paper from the pools - the B-piece buyers - found their inexpensive CDO funding mechanism had dried up. So they now needed higher returns. They also rummaged through loan files before agreeing to invest and began "kicking out" a much larger numbers of loans that they considered too risky. Loan originators tightened up underwriting to avoid these dreaded "kick-outs."
The rating agencies demanded higher "subordination levels" - meaning that bigger portions of each pool needed to be funded by higher risk, and higher yield, bonds. AAA buyers, who had funded as much as 90% of the pools in the spring, now invested in only the bottom 85%. Other, higher yield bond investors had to take up the slack, thus pushing up the blended average yield on the pool - and passing on the increase to ordinary borrowers in the form of higher spreads on loans.
Finally, the loan originators - mostly large banks and Wall Street firms - insisted on higher profit margins, and this further pushed up the spreads offered to borrowers. The originators needed higher margins for two reasons. First, they found themselves with alarming numbers of "kicked out" loans that, if not securitized, would likely need to be sold at a loss. The lenders needed higher profits to cover that additional risk. Second, with their rates high and their ability to execute uncertain, these lenders were writing much less loan business. So there was no way to operate at the razor-thin margins of the past couple of years and "make it up in volume."
For borrowers, the result of all these pressures has been both higher prices and lower loan proceeds. Life companies, always the conservative lenders, increased their spreads to levels somewhat below the conduits, but have stuck to their disciplined underwriting. This is where we are today. So where are spreads headed over the next 12-18 months?
The higher spreads are here to stay. We won't see those spreads in the low 100s' again any time soon. Today's spreads are, after all, close to a historical average, and they have increased to reflect the real risks in commercial mortgages. CMBS investors, except perhaps for the AAA buyers, have no reason to drop yield requirements any time soon. And CMBS lenders, faced with more "kick-out" risk along with lower volume, will cut overhead or sit on the sidelines before reducing profit margins.
Events that could push spreads higher are more likely than any trends that could push them lower. A recession would increase the relative risk of all non-Treasury debt instruments, increasing spreads on mortgages along with corporates and other bonds. As the graph above shows, this is what happened in 2000-2002. Also, any increase in defaults, or even delinquencies, in the loans underlying existing CMBS pools would cause investors in new pools to push up yield requirements. Such a stress on existing loans would be a likely result from any economic recession, and could also appear as a consequence of the aggressive underwriting of the last twelve months. Finally, as we saw in the Russian debt crisis of 1998 and the recent subprime turmoil, any "flight-to-quality" event tends to push mortgage spreads upward.
The "wild card" in forecasting future spreads is the effect on the supply of mortgage dollars from decreases in loan volume from CMBS lenders. As a result of less competitive pricing and uncertain execution, their volumes have dropped precipitously from the red-hot pace of 2006 and early 2007. Until conditions in the securitization market settle down, CMBS originations will continue to be weak. Insurance companies and banks simply do not have the capacity to take up the slack. If CMBS lenders are unable to contribute a significant share to the commercial mortgage market, spreads will have to rise to entice them back in - also to draw enough additional funding from insurance companies and banks - in order to meet loan demand.
To summarize, we see flat to rising spreads in the next two quarters, and very possibly beyond that. In addition, we can point to some recent shifts in the competitive dynamics among permanent loan sources that will result in a changed landscape for borrowers.
Our best guess is that the CMBS lenders will return to the market in early 2008, at origination levels well below their earlier pace. With higher pricing than life companies, the CMBS lenders will go back to focusing on "B-" and "C" quality assets.
The two-tier market of the 1990s will re-emerge. Life companies will go on cherry-picking the higher quality assets. CMBS lenders will underwrite the lower quality deals with disciplined underwriting and well-funded escrows. Banks will compete with CMBS lenders by offering more borrower-friendly service to offset their somewhat higher pricing. FHA will attract more of the full-leverage multifamily business, and they may push spreads down a bit on this most attractive asset class.
Finally, where do borrowers facing financing decisions stand today? Funds are adequate ...Spreads are at an average level... 10-year Treasuries, in the "mid 4s," are below their average of 5.11% since 1996. So despite all the turmoil, borrowers today can obtain permanent loans in the "low 6's" - which looks pretty good in historical perspective.
1 Obviously you pay less for low leverage loans and on favored property types like apartments, more for riskier asset classes like hotels. Today's full loan spread is widely available from life companies, but is less than spreads typically quoted by CMBS lenders
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