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Monday, 10 June 2019

The CMBS Market Turns 25: From Mega Deals to Miami Beach

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By Manus Clancy, Trepp LLC

Heading into the summer of 1998, those who helped create the CMBS market had every reason to feel optimistic about the industry's future. The market was now several years old, a number of banks had started "shelves" for issuing CMBS deals and the types of issues had evolved from deals with just a few large loans to deals made up of hundreds of loans and balances totaling in the billions.

Lehman Brothers Commercial Trust, 1998-C1 (LBCMT 1998-C1), which amazingly still remains outstanding more than 20 years later, was a case in point. It was issued in March 1998 and had 259 loans at securitization with a total balance of more than $1.7 billion. It wasn't unique as other investment banks, including JPMorgan, Citigroup, DLJ, Credit Suisse First Boston, Merrill Lynch, Morgan Stanley and Goldman Sachs, each had launched their own. Soon to follow would be Bear Stearns, Prudential Financial, First Union, Deutsche Bank, Salomon Smith Barney, Paine Webber and Wachovia Securities.

By the time most of the industry assembled for CMBS pioneer Ethan Penner's annual post-Labor Day fete that year, the CMBS market was already facing its first existential threat. The Russian debt crisis that August had resulted in the collapse of Long-Term Capital Management. The hedge fund buckled the following month and a consortium of 16 banks cobbled together more than $3 billion in bailout funds to keep the LTCM default from turning into a financial market epidemic. As one CMBS Founding Father said at the time, "there's blood in the water."

You might say, where there's blood, there's also rumor. The scuttlebutt in the CMBS industry was that some of the issuers were sitting on huge mark-to-market losses. The early issuers, like today, would warehouse loans until they reached critical mass for bringing a deal to market. They would hedge for interest rate risk, but spread-hedging was either non-existent or tricky. They also tended to warehouse for longer periods of time than they do now, so the balance of loans on the firms' books would swell.

As spreads blew out late in the summer of 1998, the value of the loans being warehoused plummeted. The spread widening was underscored by the miserable execution of Morgan Stanley Capital I Inc., 1998-CF1 (MSC 1998-CF1), which priced in August 1998 near the height of the storm.

But the CMBS industry was not one to turn its back on a good time, and Penner's 1998 confab would go on in the face of the tumult.

The Father of CMBS

If Lewis Ranieri was the father of mortgage-backed securities and collateralized mortgage obligations, Ethan Penner was the father of CMBS.

The beauty of residential loans, as far as securitization was concerned, was their homogeneity. There were no tenants to worry about; prepayment restrictions did not exist; borrower names could not be revealed; and loans had similar terms. An investor might know only a few pieces of information about a loan, its balance, rate, whether its coupon was fixed or floating, its term, location of its collateral and the property type. There wasn't much more than that.

Things were messier in the CMBS market. The Resolution Trust Corp. (RTC) was started in the late 1980's to help liquidate assets the federal government had inherited from failed savings and loan institutions. The market for securitizing residential loans had been established years before the S&L crisis with the issuance of MBS and CMOs.

The same couldn't be said for commercial mortgages. Data for the sector was considered lumpy, idiosyncratic and incomplete. Nonetheless, the RTC found success creating securities backed by these "noisy" assets.

That gave Penner his opening. But credit for the structural nuances of CMBS must go to the RTC. Its deals included both a master and special servicer, for instance, which became a staple of CMBS deals.

Some of Penner's early deals came with the moniker "mega." The deals contained a small number of large loans—hence the "mega" name. The first such deal was Nomura Asset Securities Corp., 1994-MD1, (NASC 1994-MD1). Others could lay claim to having done the first CMBS deal, but earlier deals were either single-asset or single-borrower transactions. NASC 1994-MD1 was backed by nine loans against properties owned by different sponsors. It was the first private-label, multiple-borrower transaction. Despite having only nine loans in its collateral pool, the deal was structured with 15 bond classes.

Profits from early CMBS deals were sizable. After all, few lenders were actively competing for loans. Penner used some of those profits to throw terrific parties that are still talked about today. At one event, he talked the Eagles rock band into reuniting for the entertainment of his audience. He would raffle off cars to lucky winners. Bob Dylan would be coaxed into singing for the commercial real estate "man."

The 1998 version of Penner's gala was not lacking in star power. Even as the foundations of the CMBS market rocked, nothing at the San Francisco party hinted at the concerns. Comedian Bill Maher hosted the opening session. Other guests included former Presidential candidate and later California governor Jerry Brown, as well as San Francisco Mayor Willie Brown. The first night's dinner entertainment was provided by Diana Ross. On night two, Robin Williams served as the warm-up act. He'd be followed by Joni Mitchell, Stevie Nicks, Don Henley, Michael McDonald and Gwen Stefani, among others.

You could say that the San Francisco blowout was the end of phase one of the CMBS market. Nomura would suffer a $2 billion quarterly loss, but it wasn't alone. Others, who entered the market because of the sizable profits to be had, took a beating as well.

It would not be the last time the market would face adversity and certainly not the first time the industry's resilience would be called into question. With that introduction, we offer up a 25-year retrospective of the CMBS industry—the highs, lows, mistakes, innovations, near-death experience and revival.

Phase I – 1994-1998: The Early Days

While Ethan Penner was at the center of the founding of CMBS, he was hardly alone. Lehman Brothers and Credit Suisse First Boston were also aggressively building teams to support the new financing vehicle.

The early deals were tricky for several reasons. First, the data was messy. Issuers struggled with how to represent lockout provisions. Even stickier were yield maintenance calculations. No two calculations seemed to be the same—and describing the nuances in a prospectus was burdensome.

Interestingly, some of the early Nomura deals included extremely intensive calculations. In an effort to accurately distribute yield maintenance charges, the calculation called for all bonds' cash flows to be projected, first assuming the prepayment did not take place and then assuming the prepayment of the loan. The difference in cash flows between the two scenarios would be discounted and served as the basis for distributing yield maintenance. As a result of the complexity, a prepayment scenario could take 20 minutes to calculate. The method was noble, but impractical for traders. It was phased out after a few deals.

Then came the issue of how much could be disclosed—Tenant names? Borrower names? Lease expiration dates? Net operating income? Occupancy?

Money managers were hesitant to allocate a great deal of capital to the asset class because of the lack of transparency and liquidity in the space. At the time, data were transferred not by email, but through the distribution of floppy disks via overnight mail or messenger.

One of the most noteworthy contributions to the early evolution of CMBS was the formation of what then was the CSSA, the Commercial Real Estate Secondary Market and Securitization Association, which in 1999 changed its name to the CMSA, or Commercial Mortgage Securities Association, and more recently to CREFC, or Commercial Real Estate Finance Council.

The trade group was overseen by members from banks, rating agencies, servicers and CMBS investors, all of whom were committed to putting the industry on a strong footing.

Among its early moves was the development in 1997 of the Investor Reporting Package, or IRP, a standardized layout that would be adopted by all servicers and trustees for purposes of updating monthly loan and bond data. The IRP still exists and is now in its eighth iteration. But it was the early founders that established the protocols and the schematics upon which the industry was built. The first version contained some 100 of the most important bond and loan property level fields. It's grown substantially since then to also include property and deal-level file standards.

Another important milestone was the issuance in 1996 by Lehman Brothers of Structured Asset Securities Corp., 1996-CFL (SASC, 1996-CFL). The so-called ConFed deal included 558 loans—some fixed, some floating—that had been on the books of the former Confederation Life Insurance Co. The ability to securitize such a heterogeneous and sizable number of loans gave confidence to the fledgling market that intricate deals such as this could get issued.

One sign that the CMBS market was ready for prime time was that Jack Kemp, then vice presidential nominee, was tapped as keynote speaker at the industry's 1996 conference, just two days following that year's presidential election.

Also advancing the market was the emergence of new data and analytic providers. Conquest and Trepp (which owns Commercial Real Estate Direct) began to develop websites and data sources that were better contoured to the nuances of commercial real estate. The tools gave investors better transparency into collateral data. They also provided trading-quality data and models to bond traders and developed analytical tools for investors, allowing them to stress bond cash flows.

Issuers, trying to lure borrowers, briefly offered and underwrote "buy down" loans. In a nutshell, a borrower would make an upfront cash payment in exchange for a lower coupon, effectively buying down the interest rate. But that made the loans appear to have a higher debt-service coverage ratio than they might have had without the buy down. When investors discovered the technique, the practice was quickly retired.

One footnote of this era came as a result of the LTCM crisis. The first conduit deal larger than $1 billion was issued in late 1996; the first greater than $2 billion came exactly one year later; the first to pass $3 billion just four months after that. The industry would not see a $4 billion deal for another seven years. The lesson learned from watching big losses come from overstuffed warehouse accounts in 1998 led issuers to bring deals more quickly to market, rather than letting risk linger awaiting securitization.

Phase II – 1999-2004: Dealing with Externalities

The second phase of the CMBS market was dominated by events outside the control of the commercial real estate industry. The bursting of the dot-com bubble followed by the terror attacks of Sept. 11, 2001 resulted in volatility, but they weren't existential threats to the CMBS industry.

From 2000 to 2002, the bursting of the dot-com bubble resulted in a nearly 80 percent drop in the tech-heavy Nasdaq stock index. By itself, this did not force the CMBS primary market to become unglued. But the volatility in the market kept issuers on their toes. The huge collapse of the Nasdaq index led to lower interest rates, however, which benefited borrowers, even as bond spreads widened.

More impactful were the 9/11 attacks. Once the nation began to emerge from its grieving, several questions had to be answered: Would Americans continue to travel by air as readily as they had in the past? Sadly, would large office buildings, hotels and shopping centers become soft targets? Could properties be insured against terrorism risk?

The early reaction had the effect of suppressing issuance. In the wake of the 9/11 attacks, issuance came to a standstill. Concerns about hotel loan defaults—particularly from vacation destinations—spiked. Bond issuance stalled until questions about how properties would be insured against damage caused by acts of terrorism were addressed. Congress the following year passed the Terrorism Risk Insurance Act, opening the door for property owners to obtain insurance against terrorist acts. CMBS issuance slowly re-emerged.

The second Phase of the evolution of the CMBS market ended with the market finding its footing.

By 2004, optimism had returned and issuance grew. Because of jitters from events early in the decade, the deals issued in 2003 and 2004 were underwritten conservatively and ultimately suffered only modest losses compared to deals issued later. But the seeds for the next crisis were being planted. Without much fanfare, mezzanine lending was starting to grow, giving borrowers the ability to put more and more leverage on their properties. The securitization of those mezz loans—along with the securitization of non-investment grade bonds—began to emerge in late 2003 and 2004. Leverage on senior loans also began to increase, as did the volume of loans that paid only interest for their full terms.

Phase III – 2005-2007: The Go-Go Years

If the years before the Great Depression of 1929 were known as the 'Roaring 20s' can we call the stretch between 2005 and 2008 the 'Imprudent Aughties?'

Unlike with the dot-com bubble, commercial real estate was just about front and center for the Financial Crisis of 2008. The subprime residential mortgage market gets the top spot, but commercial real estate certainly was up there.

The era saw explosive jumps in property values, the collapse of borrowing spreads, which further pushed values higher, the growth of collateralized debt obligations, the introduction of synthetic CDOs, the start of "pro forma" lending—that is, lending based on expected property income growth—and a sharp reduction of borrower equity in properties. In fact, toward the end of the cycle, because borrowers could line up generous layers of senior and mezzanine debt, as well as B-notes, they'd often have equity totaling less than 10 percent of a property's value. That's not even considering the often inflated appraised values of the time. If mark-to-market valuations had been done in 2009, many loans from 2007 would have been found to have negative equity.

Of course, issuance took off as liquidity exploded. By 2007, total CMBS issuance peaked at $230 billion, a record unlikely to be topped anytime soon. Newly issued benchmark CMBS bonds—those with the highest possible ratings and 10-year average lives—were being priced at a spread of 25 basis points more than Treasurys or less. Spreads on BBB- bonds were regularly printing in the 70-bp range. And many B-pieces—comprised of bonds rated BB- and below—found their way into CDOs, which allowed B-piece buyers to leverage their investments and effectively sell off much of the risk they held.

Other markets were opening up as well, as there was issuance growth in Europe and Japan during this time.

At the loan level, standards were loosening at every turn. These examples look reckless in hindsight, but were representative of commonly accepted practice in 2006 and 2007:

• The $1.22 billion of CMBS debt on the trophy office building at 666 Fifth Ave. in Manhattan was underwritten with a DSCR of 1.46x, but the in-place DSCR was only 0.65x. Lenders assumed in-place rents, which were in the $40/sf range, would eventually double as leases rolled. The loan defaulted in 2011, with a large portion of the original balance written off.

• The $3 billion loan against the 11,241-unit Stuyvesant Town/Peter Cooper Village apartment property in Manhattan was underwritten with an in-place DSCR of well less than 1.0x and an assumption that the new owners could move a large chunk of the property's rent-stabilized units to market rents. The senior loan against the property ultimately paid off in full. At one point, the property's value had declined so much that it implied a 50 percent loan loss.

• The Biscayne Landing loan was essentially a construction loan stuffed into CMBS. The project was given a $475 million valuation even though construction was only beginning. It was resolved at a total loss.

But as with U.S. stocks and residential housing at the time, there seemed to be no peak in sight.

Phase IV - 2008-2010: The CMBS Ice Age

The lights went out on the CMBS market on June 27, 2008. That was the closing date of Banc of America Commercial Mortgage Inc., 2008-1 (BACM 2008-1), the last CMBS conduit deal that would get done for 21 months.

The signs of a potential market demise came earlier that year as residential mortgage delinquencies spiked. Bear Stearns defaulted in March 2008 and fixed-income spreads were gapping out across all assets classes.

One of the first signs that problems would not be limited to the residential space came in August 2008, when it appeared the $225 million loan against the 1,228-unit Riverton apartment property in Manhattan's Harlem section would default. All of the property's units were subject to New York City's rent-stabilization rules that limit annual rent increases. The sponsors, a venture of Rockpoint Group and Stellar Management, set up a large reserve to cover debt-service payments while they worked to bring rent stabilized units to market-level rents. The pro forma DSCR on the loan was 1.73x, but that assumed successful transition of a large number of apartments, which was not easy, as it would turn out. The in-place DSCR was only 0.39x and the reserve would run out in the summer of 2008, triggering the default—less than 18 months after the loan was securitized.

Until then, many CMBS investors had not realized that CMBS loans were being underwritten on a pro forma basis. The news of the default rattled the CMBS market even more. The loan would ultimately suffer a loss of nearly $107 million.

The Riverton story was followed by countless other defaults on loans that were underwritten at peak valuations, with little equity and pro forma financials. The previously mentioned 666 Fifth and StuyTown loans also defaulted. Large mall owner General Growth Properties would file for bankruptcy as would Innkeepers Hotel REIT. Office developers struggled to stay afloat.

Over time, the Trepp CMBS delinquency rate would top 10 percent. Several loans were resolved with losses north of $100 million.

Phase V - 2011-2019: The Comeback

The first sign of the CMBS market returning actually came in late 2009 when JPMorgan Chase Commercial Mortgage Securities Trust, 2009-IWST (JPMCC 2009-IWST) and Banc of America Large Loan Inc., 2009-FDG (BALL 2009-FDG) were issued. The former, a $500 million, single-borrower transaction, breathed life into the market. Backed by a pool of several dozen retail properties, it had a loan-to-value ratio of less than 60 percent. The hopes of CMBS desks everywhere were riding on its shoulders.

The revival of the CMBS market was helped by the Term Asset-Backed Securities Loan Facility, or TALF, program. The liquidity facility, which was announced in November 2008 and kicked off a few months later, opened up trading in CMBS, which had been all but shut down. The program was closed for new loans in June 2010 as a result of the markets becoming sufficiently liquid.

At the height of the panic, in late 2008, the bellwether AAA-rated A4 bond of GS Mortgage Securities Corp. II, 2007-GG10 (GSMS 2007-GG10) was being quoted at a spread of 1,500 bps more than Treasurys, which corresponded to a price of around $50. Many mezzanine and junior AAA bonds (AMs and AJs) were being quoted in the $20 or $30 range or less. The TALF program began a march that would eventually lift the value of those bonds back to par or better. While senior AAA classes avoided losses, some AMs and many AJ ultimately would suffer losses.

To be sure, the comeback was slow, with 2010 seeing about $12 billion in total private label issuance—a fraction of what had been issued in 2007. In addition, many of the loans issued in 2006 and 2007 remained outstanding and in default—a constant reminder to investors of the risks in commercial real estate.

The new decade brought work back for a great many. For originators and issuers, new lending—while not coming close to the go-go years of 2006 and 2007—continued to grow. Private-label CMBS issuance grew to $80 billion in 2013 from roughly $30 billion in 2011. Special servicers aggressively dealt with the mountain of distressed CMBS loans and foreclosed properties. Distressed asset buyers found plenty of places to play in the debt and equity markets and savvy CMBS investors that bought during the panic watched values steadily increase.

Many CMBS pros that had been in the industry from the beginning, worked again to help add even more transparency to data supplied by borrowers through trustees and servicers. Primary issuance spreads were much higher than in 2007, better reflecting the credit risks of commercial real estate. AAA bonds were structured with more credit enhancement than in 2007 and loans were underwritten much more conservatively.

The strong growth—albeit from a modest base—that took place from 2011 to 2013 gave way to more modest growth in the middle of the decade. Issuers, originators and investors remained busy as $90 billion of bonds came to market in 2014 and about $95 billion in 2015.

That time frame gave way to a new set of concerns for investors, however.

The Greek Debt Crisis forced spreads across the globe wider, leaving CMBS investors wondering if a new financial crisis was emerging. Investors also were left to wonder what would happen to all the loans that were originated in 2006 and 2007 when they reached their maturity dates in 2016 and 2017. The term "Wall of Maturities" emerged as bondholders pondered just how big the losses would be on "legacy" deals once those loans had to be refinanced. Many ultimately had their terms extended, while others suffered sizable losses.

The first signs that e-commerce could weigh on brick-and-mortar retailers began to emerge in 2016. The collapse of oil prices raised the specter of defaults on Houston office loans, as well as multifamily and hotel loans from North Dakota to West Texas. Retailer bankruptcies of all sizes started to crop up—from Sports Authority to Toys 'R' Us to Sears and several dozen others. Cracks in the student-housing market began to appear. Grocery store chains, normally considered beyond the reach of e-commerce, began to see defaults and store closings.

Late 2016 introduced one of the last challenges to the "comeback" era. The Dodd-Frank era legislation mandated that CMBS issuers had to keep "skin in the game" by retaining at least a 5 percent stake in any new CMBS deal. The stake could be held by B-piece buyers, but they'd be restricted from leveraging, hedging or selling their positions, essentially for the life of a deal. That introduced a new wrinkle to issuers.

For a stretch, it appeared that the mandate might bring the CMBS market to another halt and many feared that the CMBS market would witness another hibernation. The theory had merit. It was anticipated that B-piece buyers would need significantly greater yield compensation to meet the mandate, making CMBS less competitive compared to other lending sources like banks and insurance companies. What wasn't expected was that bond investors, particularly those high in the capital stack, would pay up for bonds from deals subject to the risk-retention rules. Those tighter spreads kept CMBS competitive with other lending sources and the industry dodged another bullet.

As has been its tradition, the industry continued to innovate throughout the post-crisis comeback. New types of loans were created and securitized. Non-performing loan deals started to emerge as did issues backed by single-family rentals. The latter came as a response to the need to recapitalize underwater single-family homes from the financial crisis.

Also appearing were commercial real estate collateralized loan obligations as another financing vehicle.

The post-crisis period also saw enormous growth among the government-sponsored enterprises, or GSEs, in direct multifamily lending. The surge, which began immediately after the financial crisis, was a response to the shutdown of the private-label CMBS market in 2008-2010. Prior to the crisis, the GSEs had participated in multifamily lending by purchasing "multifamily directed" CMBS bonds, their A-1A classes. Meanwhile, the agencies, Fannie Mae and Freddie Mac, developed their own securitization platforms. As a result, CMBS would never recover its lost multifamily lending market share. Multifamily lending remains a smaller part of recent vintage CMBS than it was from 2005 to 2007.

Phase VI – 2020 and Beyond

Over the last 25 years, the CMBS market emerged from scratch to provide an additional funding source for commercial real estate property owners, it has lowered the cost of borrowing and has made commercial real estate far more liquid than it ever was. The market has seen a number of innovations, many the product of sweat equity rather than lightning-bolt inspiration. Of course, there have been several near misses. Some might say the market has been lucky to survive 25 years. But as Branch Rickey, the legendary Brooklyn Dodgers general manager, once said, "luck is the residue of design."

We think that applies well to the CMBS market, which has been at the forefront in reporting timeliness, consistency and transparency. The early efforts to establish these standards served the market well during the various dark times. Investors trusted the industry to come up with new reporting standards in response to crises, because it had always done so in the past. This type of forward-looking mindset has served the industry well for 25 years and we believe the foundation has been put in place for the market to continue to grow and thrive.

See you all at the Golden Anniversary!

Comments? E-mail Manus Clancy or call him at (212) 754-1010.


“The Weekly”

“The Weekly” is Commercial Real Estate Direct’s PDF newsletter, sent to subscribers every Friday morning. With over 100 news stories published on Commercial Real Estate Direct each week, “The Weekly” features the top stories in commercial real estate that industry participants need to know first. “The Weekly” also contains:

  • Breaking mortgage, CMBS, and REIT news

  • Quarterly league tables with rankings of B-piece buyers, book runners, and lenders

  • Industry moves and changes in “The Insider“

Additional Info

  • Syndicate to Realpoint: No
  • Subject: CMBS - non-deal specific (CMBS-G), Commercial MBS (CMBS)
  • Private: No
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Data Digest







Top Bookrunners Domestic, Private-Label CMBS - 2017
Investment Bank #Deals Vol$mln MktShr%
Goldman Sachs 17.59 11,819.34 13.68
JPMorgan Securities 14.52 10,968.11 12.70
Citigroup 12.04 10,012.71 11.59
Wells Fargo Securities 14.02 9,936.06 11.50
Deutsche Bank 12.55 9,879.74 11.44




cppichart FP



CMBS 2.0 Spreads


Top CMBS Loan Contributors - 2017
Lender #Loans Vol$mln MktShr%
Goldman Sachs 146.89 11,719.34 13.63
JPMorgan Chase Bank 117.68 10,114.14 11.76
Deutsche Bank 198.48 9,689.97 11.27
Morgan Stanley 166.18 8,539.78 9.93
Citigroup 199.05 8,088.24 9.41





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