Transcript The Growth and Performance of Public International Real

U.S. Commercial Debt Markets
Evolution
&
Dislocation
By
Glenn R. Mueller, Ph.D. – Professor
Kyle Cascioli – Adjunct Professor
Why Real Estate Fits A Portfolio - Size
U.S. Real Estate vs. Other Asset Classes - 12/06
Most US Institutional Investors
have an allocation to Commercial
Real Estate between 5% & 20%
Source: Pension & Investments, October 30, 2006 and Prudential Real Estate Investors, December 2006.
All Real Estate = Half - 12/06
U.S. Real Estate Values = $33.3 Trillion
Institutional Investors do NOT
buy homes – individuals buy them
to live in – they do NOT produce
income
Source: Prudential Real Estate Investors, December 2006.
Only 5% of all home
mortgage loans are
“sub-prime” loans
$ CAPITAL $
•DEBT is Major component of Real Estate
•Historically private loan sources (Banks, Ins Co’s)
•Major access to public CMBS markets in 1990s
•Cross boarder investing grows in 2000s
•Size and health of markets drives future values
Real Estate Has 2 Sectors –
Residential & Commercial
•Residential “Mortgage Backed Securities”
(RMBS) Started in the 1960s
•All prime RMBS investors take same risk
Home Mortgage
Home Mortgage
Home Mortgage
Home Mortgage
Home Mortgage
Home Mortgage
Home Mortgage
Home Mortgage
Home Mortgage
Home Mortgage
$
RMBS
Pool
$$
$
Investor
Investor
Investor
Investor
Investor
Investor
Investor
Investor
Investor
All investors
share equal
risks
PRIME Residential
Debt Market Works because
•Standard Underwriting on all loans
•80% Loan-to-Value (LTV) or debt maximum
•28% of borrower income to pay monthly debt
(known as PITI) principal, interest, taxes insurance = debt coverage
•Credit Check on Borrower – must have
minimum credit rating- or FICO score
•64% of U.S. population meets prime criteria
Freddie Mac
Ginnie Mae
Fannie Mae
US Government “Enhances” Credit & Reduces Risk through
The Fairy Godmothers of the Residential Mortgage Market
(Quasi-Government Agencies) – they do NOT make sub-prime loans
SO – How did sub-prime loans start?
• A LONG story
– Starts with CMBS in 1989
– CMBS evolves or “mutates” to CDOs in 1999
– Was function of cheap $ circa 2005
http://yegsz.com/Yieldsz/index2.html
– Creative Wall Street Bankers figure out how to put
junk into CDOs and get part of the CDO traunche
rated as AAA, AA, & A bonds
COMMERCIAL CMBS is Different
Many Types of Commercial Loans in CMBS
•
•
•
•
•
•
•
•
•
•
Multifamily Housing
Retail
Office
Industrial / Warehouse
Hospitality
Health Care
Self-Storage
Mobile Home Parks
Credit Tenant Leases
Mixed-Use
Commercial Debt Market
CMBS Works Differently
•Complex Underwriting
•75% Loan-to-Value (LTV) or lower debt level
•Look at leases to see if cash flow income can
cover debt payments – need 1.2x debt service
coverage ratio (DSCR)
•Owner/Borrower does NOT guarantee
payments (called “non-recourse” lending)
•Local market knowledge important
Commercial Debt Market
Works Differently
•“Commercial Mortgage Backed Securities”
(CMBS) Started in the 1988
• 1980’s Savings & Loan debacle – (they made bad commercial loans)
• Congressional enactment of the “Financial Institutions
Reform Recovery & Enforcement Act of 1989 (FIRREA)
•US Government creation of the Resolution Trust Corporation (RTC) used CMBS
•CMBS investors each take different risks in each Traunche
Apt Mortgage
Office Mortgage
Retail Mortgage
Hotel Mortgage
Industrial Mortgage
Apt Mortgage
Office Mortgage
Retail Mortgage
Hotel Mortgage
Industrial Mortgage
AAA Investor
AAA Investor
AAA Investor
CM B S
Pool
Traunched
$
AA Investor
AA Investor
A Investor
BBB Investor
BB Investor
B Investor
N R Investor
Each investor
takes different
risks !!
CMBS Has Grown Substantially
250
CMBS Issuance $ Billions
200
150
100
50
0
1989 1991 1993 1995 1997 1999 2001 2003 2005 2007
Source: Commercial Mortgage Association
Commercial Mortgage Historical Default,
Delinquency & Loss Rates
1st Quarter 1988 – 2nd Quarter 2006
Trend Analysis Used to “benchmark” Traunch levels
8%
7%
Delinquency
6%
Foreclosure
5%
Avg Losses*
4%
3%
2%
1%
0%
88 Delinquency
89
90 & Foreclosure
91
92 Data
93 Source:
94 ACLI,
95 Stifel96Nicolaus
97
98
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
Q
2
2
2
2
2
2
2
2
2
2
2
99
00
Q
Q
2
2
*Average loss percentage calculated assuming 65% recovery on defaulted loans
Source: American Council of Life Insurance Companies (ACLI)
01
Q
2
02
03
Q
Q
2
2
04
05
Q
Q
2
2
06
Q
2
Basic CMBS Structure
Sequential Pay
 Time-tranched AAAs
 Fixed-rate bonds

Avg Subordination %
10%
AA
A
6%
BBB
14%
2%
BB
B
0%
NR
4%
Senior I
AAA
AAA
17%
Senior II
Senior III
Subordinate I
% Total Pool
IO
83%
3%
4%
4%
Subordinate II
2%
Subordinate III
2%
First Loss
2%
AAA bonds get paid first then AA, then A, then BBB, then BB, then B – finally Non Rated which is in the first loss position.
Structural View CSFB pool 2002-CKP1
Class
Current
Type
Rating
WAL
Window
A1
54,044
SEQ
AAA
2.5
06/02 - 11/06 PPPPPPPPPPPPPPP
A2
112,435
SEQ
AAA
7.4
11/06 - 08/11 . . . . . . . . . . . . . . . . . . PPPPPPPPPPPPPPP
A3
601,059
SEQ
AAA
9.5
08/11 - 01/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .PP
B
39,715
MEZ, SUB
AA
9.7
01/12 - 02/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . … . .P
C
13,652
MEZ, SUB
AA-
9.8
02/12 - 02/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D
26,063
MEZ, SUB
A
9.9
02/12 - 02/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …. . . .P
E
14,893
MEZ, SUB
A-
9.9
02/12 - 03/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …… . . .PP
F
13,652
MEZ, SUB
BBB+
9.9
03/12 - 03/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …….. . . . . .P
G
14,893
SUB
BBB
9.9
03/12 - 03/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ……….. . . . .P
H
14,893
SUB
BBB-
9.9
03/12 - 03/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …………. . . . P
L
16,134
SUB
BB
9.9
03/12 - 03/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …………... . . . P
M
8,688
SUB
BB-
9.9
03/12 - 03/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . …………… . . . P
N
7,447
SUB
B+
10.0
03/12 - 10/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ……………. . . . PP
O
8,687
SUB
B
10.5
10/12 - 10/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ……………... . . . . P
P
4,965
SUB
B-
10.5
10/12 - 10/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………………. . . . . P
Q
4,964
SUB
CCC (NR)
10.5
10/12 - 10/12 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………………... . . . . . P
Note that A1 gets paid principal back (P) each period for the first 2.5 years,
then A2 gets principal (P) and so on – Q gets paid last in year 10
. .P
CMBS Accepted in US & Globally
Non-US CMBS started a decade after US markets were started
CMBS Issuance
$250
US
billions
Non US
$200
$150
$100
$50
$0
2001
2002
Source: Real Capital Analytics – rcanalytics.com
2003
2004
2005
2006
Commercial Mortgage Market – 2007
($ Billions)
3,000
10%
9%
2,500
Commercial Loan Originations continued
even when Default rates were 7%
2,000
8%
7%
6%
1,500
1,000
500
5%
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
Government Service Entities = GSE
Insurance Co.
Agency/GSEs
4%
Savings Institutions
3%
Commercial Banks
2%
ACLI Delinquency
(right scale)
1%
0
CMBS
0%
Sources: 2Q 2007 Federal
Reserve Flow of Funds
Release
(9/17/2007); 2Q
2007
American Council of Life
Insurance ACLI Mortgage
Loan
Portfolio
Profile
(8/9/2007)
Commercial Mortgage Market – 2Q 2007
100%
CMBS has grown to 25% of
annual commercial loan
originations
80%
CMBS
60%
Agency/GSEs
Insurance Co.
40%
Savings Institutions
Commercial Banks
20%
0%
86 988 990 992 994 996 998 000 002 004 006
9
1
1
1
1
1
1
1
2
2
2
2
Source: 2Q 2007 Federal Reserve
Flow of Funds Release (9/17/2007)
CMBS Market Delinquency Rate
Sources: Morgan Stanley; Trepp
1Q
07
3Q
06
1Q
06
3Q
05
1Q
05
3Q
04
1Q
04
3Q
03
CMBS loans performing
well with VERY LOW
Delinquency rates
currently
1Q
03
3Q
02
1.8%
1.6%
1.4%
1.2%
1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
CMBS viewed as less risky in the market
AAA Subordination Levels
35%
MORE of each CMBS pool have been
rated as AAA each year as they were
found to be less risky (less chance of
delinquency or default) from 70% in
1997 to 88% in 2007
30%
25%
20%
15%
10%
5%
Source: Merrill Lynch
07
1Q
20
06
20
05
20
04
20
03
20
02
20
01
20
00
20
99
19
98
19
19
97
0%
BUT more risk with “Interest Only” Loans
Interest-Only Loans in Conduit CMBS
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
20
05
20
2Q 06
20
07
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Source: Bear Stearns Research
Partial Term IO
Full Term IO
Expect less “interest
only” loans in 2008 as
credit markets tighten
up. Lenders now
want full amortization
BUT Markets don’t know how to price
“new” risks
CMBS Spreads to Treasury
600
AAA rates jump from 75 to 200
500
BBB- jump from 125 to 400
400
AAA rates jump from 75 to 125
300
BBB- jump from 150 to 525 !!
200
AAA - 10Yr
BBB
BBB-
100
0
97
9
1
98
9
1
99
9
1
00
0
2
Source: Citigroup Global Markets
01
0
2
02
0
2
03
0
2
04
0
2
05
0
2
06
0
2
07
0
2
CMBS AAA risks
– not very high
CMBS vs. Other Fixed Income
150
CMBS AAA only 10 BP over
Corporate AAA
125
AAA CMBS
100
Corporate Bank and
Finance
Fannie Mae DUS
75
50
25
Sources: Citigroup Global Markets; Morgan Stanley
9/
07
8/
07
7/
07
6/
07
5/
07
4/
07
2/
07
3/
07
1/
07
0
“Opportunity Funds” as CMBS Buyers
CMBS % Purchased by Opportunity Funds
25%
20%
Opportunity Funds like the risk/return
relationship of CMBS
15%
10%
5%
0%
2004
Source: Morgan Stanley
2005
2006
2Q 2007
CMBS has worked for 20 years
• The risk in the NR traunch was underwritten by Crimmie Mae a
mortgage REIT for the first 10 years - 1988 to 1998
• Crimmie Mae bought all NR traunches, but they reviewed and
approved all loans and also took the special servicer position & fee –
thus Outside / Independent oversight worked well
• When REIT prices declined in 1998 Crimme Mae stopped
purchasing and Wall Street Banks were stuck with the NR traunches
• In 1999 a Wall Street Bank invented CMO (Collateralized Mortgage
Obligations) and placed all their NR traunches of CMBS into the
CMO. (CMOs investing in securities NOT real estate)
• They convinced rating agencies that not all the NR traunches could
go bad – so some of the CMO could be rated AAA, AA and A (and
sold to low risk investors)
CDO created to securitize JUNK
•The CMO idea was so popular that CDOs (Collateralized Debt
Obligations) were created to put other risky debt investments into a
traunched security. CDOs can have credit card debt and other high risk
/ high loss debt in them
•Looking for more high risk investments – the Wall Street Banks
created “Sub-Prime” Mortgages and started selling them through
unregulated mortgage brokers, home builder mortgage companies and
residential home brokers mortgage subsidiaries
•They worked to enlarge the AAA traunch of the high risk CDOs by
purchasing bond insurance to improve traunch ratings
•Without a NR traunche buyer – the Wall Steet Banks kept the NR
traunche on their books – Banks currently taking all their losses
•NO PROBLEMS while the residential market was going UP – but bad
now that the market is going down
New Debt “Innovation (First-Step)”
•Combine Low Quality Debt Loans
•Package them like CMBS
•“Collateralized Debt Obligations” Started 1999
•Each CDO investor takes different risk
BB CMBS
Credit Card Debt
B Debt
NR CMBS Debt
BB CMBS
Credit Card Debt
B Debt
NR CMBS Debt
AAA Investor
AAA Investor
CDO
Pool
Traunched
$
AA Investor
AA Investor
A Investor
BBB Investor
BB Investor
B Investor
“It can’t all go bad! ? So some must be good !”
N R Investor
Each investor
takes different
risks
New Residential “Innovation (2nd-Step)”
•Give Bad Credit Borrowers Loans
•(including credit card and “sub-prime” residential mortgage debt)
•Package them like CMBS
•“Sub Prime Mortgage” Started in the 2000
•Each CDO investor takes different risk
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
Sub Prime Mortgage
AAA Investor
AAA Investor
$
CDO
Pool
Traunched
$$
$
AA Investor
AA Investor
A Investor
BBB Investor
BB Investor
B Investor
N R Investor
Each investor
takes different
risks
CDO Market Pricing Changed Quickly
Spreads 12/31/06 vs. 8/31/07
S+500
S+400
Investors perceive higher risks in Lower Rated Traunches
S+300
S+200
S+100
S+0
AAA
AAA
AA
A+
A
12/31/06
Market
12/31/07
Source: Merrill Lynch
A-
BBB+ BBB BBB-
Market 8/31/07
CDO Market – Flat Issuance Growth in 2007
($ Billions)
40
35
30
25
3Q
20
15
$7.8B
10
5
YT
D
8/
31
/0
7
20
06
20
05
20
04
20
03
20
02
20
01
20
00
19
99
0
Volume of Deals
Source: Wachovia
Market Disruption – P&L Impact on Conduits
(bp)
$1 Billion Portfolio
AAA Spreads
(70% of Capital)
140
600
120
500
58
100
80
60
40
20
0
29
7/1/07
63
BBB Spreads
8/31/07
400
500
300
8/31/07
70
7/1/07
200
247
100
63
0
70
Investors perceive higher risks in
Lower Rated Traunches
CMBS Spread over Swaps
Credit Swap Spread over Treasuries
Insurance Companies saw more Risk in 2007!
CMBS vs. Insurance Company Mortgage Originations
through First half of 2007
($ Billions)
180
160
140
120
100
Capital Markets
Insurance Companies
80
60
40
20
2
20 006
07
YT
D
20
05
20
04
20
03
20
02
20
01
20
00
19
99
19
98
19
97
0
Sources: Commercial Mortgage Alert; 2Q 2007 ACLI Mortgage Loan Portfolio Profile (8/9/2007)
Commercial vs. Residential
• Commercial Mortgage Markets - OK
–
–
–
–
professional people who know what they are doing
AAA debt still trading in the marketplace
Commercial Real Estate fundamentals still good
BBB at high premiums due to uncertainty – market will adjust
• Residential Mortgage Markets – need to settle
– Prime residential loans still - OK
– Sub-Prime loans in trouble (but only 5% of total market!)
• Banks hold lowest traunch where “first loss” is taken
• U.S. Government stepping in to help resolve problem
• At least one year till resolution and market settles
Conclusions
•CMBS gives liquidity / lower cost to Real Estate debt
• CMBS – lower B traunches are mis-priced today (the opportunity)
•CDO created way to repackage / improve rating on high risks
• Most CDOs have securities NOT assets behind them!!
•Sub-prime residential debt hurt ALL debt markets
•
(dis-location creates opportunity)
•BUT – sub-prime is only 5% of all US mortgages
•Only 13.5% of sub-prime mortgages are in default (less than 1% of all mortgages)
•Markets will recover – just like after Russian debt crisis in 1998
• Rational long term investment focus can take advantage of dislocation!
• Markets are TRANSPARENT – lots of information available – good decisions can be made