Gauging where the asset backed securities (ABS) market will end up by the end of 2008 is becoming a bit like the popular children’s game, pin the tail on the donkey. But in the case of structured finance, it is arguably the originators, investors and rating agencies currently fumbling around, unsighted and unsure about the market’s direction, deal count and pricing.
For investors in commercial mortgage backed securities (CMBS), representing about €47bn of the €496bn of collateral that supported issuance in the European ABS market last year, the analogy is the same, but with a few extra twists. “What are bankers going to do for the next 24 months?” asked one bemused investor when he heard that the market has closed for the time being.
Combined, mortgage-related markets, including residential mortgage backed securities (RMBS) and CMBS, accounted for 60 per cent of total European ABS issuance in 2007, according to figures from the European Securitisation Forum (ESF).
But the same batch of figures also reveals just how bad, relative to this time last year, market inactivity has become for CMBS in Europe as a direct consequence of the retrenchment in credit worldwide since second quarter 2007. Fourth quarter issuance was €4.7bn compared to €20bn a year ago, a drop of 75 per cent.
Colin Fleury, senior portfolio manager, Henderson Global Investors, believes the pricing of transactions has put pressure on CMBS volumes and the likelihood of any new deals this year. “Where is pricing going at the moment? It is difficult to say. But trying to convince real money accounts to do some buying is taking a lot of effort, the technicals are horrendous at the moment and not many ABS funds are able to take a two year view,” he says.
“I’m certainly not going to sit in front of investors with the view that they will make money in the next few months. They could buy triple-A paper at 300 basis points, which could be worth 200 points by next week.”
A research note issued this month from Fitch Ratings claims the UK CMBS market, with commercial property values (especially office and retail) falling by as much as 20 per cent in some regions, will be feeling sore for the longest: “CMBS is showing stability across the board, with the exception of the UK, which is undergoing a correction that may last for some time yet,” it found.
One example of how the cost of a CMBS deal has ratcheted up recently – and therefore giving both originator/borrower and investor the shakes – are February spreads on five-year jumbo loans, a key indicator of overall CMBS market price direction. Triple-A spreads moved out by 41 basis points to 107 points and triple-B widened by 145 basis points to 398 points over Euribor. The few investors still active in the market are clearly demanding more credit surety (higher risk premiums) and even for hitherto secure notes underwritten with triple-A ratings.
Caroline Philips, managing director and head of securitisation at Eurohypo, the European real estate bank and a key player in mortgage-backed debt issuance, believes the timing is right to buy CMBS paper. “I think the market in Europe is fundamentally mispriced compared to the risks involved in having paper in your portfolio…there is nothing fundamentally wrong with CMBS,” she says. “It’s a good time to buy paper and a good time to issue loans and investors will return to the market. The problem at the moment is that it is not behaving rationally and only partly functioning, until pricing comes down.”
Market vulnerability
But it is the direct relationship between the irrationality of the CMBS market, at present, and the erratic, but necessarily upward, pricing of CMBS deals which the sell-side says is underpinning market vulnerability. “We have a major dislocation from reality and this is apparent in the credit spreads,” says Nehal Farooqui, managing director, ABN Amro.
“While we do have a few downgrades of CMBS transactions, this is not as sensationalist as what is written about in the media. But certainly current levels of pricing make syndication more attractive than securitisation,” he concludes.
And figures published by Fitch Ratings confirm that downgrades of CMBS transactions in Europe have been fewer than public perception has suggested. Between January and November 2007, from 399 deals rated, 59 were upgraded and only 10 downgraded, with all downgrades triggered by performance issues, unlike in 2006, when the majority had been caused by the downgrade of credit-linked entities, either corporate or sovereign. The same rater comments: “The major risk facing the CMBS market is the lack of liquidity, as most major lenders who accessed the capital markets have largely stopped originating new loans.”
Citi’s head of European ABS research Birgit Specht, is working on the principle that investors will come to market, but in their own time. She explains: “Across the board the trend is for widening spreads and there is no liquidity, but there is the cash to invest and in my view, it will be the real money investors, with expertise in commercial real estate, returning the earliest.”
‘Real money’ - like European money market funds and some pension money - but what about leveraged money, like SIVs [special investment vehicles] and hedge funds, which was a great source of liquidity in the market’s heyday?
 | Ms Specht foresees these investors returning by 2009, while Ganesh Rajendra, head of securitisation research at Deutsche Bank, identifies a shift to a buyer/investor’s market but with the caveat “that there are currently no buyers around to fill the void left by European money market funds”. |
With the European CMBS market now re-priced upwards and liquidity levels unlikely to rise for sometime, any recovery will be based around simpler, smaller and lower leveraged transactions, industry sentiment predicts, with issuers from Germany taking the strain.
Investors, like Henderson’s Colin Fleury, view a downsizing exercise as an initial
remedy. “At the moment there’s no new origination of loans, with much of the warehouse risk still sitting with banks. In fact, if I was in a triple A deal I would close my position today. The market needs to get smaller but remains in a better position than it was twelve months ago,” he says.
And the investor base is changing too, claims Christopher Walsh, partner, Clifford Chance. “We are advising on more innovative structures, though not necessarily more complex. There is still an awful lot of debt and loans that should have come out last year but haven’t because of the market conditions, and we see tailored deals for investors from the Middle East for example,” he says.
THE UK CMBS MARKET
Property values are fundamental to CMBS market activity and the UK’s office and retail portfolio has declined by as much as a fifth since summer 2007, though from a higher base than the rest of Europe, figures from CBRE find.
But it wasn’t necessarily declining property prices that started the selling rout and buying stalemate, according to Andrew Currie, structured finance director at Fitch Ratings. “Things got crazy around May 2007, when we found transactions being presented to us for rating which had underlying portfolios securitised on the value of bingo halls,” he says.
Since then, transaction volume has slowed and there has been a general flight to quality and from specialised property assets such as student housing, nursing homes and pubs towards prime assets.
Outside of the UK, high quality assets in liquid markets where property development is more controlled will suffer less this year, like offices in the Paris CBD. Whereas established markets, such as London, which have experienced tightening in capitalisation rates (the higher the cap rate, the lower the value), may suffer a longer or steeper correction.
Lehman Brothers’ CMBS origination in 2006, the £623m Windermere VIII, securitised office properties in London (61 per cent of the pool) and the rest based on UK properties in “midtown” submarkets, like Middlesbrough and Colindale. The issue has recently been put on negative outlook by Fitch Ratings, with factors like repeated rental arrears due to one tenant not paying on time, and vacant space, increasing the risks that underlie the credit worthiness of Windermere.
MIXED MESSAGES
The quality of information and data provided by CMBS originators to investors is mixed and this has worsened the situation, some in the industry claim.
Jerome Gatipon-Bachette, deputy head of CMBS Europe, Société Générale Corporate & Investment Banking (SG CIB), believes today’s market climate “necessities that investors demand more independent analysis of underlying assets, such as property values” from rating agencies. Moody’s Ifigenia Palimeri, claims pre-crisis, the demand wasn’t there. “We very rarely received any calls from investors on issues such as surveillance of the transaction, and investors were not as interested with our comments when the securities were doing well,” she says.
However, even if investors are eager to know more about what they were buying, the quality of information remains poor, believes Andrew Currie of Fitch Ratings. “To be honest the reporting (from originators) is rubbish! CMBS is a relatively new market and this is shown in the data, and we are working with very poor information, we need to encourage good reporting from originators if the market is going to go back to liquidity,” he adds.
But the focus has also turned to the role of the raters. Saul Greenberg, an independent advisor on ratings, explains: “Raters are now seen as providing an opinion, and not the gospel. To the extent that raters have access to a number of arrangers and servicers, they should demand what information they require for adequate surveillance.”
