Why Are CMBS Multifamily Delinquency Rates So High?

The 60 day delinquency rate for multifamily CMBS loans is skyrocketing. From a Fitch release:

Declining performance, particularly in oversupplied markets, as well as in secondary and tertiary markets, has pushed the multifamily delinquency rate to 4.55%, the highest of all property types. Multifamily properties have been highly susceptible to default in CMBS during the current economic downturn.

Fitch seems to suggest the problem is the asset class, but there’s something else at work – delinquency rates on Fannie and Freddie multifamily loans are less than a tenth of the CMBS figure. From an MBA release on June 2:

Fannie Mae: 0.34 percent (60 or more days delinquent)
Freddie Mac: 0.09 percent (90 or more days delinquent)

Why are the agency loans performing so much better? I think there are several factors at work, but the main reason is the originators of Fannie Mae and Freddie Mac loans had much to lose by selling bad loans to the agencies.

Most of Fannie’s multifamily business has been originated through their Delegated Underwriting and Servicing program. Fannie agreed to buy multifamily loans which were within their underwriting parameters without prior review. The originating lenders retained the top 5% loss exposure, and shared losses after that to a maximum of 20%. A very limited number of lenders were allowed to participate (never more than 30 nationwide). Sell a bad multifamily loan to Fannie under the DUS program, and you not only shared in the loss, you risked losing a valuable franchise.

Freddie took a different approach. They didn’t require originating lenders to share in the loss, but the ability to sell to Freddie was if anything even more tightly controlled, with a limited number of lenders restricted to specific geographic areas (see current list here). Again, sell a bad loan to Freddie, and you risk losing your franchise.

By contrast, CMBS origination was wide open. But, that may be changing. The lead story in yesterday’s Financial Times:

Treasury plans strict rules for securitisation

The US Treasury is planning a sweeping overhaul of securitisation markets with tough new rules designed to restore confidence by reducing the incentive for lenders to originate bad loans and flip them on to investors…

The Treasury plans to force lenders to retain at least 5 per cent of the credit risk of loans that are securitised, ensuring that they have what investors call “skin in the game”. The 5 per cent rule – which looks set to be applied in Europe as well – is less draconian than some bankers feared.

Would such a rule have prevented bad CMBS loans? Probably not; I believe the risk of franchise loss was a much more important determinant of lender behavior. But, it’s a start.

Why Did Financial Middlemen Do So Well in the Bubble?

Ryan Avent at The Bellows thinks the compensation finance people received during the boom indicates something was drastically wrong:

When you have a few people taking home billions, that’s a sign of either very good luck or some brilliant new strategy. When you have a lot of people in finance taking home billions, then something has gone badly wrong. Either something unsustainable is building, or there are some serious inefficiencies in the market.

In a similar vein, Baseline Scenario notes the benefits of financial “innovation” did not flow to the customers:

You invent something great, you make a lot of money, then your competitors copy you, prices go down, and the long-term benefits go to the customers. And you and your competitors all get more efficient, meaning that you can do the same amount of stuff at a lower cost than before. If you want to make another killing, you have to invent something new, or at least invent a better way of doing something you already do.

By contrast, the historical pattern of the financial sector – rising revenues, rising profits, and rising average individual compensation – is what you get if there is increasing demand for your services and, instead of competing to lower costs and prices, you limit supply. Sure, prices fell on some financial products, but financial institutions encouraged substitution away from them into new, more expensive products, with the net effect of increasing profitability (and compensation).

Why didn’t competitive pressure keep a lid on financial sector compensation? In the mortgage world, it’s because everybody was getting what they wanted. Borrowers were getting great rates, in part because loans were underpriced but also because the broader interest rate environment was very favorable. Loan proceeds were high, terms were relaxed, and loans were quick to be approved on the terms applied for (more on that at my post, “Why Did WAMU Abandon Underwriting Standards?”). On the other side, investors were getting what seemed to be an infinite supply of AAA securities to buy, at yields better than treasuries. No one begrudged the money the RMBS and CMBS middlemen were making.

As it turns out, of course, there was a cost associated with giving everybody what they wanted. That great financing inflated the bubble which is now inflicting huge losses on borrowers, and the securities were grossly underpriced for the systemic risk associated with them.

Economy and Real Estate Post Picks: Week of April 20, 2009

Will the Recession End in a Few Months? Two economic forecasters think so

Can the Economy Function Without Securitization? This post argues restoring  securitization markets should be a top priority.

Commercial Real Estate Values at 2005 Levels: Moody’s Commercial Real Estate Indices indicate gains over the last four years have been reversed.

Which Way Are 10 Year Treasury Rates Headed? Two opposing views

What Will be the Shape of this Recession? V, L, or D?

My Securitization Misconceptions

I am not a CMBS insider – although I’ve been doing nothing but income property finance for 30 years, it’s almost always been for whole loan lenders. However, a good chunk of that time was spent originating Fannie Mae multifamily loans and competing against CMBS lenders for business, and we lost that competition on many, many deals. I found this surprising – how could pricing be better on a securitized deal than the pricing offered by an institution with an implicit government guarantee? How could CMBS lenders offer better pricing on deals that had screamingly obvious flaws? At the time, I came up with some answers I thought made sense, but it turned out I was wrong.

Simple securitization is not complicated. You take a pool of loans and project the aggregate principal and interest cash flows from the pool. Picture the cash flow as a river with a series of waterfalls. First the cash flow goes to the A piece buyer, and the remainder goes to the B piece buyer. If the cash flow falls a little short because there are losses on some loans, the A piece buyer still gets his return but the B piece buyer gets shorted. If the cash flows are massively short (for example, many loans default as a result of a global financial meltdown), the B piece buyer is wiped out and the A piece buyer will also suffer some losses. If you’re a do-it-yourselfer, I recommend Keith Allman’s book, Modeling Structured Finance Cash Flows with Microsoft Excel; spend an afternoon with it and a laptop and you can do your own securitization model.

My first misconception was how value was created out of this process. The idea was the aggregate value of the allocated cash flow was worth more than the whole, much like the value of the packages of meat in the supermarket cooler are worth more than the whole cow. Some people want sirloin, some want hamburger, and by giving people what they want the parts are worth more than the whole.

Although to some extent value was created in this process, the real problem is the securities were simply mispriced. From The Economics of Structured Finance, A paper by Joshua Coval, Jakub Jurik, and Erik Stafford:

The rapid growth of the market for structured products coincided with fairly strong economic growth and few defaults, which gave market participants little reason to question the robustness of these products. In fact, all parties believed they were getting a good deal. Many of the structured finance securities with AAA-ratings offered yields that were attractive relative to other, rating-matched alternatives, such as corporate bonds. The “rated” nature of these securities, along with their yield advantage, engendered significant interest from investors.

However, these seemingly attractive yields were in fact too low given the true underlying risks. First, the securities’ credit ratings provided a downward biased view of their actual default risks, since they were based on the credit ratings agencies’ naïve extrapolation of the favorable economic conditions. Second, the yields failed to account for the extreme exposure of structured products to declines in aggregate economic conditions (i.e. systematic risk). The spuriously low yields on senior claims, in turn, allowed the holders of remaining claims to be overcompensated, incentivizing market participants to hold the “toxic” junior tranches. As a result of this mispricing, demand for structured claims of all seniorities grew explosively. The banks were eager to play along, collecting handsome fees for origination and structuring. Ultimately, the growing demand for the underlying collateral assets lead to an unprecedented reduction in the borrowing costs for homeowners and corporations alike, fueling the real estate bubble that is now unwinding.

My second misconception was that the B piece buyers were the canaries in the mine. Rating agencies blessed the cash flow projections, but the real safety valves were the B piece buyers – since they were to take the first loss, they had a strong incentive to make sure the projections were reasonable. If the deals were too risky, B piece buyers would stop buying. This is what happened when CMBS spreads widened in 1998 after Russia defaulted on its bonds, so I thought that B piece buyers were an effective check on the market.

We now know, however, that B piece buyers were repackaging their exposure, obtaining a triple AAA rating of most of it, and selling their pieces as CDOs. Baseline Scenario provides a good explanation of how this worked in this post. Since the B piece buyers weren’t retaining the risk, there was no canary to signal the problem.

For more on securitization, Derivative Dribble is an excellent source. I recommend starting with Tranches and Risk.

Economic and Real Estate Post Picks: Week of March 23, 2009

CMBS Performance Trends and Maturities: A comprehensive look at delinquency and loss trends by vintage and asset class, and upcoming maturity risk

Martin Hellwig on the Financial Crisis: A lucid account of how relatively small subprime default losses amplified into today’s financial crisis

Real Disposable Personal Income Up: For the fifth consecutive month

The State of the Economy: A great visualization of seven economic indicators showing normal levels, where we are, and the direction we’re going

Personal Consumption Expenditures Positive for February: Good news on this key indicator.

Whose Error was the Housing Crisis?

Who is responsible for the housing crisis? Some candidates are borrowers, lenders, rating agencies, and securities investors.  Attempts to blame one party or another fail, because the crisis is the result of a combination of errors by different parties which all aligned. Think of a wedge of Swiss cheese; to see through it, all the holes must line up. This approach is explained in James Reason’s Human Error, and illustrated in a diagram from that book:

In the housing crisis, here are some errors which had to align to get to where we are today:

1) Borrowers took out loans they couldn’t afford

2) Lenders made loans to borrowers which the borrowers couldn’t afford

3) Ratings agencies rated securities comprised of these loans as safe

4) Security purchasers relied on the erroneous ratings and bought the securities

Any of these parties could have averted the crisis had they avoided their respective error.

I am not saying that every member of each class made their error; plenty of potential borrowers didn’t borrow, not every lender made bad loans, not every rating was bad, and not every investor bought bad securities. But, enough of each class made these mistakes to trigger the events leading to the current situation.

Also, I am not saying that individual actors didn’t benefit from their actions at the time – there were certainly some winners. And, looking at each individual decision made, it’s not clear that any of them were irrational at the time. These were errors in the sense that, in hindsight, collectively we would have been better off if people had acted differently.

In any complex system, it’s often more likely that a major breakdown is the result of an alignment of errors, rather than the failure of a single component.

In Defense of a CRE “Bailout”

The blogosphere is abuzz with the news big commercial real estate owners want newly originated AAA CMBS paper to be eligible for purchase through the Term Asset-Backed Securities Loan Facility (see posts from Housing Wire, Clusterstock, Market Movers, and Calculated Risk. You can read the actual request here). Everyone is framing this as a bailout, but I think they’re missing what’s really going on.

The request talks about the large volume of CRE loans which are maturing, and the fact that the traditional sources that would ordinarily refinance these loans are out of the market. That’s true, but it doesn’t matter. If you have a good, performing CRE loan which matures and the lender or servicer is not willing to extend at a market rate, a bankruptcy judge will be happy to help. A simple extension at a market rate to protect real equity is about as straightforward a Chapter 11 plan as you can get. Yes, it would be nice if you didn’t need to go to court to refinance your loan, but these cases are not what the request is about.

The problem children are the CMBS loans which are underperforming and which can’t qualify for a new loan. Normally the lender would foreclose and sell the REO. During a credit crunch, the selling lenders finance the sales (they don’t want to, but there’s no alternative). With a CMBS loan, there is no one available to finance the sale – the security holders are not in that business. To move these properties without financing, CMBS servicers will offer huge discounts (remember, it’s not the servicer’s money so they won’t be hesitant to do so).

Why do the owners of performing properties care? Those discounted sales will become the comparables to establish value for performing properties, and the entire market will be devalued. Institutional holders who have to mark their portfolios to market will get clobbered. Further, the buyers of the greatly discounted properties will have a much lower basis and can drop rents and still make a reasonable return, which will also pull down the rest of the market.

What’s the public policy motivation to prevent this from occurring? It’s pretty hard to make a case that a CRE landlord deserves sympathy, but I’ll give it a try. If you rank ordered all the CRE in the country by asset size it would look like a power curve with a very long, fat tail. There are a  few very large projects, more large ones, many more medium sized, and a gazillion small ones. Most of the CRE in the country is not held by people like Donald Trump, it’s held by people who have assets but do not live lifestyles of the rich and famous. This is not a bad constituency to help.

If you don’t buy that, there are the financial institutions holding CRE debt. In every recession there are a lot of CRE loans which experience cash flow problems, and when a loan gets into trouble it gets marked down to the value of the collateral. If the only sales are deeply discounted all cash deals, you are going to see some huge writedowns. This will not be helpful. Also, when the buyers of the discounted properties drop rents, more CRE loans will have cash flow problems when they can’t compete with the lower basis properties, resulting in more foreclosures and a really nasty downward spiral. Avoiding this spiral effect should be the main goal of those working to avert a CRE crisis, and making financing available is essential to breaking the cycle.

Finally, we should consider what buying newly originated CRE loans really means. Fannie Mae and Freddie Mac are keeping the multifamily sector afloat, buying conservatively underwritten loans at attractive spreads (currently more than double the margin of single family deals). This could and should be a moneymaker for the Fed.

All things considered, this is a good proposal. Unfortunately, the requestors are not a sympathetic group and the reason for adopting it can’t be summed up in a sound bite, so it will probably not happen.

Investor Litigation and Mortgage Relief Plans Revisited

It’s been a little more than a year since I last addressed this topic. As usual, things turned out a little differently than I expected.

Back then, the Market Movers theory was investors would not litigate over the modification plans because it would be hard to calculate damages, the litigation wouldn’t scale, and the bondholders were not a litigious group. I agreed with Felix that the economics of the litigation was not attractive and that the investors were not naturally litigious, but thought damages would not be hard to establish and that servicers would take a cautious approach which would lead to few modifications being done.

I think I was right about few modifications being done, but Felix and I both underestimated the desire of bondholders to get out from under the deals. The litigation has started (links to NY Times and Housing Wire stories). The bondholder remedy sought is the repurchase of the loans at par. That’s an ambition goal, but if they’re successful it would be a huge recovery. The threat may be enough to force a nice settlement, and the possibility will surely cause modification efforts on securitized deals to grind to a halt until the matter is settled.

Home Values, Manias, Panics, and Crashes

Last night I dusted off my copy of Charles P. Kindleberger's classic Manias, Panics and Crashes (I have the 2000 edition which leaves off at the East Asian Financial Crisis in 1997; the link is to the 2005 edition which no doubt has something to say about dot-coms). Kindleberger outlines the life cycle of a bubble, and summarizes 40+ events dating from 1618. My edition has a blurb on the cover from Paul Samuelson which says, "Sometime in the next five years you may kick yourself for not reading and re-reading Kindleberger's Manias, Panics, and Crashes." This was good advice for residential real estate and RMBS investors.

Our current situation fits Kindleberger's taxonomy perfectly:

Object(s) of Speculation: Previous bubbles have related to tulip bulbs, canals, cotton, railroads, coffee, Argentine securities, bank stocks, and many other commodities and financial instruments. In the current case, it's homes and residential mortgage backed securities (RMBS) financing homes.

Exogenous Shock Setting off the Mania: Subject to argument, but my belief is the trigger was the rapid decline and extended period of very low short term interest rates between July, 2000 and July, 2004 compounded by flawed securitization models which did not appropriately price risk and investor misinterpretation of the risks underlying the securities.

Scandals and Defalcations: Subprime fraud revelations.

Turning Point: Week of June 18, 2007, collapse of Bear Stearns hedge funds.

Domestic Propagation: Falling home prices, mortgage securities indices.

Crisis Management Devices: SIV Superfund, Joint Term Auction Facility, Paulson Modification Plan.

To a certain extent it's comforting that current events fit a well established pattern.