CMBS Leverage Most Since ’07 as Standards Loosen: Credit Markets
Landlords are piling the most debt onto commercial properties in five years as Wall Street banks bundle the loans into bonds to meet rising demand from investors seeking high yields amid record-low interest rates.
The size of mortgages bundled into bonds will surpass 100 percent of building values for the first time since 2007, before the market shut down amid the worst financial crisis in seven decades, according to Moody’s Investors Service. That measure of leverage on loans tied to everything from skyscrapers to strip malls is poised to climb 4.3 percentage points this quarter, the New York-based ratings company said in a July 11 report.
Lenders are offering larger loans to win business as borrowers look to pay off a wave of debt taken out during the real estate bubble and as yield-starved investors are pushed toward riskier assets. More generous mortgages, a boon for landlords who need to refinance debt, may fuel concern that banks are reverting to practices that led to record defaults as late payments rise above 10 percent.
“I wouldn’t say we are in a danger zone, but we are leaving the comfort zone,” Moody’s analyst Tad Philipp said in a telephone interview. “The margin of error has been diminished.”
Wall Street has arranged about $16.8 billion in commercial mortgage-backed securities this year, compared with $28 billion in all of 2011, according to data compiled by Bloomberg. Wells Fargo & Co. increased its 2012 forecast to $35 billion from $25 billion last week, and Credit Suisse Group AG projects as much as $45 billion in issuance this year. A record $232 billion in commercial-mortgage bonds were sold in 2007.
Investors are buying the debt as the Federal Reserve keeps interest rates at record lows for a fourth year. Relative yields on top-ranked bonds linked to commercial mortgages dropped to 180 basis points more than Treasuries on July 13, down from 261 basis points on Dec. 30, according to a Barclays Plc index.
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. was little changed, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 0.001 basis point to a mid-price of 112.78 basis points as of 11:33 a.m. in New York, according to prices compiled by Bloomberg.
The index, which typically falls as investor confidence improves and rises as it deteriorates, gave up a decline of as much as 1.6 basis points after Fed Chairman Ben S. Bernanke told the Senate Banking Committee that progress in reducing unemployment is likely to be slow.
“The U.S. economy has continued to recover, but economic activity appears to have decelerated somewhat during the first half of this year,” Bernanke said today. The Fed is “prepared to take further action as appropriate to promote a stronger economic recovery,” Bernanke said.
Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
The U.S. two-year interest-rate swap spread, a measure of bond market stress, decreased 0.61 basis point to 23 basis points as of 11:33 a.m. in New York. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of Goldman Sachs Group Inc. are the most actively traded dollar-denominated corporate securities by dealers today, with 89 trades of $1 million or more as of 11:34 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Late payments on commercial mortgages packaged into bonds reached a record 10.1 percent last month as bubble-era loans failed to refinance at maturity, according to Jefferies. More than $23 billion of the debt issued in 2007 is currently categorized as delinquent, the most of any year, Jefferies analysts led by Lisa Pendergast said in a report yesterday.
Underwriting in commercial-mortgage bonds is still “generally superior” to the prevailing standards of 2006 and 2007, the Moody’s analysts said in the report last week. When loans similar to those from the bubble years appear, it will be time to “sound the alarm,” Philipp of Moody’s said.
“But by then it’s too late,” he said. “It’s a good time to take stock of where we are.”
Occupancy levels and revenue for U.S. commercial property have been rising, though a stalling economic recovery and concern that the European debt crisis will escalate may crimp demand for office space, according to Wells Fargo & Co. Retail vacancies are just 0.2 percentage point lower than the 2010 high as U.S. unemployment holds at more than 8 percent and the housing market struggles to recover, Wells Fargo analysts led by Marielle Jan De Beur said in a July 12 report.
Commercial property values are staging an uneven recovery, with large cities on the coasts regaining the most value as investors seek stable tenants in active areas. Prices in major markets climbed 41 percent in May from the January 2010 low, according to the Moody’s/RCA Commercial Property Price indexes. That compares with an 18.7 percent gain for smaller cities. Values declined as much as 39 from the peak of December 2007.
Lenders use a different formula to calculate a property’s value relative to loan size than Moody’s, resulting in a lower leverage ratio. On a $1.35 billion offering from Morgan Stanley and Bank of America Corp. sold last week, the issuers estimated the average office loan in the pool to be equal to 65.5 percent of a building’s value, compared with Moody’s 109.7 percent, according to the rating company’s assessment of the transaction.
Unlike the banks, the ratings company accounts for the potential that interest rates will rise during the life of a loan, which can erode a property’s value.
The gap between where Moody’s and lenders peg that ratio will probably grow to 37.7 percent during the third quarter, the largest difference since 2007.
Leverage has been rising consistently in recent commercial- mortgage bond deals, likely leading to higher safeguards being put in place by the ratings companies, said Christopher Sullivan, who oversees $2 billion as chief investment officer at United Nations Federal Credit Union in New York.
“We’ve declined the recent deals,” Sullivan said in an e- mail. “We will continue to review and consider others that may be brought.”
Moody’s is requiring banks to boost investor protections on the lowest-ranking investment-grade portions of new deals to offset the higher-leverage loans. Deals scheduled for this quarter will need to boost loss cushions for those securities to 7.3 percent, compared with about 6.5 percent in the first quarter.
Rising leverage in new transactions isn’t cause for “excessive concern,” according to Alan Todd, a commercial- mortgage debt analyst at Bank of America in New York. Mortgages contained in recent deals are typically underwritten based on the income buildings are actually generating, rather than optimistic projections of potential revenue that were common during the boom period, Todd said.
“Having leverage increase is an unavoidable side effect of the increased competition that everyone is seeing,” Todd said. “Everybody is fighting over the same toys in the sandbox. A lot of assets are already encumbered. When something becomes available, you have to bring more to the table than somebody else would.”
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