Hedge Funds Plotting CMBS Gatekeeper Coup: Mortgages

Hedge funds are preparing to muscle in on the riskiest part of the $550 billion commercial mortgage bond market, where a handful of firms control the fate of deals.

Ellington Management Group LLC, Saba Capital Management LP and a fund of MatlinPatterson are among investors considering purchases of so-called B-pieces of newly issued commercial property bonds, according to people familiar with the three firms’ plans who asked not to be identified because the information is private. Buyers of the securities are the first to lose money when buyers default; in exchange they earn higher returns and control over which mortgages are included in new deals created by Wall Street.

The investments, which can yield as much as 24 percent, are dominated by loan specialists -- Rialto Investments and Eightfold Real Estate Capital bought 16 of the 27 B-pieces sold last year -- when about $35 billion of mortgage bonds were issued, according to Deutsche Bank AG. The pool of buyers is poised to widen as new issuance soars and investors try to ferret out ways to get high-yielding returns as the Federal Reserve holds interest rates close to zero into a fifth year.

“Funds are increasingly getting more creative in terms of complexity and illiquidity,” said Rael Gorelick, co-founder and principal of Charlotte, North Carolina-based Gorelick Brothers Capital LLC, which invests in mortgage funds. “This is a rates-are-low story. Where else are you going to go?”

Property Recovery

Buyers have been drawn to securities tied to skyscrapers, shopping malls and hotels after property values recovered 45 percent since bottoming in 2009. That’s helped Wall Street firms revive the market for new debt, which package mortgages into securities of varying risk with the majority getting the top credit grades.

JPMorgan Chase & Co. raised its 2013 CMBS sales forecast to $70 billion from $45 billion last week as issuance in January and February exceeded expectations. Wall Street arranged $8.3 billion in new transactions last month, the highest monthly tally since December 2007, according to Deutsche Bank.

JPMorgan is offering $1.28 billion of the debt composed of 50 loans on 101 properties across the U.S., and Wells Fargo & Co., Goldman Sachs Group Inc. and Deutsche Bank are also marketing CMBS this week, according to data compiled by Bloomberg.

The new issue market “is really getting into a more consistent flow this year.” said Noelle Saverese, co-portfolio manager of MatlinPatterson’s $400 million mortgage strategy. “That’s why you’re hearing about that strategy now.” She declined to say whether the firm is buying the debt.

Saba, Ellington

Boaz Weinstein, founder of Saba, said this month that CMBS was his best investment idea at the EnTrust Investment Summit in New York.

The firm, started in 2009 to profit on price discrepancies between loans, bonds and derivatives, has been in talks with banks about the investments, according to three people with knowledge of the matter, who declined to be identified because the discussions are private. Jonathan Gasthalter, a spokesman for the New York-based firm, which manages about $5.3 billion, declined to comment.

Ellington, a $5.1 billion mortgage investor run by Michael Vranos, is also considering the strategy, two people said. Patrick Clifford, a spokesman for Ellington, declined to comment.

Larger Pool

A larger field of B-piece buyers would be a boon for borrowers looking for financing, according to Steven Schwartz, a managing director at Torchlight Investors, which buys the securities.

“It’s not great to have a market as big as CMBS reliant on three or four investors,” Schwartz said. “More investors and a wider capital base are a good thing for the CMBS market.”

The industry hinges on B-piece buyers, who police underwriting standards by digging into property details before other investors and reserving the right to throw out loans deemed too risky. Prior to the 2008 credit crisis the investors also oversaw troubled loans within the deals. Fitch Ratings described the buyers during the property boom as an “old cartel” in a report yesterday.

“This is the most important part of the capital structure as far as the street is concerned,” Schwartz said. New deals can’t proceed without the approval of the investor. “The consequences of not closing can go beyond economics so there can’t be a fail here.”

Narrowing Spreads

New entrants are looking into this segment of CMBS as yields on safer classes of the debt and the rest of the fixed income market shrink. High-yield bonds are paying 6.5 percent, down from 8.4 percent in June. Leveraged loan prices last month reached the highest levels since the credit crisis, according to the Standard & Poor’s/LSTA U.S. Leveraged Loan 100 Index.

Spreads on CMBS securities rated BBB-, the lowest investment-grade ranking, have narrowed 110 basis points to 350 basis points more than the benchmark swap rate since December, according to JPMorgan data. The debt priced to yield 535 basis points over swaps six months ago, according to data compiled by Bloomberg.

Some buyers attracted to B-pieces are being drawn by the ability to recoup some cash by selling portions of their investments, particularly those rated just below investment grade, according to Richard Hill, a debt analyst at Royal Bank of Scotland Group Plc.

“We certainly saw some BBs trading in January as B-piece buyers looked to opportunistically sell them into the market,” Hill said.

Reducing Interest

That’s raising some concern that buyers are lowering their interest in the collateral. During the boom years, B-piece buyers were able to repackage their purchases into collateralized debt obligations, or CDOs, keeping small slices and selling off the rest, watering down their role as gatekeepers and fueling a record $232 billion in sales in 2007.

“If your investment in the deal is reduced, your interest in the collateral being put in the deal may be reduced,” said Torchlight’s Schwartz. “It doesn’t have to be, but it might.”

It won’t be easy for new firms to break into the B-piece market, he said. The buyers will have to prove to Wall Street banks they understand bond structures and have the resources to conduct due diligence on 100 loans at a time and sign off on a deal in six weeks, he said.

For hedge funds the opportunity though may be worth it. “They are definitely one of the more attractive ones but at the same time one of the more risky ones,” MatlinPatterson’s Saverese said of the B-pieces. “You have to be careful. But you are getting paid for your risk.”

Before it's here, it's on the Bloomberg Terminal.