Boiled Frog Syndrome Afflicts CMBS as Underwriting Eases

The growing din surrounding loosening standards in the commercial-mortgage bond market is doing little to deter buyers.

Investors are lapping up the securities and accepting less interest to do so even as Moody’s Investors Service warns that risks are building in debt linked to properties ranging from shopping malls and skyscrapers to hotels. After a month-long lull in issuance, Wall Street banks sold about $3.6 billion of bonds yesterday, a week after the ratings company said investors were facing a case of “boiling frog syndrome,” where they fail to react to gradually increasing threats until it’s too late.

“There is no doubt underwriting is getting weaker,” Keerthi Raghavan, a debt analyst at Barclays Plc in New York, said in an interview. The pace of deterioration “really picked up steam starting in the middle of 2013.”

Banks are loosening terms for property owners amid rising competition to underwrite loans and package them into bonds, sparking concern that standards are slipping back toward the lax norms that precipitated the real estate crash in 2008. That’s allowing landlords to pile on more debt.

Leverage Grows

Deutsche Bank AG, Wells Fargo & Co., Royal Bank of Scotland Group Plc and JPMorgan Chase & Co. all sold commercial mortgage-backed securities this week. They issued bonds with the lowest investment-grade rating of BBB- to pay investors as little as 315 basis points more than the benchmark swap rate, said people with knowledge of the sales, who asked not to be identified, citing a lack of authorization to speak publicly. That’s as much as 50 basis points, or 0.5 percentage point, less than buyers accepted for similar securities a month ago.

The size of loans relative to property values, a measure known as loan-to-value, or LTV, has climbed to within five percentage points of the 2007 boom-era peak of 117.5 percent, Moody’s said in its first-quarter report on the CMBS market.

In a $1 billion offering led by Deutsche Bank, investors are taking on more leverage than most deals completed during the past six months, according to Kroll Bond Rating Agency Inc. The transaction, linked to 59 mortgages on 86 properties across the U.S., has an LTV of 101.5 percent as measured by Kroll. That compares with an average LTV of 99 percent in recent issues, the ratings firm said in a report for investors.

Pressure Builds

The largest mortgage in that deal is a $140 million loan on the Bronx Terminal Market, a retail center next to Yankee Stadium in the New York City borough that’s anchored by BJ’s Wholesale Club, Home Depot and Target stores, according to Kroll. The underwriters, which also include Cantor Fitzgerald LP and Jefferies Group LLC, pegged the LTV of the debt at 63.3 percent, while Kroll puts it at 113.2 percent.

LTVs as measured by ratings companies are typically higher than those calculated by lenders because the raters take into account the potential for future changes in real estate values.

Pressure has been building for lenders to write more loans as CMBS issuance trails forecasts. Dealers sold $4.1 billion of the securities this month, down from $7.85 billion last April, according to data compiled by Bloomberg.

Banks have arranged about $23.6 billion of CMBS this year, lagging behind the $100 billion that analysts across Wall Street predicted for 2014 at the start of the year. Sales, which doubled last year to $80 billion, stood 30 percent below last year’s level as of April 25, according to JPMorgan.

Raters Respond

As the race to catch up intensifies, the alarms being sounded on slipping standards have grown louder. Credit Suisse Group AG analysts said in a report earlier this month that steps being taken by the ratings companies to counteract the decline may not go far enough.

“We are admittedly torn” about the increasing demand for risker bonds on new deals, Jefferies Group analysts led by Lisa Pendergast said in a March 31 report. “An improved economic outlook bodes well for credit, but we are still concerned about less conservative underwriting.”

Credit graders are responding to eroding standards by increasing the amount of investor protection required for underwriters to get the ratings they want. So-called credit enhancement is equal to the amount of losses a transaction can withstand before the security takes a principal loss.

Banks have been bypassing Moody’s on the riskier portions of recent deals, which include as many as a dozen classes, as the ratings company demands more protection to garner investment-grade rankings. Building a larger buffer for investors makes the deals less profitable for lenders.

Not 2007

Deutsche Bank’s deal, the only transaction issued this week that included securities with Moody’s lowest investment-grade rating, had the highest credit enhancement. Investors in those bonds are shielded from the first nine percent of losses should borrowers default. That compares with as low as 6.6 percent a year ago.

Underwriting standards, though declining, have not given way to the types of excesses seen in 2007 when a record $232 billion of CMBS was sold, according to Barclays’s Raghavan. With an improving economic outlook and commercial-property values rebounding, borrowers are on more solid footing today than they were seven years ago, he said.

“We haven’t fallen off the credit cliff so far,” said Leo Huang, who oversees commercial real estate debt at Ellington Management Group LLC, the $6 billion hedge-fund firm founded by Michael Vranos.

Boiling Frogs

Investors are increasingly comfortable buying new CMBS deals, indicating confidence in current lending guidelines even as standards relax from the stringent terms that prevailed in the aftermath of the financial crisis, he said.

The amount of cash being generated by commercial properties relative to how much is needed to pay the mortgage is still high compared to the margins seen during the boom years, according to Moody’s. Yet as leverage creeps higher, investors are at risk of confronting deals that are as poorly underwritten as those done leading up to the market’s crash, analysts at the credit grader led by Nick Levidy said in an April 21 report.

The analysts likened the increasing risks to the boiling frog syndrome, a metaphor referencing the belief that frogs won’t jump out of a pot as the water gradually comes to a boil.

While property valuations run the risk of climbing too far as investors pour cash into the real-estate market in search of higher-yielding assets, a lack of new construction has kept prices in check, according to Jonathan Pollack, the global head of commercial real estate at Deutsche Bank.

‘Looks Cheap’

“You can get oversaturated with capital and supply,” Pollack said yesterday in an interview with Bloomberg Television’s Stephanie Ruhle and Erik Schatzker at the Milken Institute Global Conference in Beverly Hills, California. “That hasn’t happened yet. Diversification of capital sources is very healthy for the market.”

Deutsche Bank is the top underwriter of CMBS deals globally and in the U.S., according to industry newsletter Commercial Mortgage Alert.

The extra yield above borrowing benchmarks that investors are paid to own top-ranked bonds issued since the crisis has narrowed five basis points in the past month to about 75 basis points, according to JPMorgan.

Demand for risker CMBS is likely to continue as long as yields across fixed-income markets remain stunted by the Federal Reserve’s policy to suppress interest rates. There are few places to look for the same level of spread relative to benchmarks, according to Barclays’s Raghavan.

“CMBS still looks cheap,” he said.

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