Operational, Mechanical Issues Keeping Investors From Synthetic CMBS

Operational and mechanical issues are the major reason that many investors have stayed on the sidelines of the growing single-name synthetic commercial mortgage-backed securities market. The development of a CMBS-focused derivatives clearing house and more standardized contract documents will be necessary for the market to move toward its next level of liquidity, market participants said.

Dealers last week noted that there is some debate as to whether the option of having physical delivery on derivatives contracts will remain as the market matures. As the credit default swap market becomes larger than the cash market it is referencing, the number of investors looking to short the underlying credits is expected to increase in tandem.

In this market, investors have the choice between physical delivery and cash settlement. A key distinction between the two is that following physical delivery, the seller of protection has recourse to the reference entity, or cash bond, as well as the opportunity to participate in the workout process in the event of a default. In other, more mature sectors, such as corporate bonds, the physical settlement option is not always available since CDS are often used to hedge exposures to assets that are not readily transferable or to create short positions for users who do not own a deliverable obligation.

But for investors who do not own the underlying cash bond, and who are not trading with the intention of capturing the spread differential between the cash and the synthetic, physical delivery is less important in terms of pricing. Investors said that certain firms handle contracts differently and more efficiently. As the CMBS market moves toward document standardization, the issue will have to be settled.

Traders also said that many desks are also moving toward independent pricing, when a firm provides independent price verification that is delivered from the vantage point of the firm as a whole. The firm's interests may not always coincide with those of an individual trader, they noted. Although the CMBX index got off to a slow start and traders have reported one-sided flows, several desks have signed up new first-time accounts for the index in the past few weeks. The number of retail investors in the space is believed to be somewhere around 10.

Sorin Capital, which last year issued the first commercial real estate collateralized debt obligation backed entirely by synthetics, also recently bought into the index for the first time. This could signal that other hedge funds that plan to issue CDOs backed by synthetics will also begin to partially trade via the index. Sorin officials declined to comment.