IF CMBX, a synthetic Commercial-mortgage-backed-securities index, is to be believed, commercial real estate credit is in deep trouble, caving in to the same pressures that savaged the residential mortgage market beginning last year. But it may be the index, not the underlying market, that’s out of whack.
Launched two years ago by London- and New York–based market data company Markit Group and a consortium of investment banks, CMBX measures the credit default swap market in CMBSs according to a spread indicating how owners of cash bonds are calculating default risks: The wider the spread, the more people are buying rather than selling protection on the index. In mid-March the spread on a triple-B-rated CMBX tranche had widened to 2,000 basis points, from 500 last fall. Those spreads compare with just 275 on the benchmark, the more stable triple-A-rated tranche.
This pricing implies “average deal-level losses of 44.8 percent on all of the deals the index references,” says Darrell Wheeler, head of CMBS research strategy at Citigroup.
That’s far out of line with the tumultuous residential mortgage market — where fourth-quarter delinquencies, or loans 30 or more days overdue, stood at 5.82 percent, up 87 basis points on the year, according to the Mortgage Bankers Association of America — let alone the relatively placid commercial mortgage scene. Realpoint, a Horsham, Pennsylvania, research and analytics firm, says that CMBS delinquencies in March were 0.37 percent, not much more than the 0.33 percent a year earlier.
“We believe that there is a real disconnect between CMBX and commercial real estate fundamentals,” says Robert Dobilas, president of Realpoint. Though he expects delinquencies to rise, he adds, “we would be very surprised if they exceed 1 percent.”
The index is based on a basket of 25 CMBS deals that are selected as representative of the broader market. Trading a credit derivative priced against the index allows for a transfer of the risk: An investor can purchase a credit default swap as a hedge against defaults, as the seller of the swap guarantees the creditworthiness of the bond.
Kenneth Cohen, head of commercial real estate lending at Lehman Brothers, one of the major banks that devised the index, believes that the volatility has more to do with the nature of CMBX as a structured product than with CMBS fundamentals. “There are a lot of people playing in the CMBX market who don’t understand the collateral behind the derivatives,” says Cohen, noting that these are loan assets not sullied by the residential mortgage crisis. What’s more, the CMBX market is over the counter and inherently illiquid, creating the sort of valuation challenge that plagues other OTC marketplaces. CMBX is rebalanced every six months, and each day banks update Markit Group with information on where they believe the market is. “This is an OTC market where there is not a great deal of transparency,” says Manus Clancy, a managing director at New York–based CMBS analytics firm Trepp.
Market participants are well aware of the divergence between the cash and synthetic markets, but what can they do about it?
Ben Logan, head of structured products at Markit Group, which this month is scheduled to release the latest iteration of the index, argues that the differences simply need to be taken into account. CMBX — a risk, rather than an interest rate, trade — doesn’t have the same “supply-and-demand dynamic” as does cash CMBS, he notes. He adds that CMBX has contributed to transparency, though “there are things that the market can do to improve transparency going forward.”
Citigroup’s Wheeler says that an understanding of CMBX’s disconnect from the fundamentals “has started to take some hold,” but this has not yet been priced into the spreads.
Even as firms use CMBX as a tool for marking asset values to market, Wheeler remains doubtful as to whether its liquidity is adequate to the task. “We are not quite sure that the index has yet established a balanced, two-way market that would justify using it as a valuation indicator for long-term commercial assets that have been bought by accounts that intend to hold them to maturity,” he says. Adds Trepp’s Clancy: “The firms that mark their books every day are forced to adhere to this. The wider it goes, the bigger the losses. The market has been in this spiral since November that people can’t seem to break.”
