Imagine a hot NASCAR race in which a yellow car, a blue car and a green car are zooming along several laps into the race. The yellow car spins out of control as it banks around a curve. It smashes into the blue car, which ricochets into the green car and careens onto the apron. The green car recovers and drives ahead. The yellow car slams into the wall and bursts into flames. The blue car is hardly damaged, but getting back into the race is difficult--the course has shifted and requires new strategies. [??] In 2007, a vibrant commercial mortgage-backed securities (CMBS) lending market was essentially pushed off-track by a residential subprime mortgage market that crashed and burned, and by unanticipated changes in rating agency practices. [??] The result was a sudden credit and liquidity crunch that dramatically changed commercial real estate's "rules of the road" for 2008 and perhaps even longer. [??] When lending conditions diverge as much as they did in early and mid-2007, it is worth asking which conditions are anomalous. Although the early part of 2007 was no doubt a borrower's ideal, the market had strayed into aggressive underwriting standards and loan structures that could have become problematic.
The adjustment that began in mid-2007 and continues today is a return to the conservative underwriting and deal structures that have typically characterized CMBS lending and mitigated the risk of delinquencies, defaults and overbuilding. Although the short-term effects may be painful, 2007's correction should prove positive for CMBS financing and commercial real estate in the long run.
A credit crunch in the making
The volatility and credit crunch that appeared almost overnight in 2007 can be directly traced to two events: the collapse of the residential subprime mortgage market and aggressive commercial real estate lending practices in which lenders emphasized volume over pricing for risk or profit. Credit rating agencies' adjustment of subordination levels on all CMBS products also contributed to changing market conditions.
Initial indications of subprime mortgage weakness appeared in late 2006. They accelerated quickly in 2007 when it became clear that the asset class was fundamentally flawed. The value of bonds collateralized by subprime mortgages plummeted, creating significant losses for many investors. Losses for collateralized debt obligation (CDO) investors, in particular, were so heavy that the market for new CDO issues collapsed.
Unfortunately, many of these investors were also buyers of bonds collateralized by commercial real estate loans. Some investors--particularly leveraged investors such as special investment vehicles (SIVs) and CDOs--stopped buying CMBS bonds altogether. The loss of these investors disrupted a number of pending securitizations and completely eliminated buyers for certain CMBS bond tranches.
In spite of sound commercial real estate fundamentals, investor confidence was badly shaken. Remaining buyers of bonds collateralized by commercial real estate loans began to question their stability. Concern that commercial real estate--like subprime mortgages--might also prove more risky than previously believed sparked two trends: First, investors began requiring higher yields on CMBS bonds. Second, reduced investor demand made it virtually impossible to sell some CMBS bonds.
The resulting yield widening was substantial. The first few securitizations of 2007 priced at 22 basis points over the swap curve for AAA bonds. By early August, securitizations were pricing at 76 basis points over the swap curve. Spreads have narrowed and widened since then; at times, spreads for AAA bonds have spiked even higher than 100 basis points over the swap curve.
Some tranches experienced even greater volatility. The spread on BBB bonds was 68 basis points over the swap curve in early 2007; it hit 750 basis points in the winter and climbed as volume outpaced demand in the fourth quarter of 2007. …