Fed Holds the Line On Interest Rates; Analysts Downplay Commercial Exposure to Sub-Prime Crash
Investors in commercial mortgage securities received a double shot of good news this week to kick off the beginning of spring -- and to offset the fear and uncertainty generated over the well-publicized financial woes of sub-prime lenders such as Irvine-based New Century Financial Corp.
Not only did the Federal Reserve hold interest rates steady Wednesday -- including leaving the prime interest rate for commercial banks at 8.25% for the third time since August -- it left open the possibility of a rate cut, sending the Dow Jones Industrials soaring 159.4 points, the biggest one-day gain since July 24.
That news followed a pair of reports issued by Fitch Ratings expressing guarded optimism that the sub-prime mortgage meltdown would likely not create undue hardship for holders of collateralized debt obligations (CDO) and asset-based commercial paper (ABCP). Along with commercial mortgage-backed securities (CMBS), the pools make up the second-largest class of commercial mortgages, trailing only commercial banks.
Such pools contain tranches of loans of various types and risk -- including high-risk sub-prime residential loans. Analysts have feared that massive defaults in sub-prime loans could spill over into commercial markets. But it turns out that sub-prime loans probably won't hurt the health of the commercial asset-based securities portfolios sheltering them.
Although the realm of mortgage-backed securities and other asset-backed pools may be esoteric to many property professionals, they are widespread. In fact, one out of every five commercial loans is now held in such pools, according to new data from the Mortgage Bankers Association.
Fueled in part by a seemingly endless supply of capital chasing real estate deals and propped up by strong CRE fundamentals, total commercial and multifamily mortgage debt outstanding shot up nearly 13% in 2006 to $2.95 trillion, according to the MBA. Commercial banks continued to hold the largest share -- almost $1.3 trillion, or 44% of the total. CMBS, CDO and other securities pools are the second-largest holders of commercial mortgages at $630 billion, or 21%. Life companies and savings institutions hold 17% and the remainder is a combination of government-sponsored enterprises such as Fannie Mae and Freddie Mac, agency and GSE-sponsored mortgage pools, and other types of loans.
"Commercial/multifamily fundamentals continue to be really strong," said Jamie Woodwell, MBA's senior director for commercial/multifamily research. "Along with the ups and downs that come with being tied to the global capital markets, in general, commercial mortgages continue to provide great liquidity, great capital flows and great transparency to the commercial and multifamily financer. We also see low delinquencies and other signs of mortgage performance continuing to show strength."
CMBS and their gold-rated triple-A bonds have traditionally been rock-solid performers -- and have never been more popular, with Fitch predicting a record-setting 2007 for loan volume.
But last week, for the first time in months, investors worried by the mortgage meltdown widened the spread between CMBS bond interest rates and the nearly risk-free U.S. Treasury note. The spread is one of the ways analysts measure the risk appetite of investors and the overall health of the CMBS market. As the frenzied rush of capital in search of deals has sparked demand for CMBS bonds in recent years, the spread had steadily narrowed, sharpening the appetite for risk.
Most CMBS issues are triple-A rated bonds that have seen risk factors increase by only a few basis points as a result of the widening spread. Lower-rated B-minus bonds have seen the spread balloon to 20 basis points.
But even with spreads rising, securities analysts downplayed the overall effect on the commercial market.
"The hype surrounding anticipated CMBS hedging and the sub-prime mortgage market crisis has ebbed away," Fidelio Tata, interest rate derivatives strategist at RBS Greenwich Capital Markets, told Reuters. "Many investors do not feel inclined to initiate significant spread positions at this juncture."
However, "with triple-A rating starting at 88% of the average CMBS mortgage securitization pool, it will only take a hiccup," said one investment advisor last week. "I'd love to buy hedges against this highly rated debt."
"This (sub-prime) debacle could make all mortgage-backed securities debt toxic -- commercial and residential," the advisor added. "Remember when your broker said 'telecom' or 'Internet' and the response was, ‘Stop right there.’"
While acknowledging that CDOs and asset-based commercial paper have a higher exposure to sub-prime loan problems, Fitch Ratings analysts were optimistic in a pair of reports released this week.
The sub-prime mortgage slowdown is likely a "fairly minor problem" for trust-preferred CDOs since most of their collateral is made up of residential mortgage loans, according Fitch Ratings/Derivative Fitch. Exposure to sub-prime residential mortgage lenders represents only 8.4% of all residential mortgage lender exposure -- and just 1.8% within the portfolios of trust-preferred and hybrid CDOs. Some isolated CDOs may have exposure "to the worst underperformers" among sub-prime lenders, said Kevin Kendra, managing director of Fitch's CDO group, in a conference call Thursday. Sales of CDOs may see a temporary decline, but issuance will rise by the end of the year, Fitch said.
Derivative Fitch Senior Director Nathan Flanders said the rating agency will continue to monitor the sector.
"There have been no deferring or defaulted residential mortgage company entities" in any Fitch-rated trust-preferred CDOs to date, Flanders said.
A Fitch survey of U.S. asset-backed commercial paper programs indicated that exposure to sub-prime-related mortgages decreased sharply in the fourth quarter of 2006 when compared to the same period a year prior, mostly due to slowing residential loan originations.
While the sub-prime exposure remains high - it was found in 24 Fitch-rated commercial paper programs - the rating company believes the levels are manageable and investors are well insulated from risk, the report found.
Senior Editor Mark Heschmeyer contributed to this report.
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