Last fall the commercial real estate market learned about the fickleness of the global capital markets. Wall Street is a two-way street that in good times provides abundant capital, but in bad times can be the most punishing and volatile place in the world.
From August through November of 1998, the market for Commercial Mortgage-Backed Securities (CMBSs) experienced greater spread volatility than ever before in its short history. Spreads for Aaa-rated CMBS classes widened from +85 basis points over comparable Treasury securities to more than +200 basis points. Credit crunches have occurred from time to time in other sectors, but the relatively young CMBS market has not previously undergone such a dramatic price adjustment.
Notwithstanding this unparalleled volatility, Moody's believes that the underlying credit quality of the real estate securities remains generally sound. The CMBS market disruption was thus a yield phenomenon, not a credit event.
Via the CMBS market, Wall Street has given commercial real estate access to a larger pool of capital, new capital sources at competitive prices, greater flexibility in leverage and more alternatives in financial structure than were ever available. This opportunity has its price, however. Commercial real estate securities are now also subject to the vagaries of global capital markets.
The commercial mortgage market now sees Wall Street as a two-way street. The capital markets offer not only unparalleled access to capital, but also unaccustomed volatility. As commercial real estate is more thoroughly integrated with the capital markets, borrowers will increasingly find that an event in Russia can and does induce loan spreads to rise in Kansas City.
The credit implications of these recent events for CMBS investors are limited. A Aaa bond is still a Aaa bond. However, a market shake-out will result in an altered transaction profile.
* Issuance volume in 1999 will shrink to approximately $50 billion - the first volume setback since 1995.
* The trend toward increased loan leverage will slow down or reverse.
* Smaller and simpler transactions will prevail, as issuers seek to manage their exposure.
* Some transformations will occur in the profile of the CMBS market, including the infrastructure, the underlying loans, the CMBS product itself and the investor base.
* Higher cap rates will delay, but not eliminate, supply-side risk.
Figure 2 Change in CMBS Spreads in 1997 Market Shift August 1997 November 1997 Change in Spread Aaa 63 81 +18 Aa 67 90 +23 A 75 103 +28 Baa 86 130 +44 Ba 185 230 +45 B 475 450 -25 SOURCE: MORGAN STANLEY What has happened?
Spreads on CMBSs widened at all rating levels (faster and more sharply than ever in the industry's short history, and faster and more sharply than other fixed-income products experienced in the same time horizon). Between mid-August and mid-October, investors demanded significantly more in compensation for CMBS at all rating levels relative to U.S. Treasuries [ILLUSTRATION FOR FIGURE 1 OMITTED]. At the same time, the spreads between other fixed-income instruments and comparable Treasuries also increased profoundly. By the end of the year, spreads came in again, making for a wild few months.
Although yields on CMBSs rose slightly more than Treasury yields declined, most of the spread widening was attributable to the drop in Treasury yields. During this period, Treasuries rallied (in price), pushing down yields for 10-year Treasuries by 123 basis points - from 5.39 percent to a low of 4.16 percent - and, for 30-year government securities, by 82 basis points - from 5.54 percent to a low of 4.72 percent. (Treasury yields measured from August 14 - the Friday before the Russian bond announcement - to the lowest yield in the period - October 5 - for both the 10-year and 30-year bonds. By October 15, the nadir in the CMBS market, Treasuries had retreated notably, to 4.40 percent for the 10-year - a total drop from August 14 of 99 basis points in yield - and to 4.97 percent for the 30-year - a total drop of 57 basis points.)
Yields for Aaa-rated classes of CMBSs widened with astonishing speed from +85 basis points in mid-August to +200 to +225 basis points in mid-October. Since the coupons on CMBSs are typically fixed-rate coupons, investors gathered that excess yield by depressing the price of CMBS. By mid-October, Aaa-rated CMBSs were yielding spreads on a par with those afforded by Baa-rated classes only two months earlier.
Spreads widened before but not as dramatically
The recent spread widening is not the first time the CMBS market has experienced some ratcheting of spreads, but it is by far the most dramatic such episode. Disruptions in fixed-income markets in 1997, triggered initially by the devaluation of the Thai currency, spilled into the CMBS market (see Figure 2). From August to November of 1997, spreads on investment-grade CMBSs widened notably in three months. At the same time, spreads for B-rated securities remained basically flat.
The disparate performance of investment-grade and below-investment-grade CMBSs in the 1997 market movement was consistent with the barbell-like profile of the buyer base. The investment-grade portion of the market is populated by fixed-income buyers, who responded in 1997 to uncertainties in the fixed-income market generally by pushing up yields on senior CMBS classes. In contrast, the B-rated segment is dominated by real estate buyers - buyers who are assuming and pricing for real estate risk.
Although mortgage real estate investment trusts (REITs) were major buyers of subordinated CMBS classes in the previous 12-18 months (mid-1997 to late 1998), they made up a smaller share of the holders of B-pieces in August of 1997...