The year now ending has been a sobering one for the commercial real estate industry, as mortgage defaults have multiplied. Two years ago, barely 1 percent of such loans were delinquent. A year ago that was up to 6 percent, and late this year the figure hit 9 percent.
At $176.7 million, the loss on a loan for the Resorts Atlantic City casino in New Jersey exceeded the proceeds.
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But it has been a great year for people who invest in securities backed by commercial mortgages. Prices have soared.
Those facts are not as contradictory as they seem. Prices have leaped not because things are great in the world of commercial-mortgage-backed securities but because they are not nearly as bad as the panic-level prices of mid-2009 had indicated.
Mortgage securitizations were supposed to make it possible to put up money for commercial real estate with little risk. First there was diversification, with sometimes hundreds of loans contained in a single securitization. Then there were tranches. Senior ones collected relatively low interest rates, but they were protected from losses because more junior tranches would have to be wiped out before losses affected them.
The bond rating agencies cooperatively came up with models that assumed little could go wrong. It was not just the top tranches that got triple-A ratings. Even junior securities got such ratings.
At the height of the crisis, the general assumption was that such ratings could not be trusted. But, “over the last year and a half,” reports Manus Clancy, the managing director of Trepp, which compiles data on securitizations, some such “junior AAA bonds went from 30 cents on the dollar to almost par.”
In other words, buyers tripled their investment. What appears to have happened is that many investors have recovered their confidence that the securitization structure works, and will prevent the damage from climbing too far up the securitization ladder.
While some investors celebrate, however, others get hit with bad news that can suddenly wipe out their stake. Just one loan going bad can have a large impact on a securitization, causing some tranches that were paying on schedule to suffer losses or even be wiped out.
That is in contrast to residential-mortgage-backed securities, for which the damage came from waves of foreclosures as properties lost value. No single mortgage has a major impact on the group.
Commercial mortgages differ in other ways. Loans that seem safe and secure can be plunged into trouble if a tenant moves out and others are not to be found. Shopping centers are facing increased competition — not least from online retailers — and in many cases are seeing rents decline, leaving them unable to pay mortgage interest.
Then there is the fact that such mortgages are almost always nonrecourse, meaning the lender can seize the property but has no claim on other assets of the owner. Moreover, many commercial properties have extremely restricted uses, limiting the number of people interested in a troubled property.
That can give borrowers power that homeowners can only dream of when negotiating with their mortgage holders. Last week a $171 million loan on a shopping mall in Virginia was sold for $115 million. Trepp reports that will wipe out some classes of two securitizations that owned the loans, and provide payouts for others. The buyer of the loan was Vornado Realty Trust, which owns the mall. In effect, it was allowed to pay off the loan at a large discount to face value.
Behind many commercial loans is a story of an investment, and sometimes it is of an investment gone bad. One 2007 securitization trust put together by Credit Suisse this week reported that it had finally closed out a $175 million loan on the Resorts Atlantic City casino. That casino had been sold for a small fraction of what was owed, so the fact that losses were coming was well known. Even so, the size of the loss was sobering: $176.7 million, or 101 percent of the amount borrowed. The cost of liquidating the loan exceeded the proceeds.
That securitization, known as CSMC 2007-TFL2, was sold just as credit markets were blowing up, and contained loans made when valuations were at their most inflated. As such it is proof that the securitization structure cannot provide safety for all if underwriting standards are truly horrid. The top tranche of that securitization has suffered no losses so far, but Standard & Poor’s now gives it a junk rating. The second tranche has begun to take losses.
Some areas of commercial lending continue to get worse. Trepp reports that 15.8 percent of all multifamily housing loans in securitizations are delinquent, and that industry has replaced hotels as the sector with the largest proportion of problem loans.
Office buildings and industrial properties have so far proved to be less prone to delinquency, but problems have been arising there as well. This week another Credit Suisse securitization, CSFB 2005-C2, announced a huge loss as it renegotiated a loan on one large office project. That disclosure highlighted another feature of securitizations, that a single move can be disastrous for one tranche and good news for another.
That move concerned a $106 million loan backed by four buildings in Irvine, Calif. Back in 2005, that was only 73 percent of the appraised value, and the property was fully leased to one major bank, Washington Mutual. The loan brought in only 5.06 percent interest, but it seemed safe.
WaMu was seized by bank regulators in 2008, a victim of bad loans. JPMorgan Chase got most of the bank, but not the lease on that office campus, and the Federal Deposit Insurance Corporation chose to cancel it. A couple of new tenants were found, but most of the space is vacant.
This week the securitization disclosed it had agreed to cut the principal by nearly half. The result, Trepp said, will be the elimination of collateral for four tranches of the security, and damage for another. Those were relatively junior tranches, however, and the top ones have yet to be hit.
But one tranche will benefit. The new arrangement extends the maturity of the loan to 2018 from 2011. That means that an interest-only tranche will get seven more years of payments.
It is reassuring that securitization prices have bounced back, and that new securitizations are now being done. The market for loans on commercial property has reopened, at least for better properties and for deals that involve relatively little leverage, meaning that the property could lose a lot of its value without the lender taking a hit.
But the hangover of the credit bubble is still being worked off, as properties produce less income or lose tenants, and as the lenders take hits. That always happens after booms, of course, but in the past many such problem loans could be worked out by banks with little publicity. Now, because securitizations financed a large part of the last boom, the cleanup process is more public than ever before. It may also be messier and longer. The Resorts casino loan had not paid interest for two years before the final loss was recorded.
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