Just when it seemed that the CMBS market was beginning to hit its stride, the industry slammed into a roadblock.
In late July, ratings agency Standard & Poor’s (S&P) suddenly withdrew its rating on a $1.5 billion CMBS offering from Goldman Sachs and Citigroup, forcing the entire deal to be dropped at the 11th hour. S&P then did the same with a $1.19 billion Freddie Mac CME issuance.
New York–based S&P said it found a flaw in its review process relating to its calculation of debt service coverage ratios, causing it to abruptly pull its ratings. The company gave no timetable as to when corrections might be made but said it would not assign new ratings until it completes an internal review.
This development has sent shockwaves throughout the investment and securitized lending communities, placing more hurdles along the beleaguered sector’s path to recovery.
“Such an event is unprecedented within the CMBS market,” wrote Richard Parkus, head of commercial real estate debt strategy at New York–based Morgan Stanley Research, in a statement. “The manner in which S&P took its action has severely eroded investor and issuer confidence in its ratings.”
For borrowers, the latest development means that the CMBS market has lost its competitiveness in the short term. After all, the interest rate on a CMBS loan is directly tied to what investors will pay for the securities, and if lenders don't know what the existing investment appetites are, it's extremely difficult to price a loan.
Six to eight weeks ago, conduit lenders were pricing spreads of about 200 basis points (bps) over the benchmark 10-year Treasury swap, making them competitive with Fannie Mae and Freddie Mac for the first time in years. But over the past month, those spreads have widened by about 100 bps on 10-year loans, which sets the conduit market back to square one.
It’s safe to say that Fannie Mae, Freddie Mac, and life insurance companies will continue to dominate the market for long-term fixed-rate debt in the near future.
Still, this latest development is just a detour on a longer road to recovery. So far this year, the CMBS market has been improving considerably from 2010, when just $11.5 billion in commercial-mortgage bonds were sold.
“While this is a pause, the market in general is still headed in the right direction,” says Mike Flood, vice president of legislative and regulatory affairs for the Commercial Real Estate Finance Council, a New York–based trade group. “While everybody is a little gun-shy after the last two years, we’re still ahead of last year and projected for $30 billion this year.”
Adding to the CMBS market’s volatility, the industry will soon have a new set of rules via the Dodd-Frank regulatory reform bill, and those rules are still in flux.
Some of the potential changes to the CMBS industry include a 5 percent risk-retention requirement that will be fulfilled either through the securitizer or the third-party B-piece buyer. Another requirement of the proposed reforms is that the originator/issuer would have to take its profits over time, rather than earning them up front.
In short, the wave of rule making yet to visit the CMBS industry will likely cause the execution to become a little more costly, which may further hamper the sector’s recovery.
“When you add regulation and checks and balances, there will be a natural increase in costs,” says Flood. “We believe that the increase in costs will be for everyone, from the issuer to the borrower, and how that shakes out all depends on the final regulation.”