In late February, investment analysts at Merrill Lynch downgraded the stocks of mortgage investment giants Fannie Mae and Freddie Mac. A few days later, both government-sponsored enterprises (GSEs) announced massive losses and indicated they expect more losses and asset writedowns over the next six months or so.
The ratings of the GSEs were downgraded to “sell” by Merrill Lynch and a host of other brokerage houses. In the wake of the negative, institutional investors sold the stocks.
Since the corporate investment marketplace has always served as a barometer for real estate bonds and real estate-related investment instruments, commercial real estate investors would do well to heed both the corporate ratings and investor reaction to these and similar mortgage investment vehicles.
The rating agencies have been quite active in reviewing and downgrading several commercial real estate-backed bonds and loan pools as well. Recent rating actions have pushed some faltering investment-grade securities to levels of non-investment grade, reflecting a host of fundamental problems with the underlying transaction.
And many institutional investors, such as pension funds and conservative portfolios of life insurance companies, have strict and ironclad investment guidelines stating they cannot hold non-investment grade securities.
CMBS takes a hit
Consider that when Fitch Ratings downgraded seven classes of LaSalle Small Balance CMBS Securities 2006-MF3 in late February, three of those classes fell to below investment grade and likely fell outside the parameters of acceptable risk for a number of institutional real estate investors. This is one of the foremost reasons that many buyers have disappeared, which caused even more erosion in value for a number ofmortgage-backed issues.
Pension fund managers must maintain a predetermined level of safety for their investors, and are often mandated to sell when loan pools fall below acceptable risk. In order for risk appetites in these large funds to be changed to accommodate a declining market, several lengthy legal proceedings will have to be undertaken.
If and when pension funds, life companies and an increasing number of hedge funds are forced to sell securities due to negative ratings developments, one can be assured that these investors represent and move very large blocks of securities. And that must be of greatest concern to traders and market observers — that multiple fund managers can be forced to sell large blocks of securities into a weak market at the same time.
Building confidence abroad
Even as the securities downgrades continue, there are a number of positive moves by institutional investors and market insiders to suggest a level of confidence building might already be underway. The CEOs of Fannie Mae and Freddie Mac have already gone on recent whirlwind tours to a number of Asian and European countries to assure institutional investors that the current U.S. market disruptions are temporary and that the firms are taking action to shore up capital and rebuild the value of securities.
Some of the best votes of confidence are recent decisions by the California Public Employees Retirement Fund and two other states to increase their investment allocations for real estate. CalPERS fund managers recently proposed an increase in real estate allocation from 8% up to as much as 12%. And the state employees' retirement systems of South Carolina and Pennsylvania have recently begun to “nibble” at real estate-related investment securities that have declined in value due to downgrades.
In a story the Associated Press broke, fund managers who represent the two states had been selectively buying real estate-related securities. South Carolina, for instance, is considering an option to “buy as much as $100 million of mortgage-related investments for its $30 billion state pension fund.”
So while there is a genuine concern that institutional investors may be forced to sell mortgage-backed securities as weaker market fundamentals continue to emerge, there is a great reprieve in sight. Traders have legitimate reasons to worry about large blocks of mortgage-backed bonds being sold by fund managers who have no other alternative.
But free markets have a funny way of correcting themselves. The very securities sold by one institutional fund manager can become another institutional manager's hot new.
W. Joseph Caton is managing director of Waterbury, Conn.-based Hartford One Group, a real estate finance consultant.
SOME CMBS CLASSES SUFFER DOWNGRADES
At least three classes of LaSalle Commercial Mortgage
Securities Inc. series 2006-MF3 are no longer investment grade.
$3.7 million class E to ‘BBB-’ from ‘BBB’
$6.8 million class G to ‘B+’ from ‘BB’
$2.5 million class H to ‘B-’ from ‘BB-’
$1.9 million class J to ‘CCC/DR1’ from ‘B+’
$1.2 million class K to ‘CCC/DR1’ from ‘B’
$2.5 million class L to ‘C/DR6’ from ‘B-’
$1.2 million class M to ‘C/DR6’ from ‘CCC/DR1’
Source: Fitch Ratings