How bad can it get for commercial mortgage-backed securities in the event of a recession in the U.S.?  

A stress test on commercial mortgage-backed securities (CMBS) in 675 CMBS bonds, finds that CMBS securities rated BB have as high as a 63% chance of downgrade in a recession scenario, according to a recent study commissioned by industry trade group, Commercial Mortgage Securities Association.

Moving up the investment spectrum, the odds against downgrading improve. Bonds rated BBB- have only a 47% chance of downgrade, while those rated BBB face a 31% chance of downgrade. AA-rated bonds face a low 2% chance of downgrade and A-rated bonds face a 6% risk. AAA-rated bonds in the stress test showed a 2% risk of being downgraded.

According to the study released at the CMBS industry trade association’s annual convention in New York, the current wide spreads on CMBS are nothing more than an irrational market reaction.

“There are no skeletons in the CMBS closet,” according to Jun Han, a CMBS researcher involved in the study and a principal of JHP Capital, a commercial real estate investment services firm. “Market fears and the liquidity crunch have dramatically distorted the value of commercial mortgage-backed securities, creating one of the best environments for investing in CMBS.”

The bonds analyzed in the study are backed by over 19,500 commercial mortgage loans and account for about 39% of the fixed-rate CMBS outstanding.  These bonds also make up the four CMBX indices used for hedging purposes by market participants.

Given the probabilities of downgrade, CMBS bonds are likely to do better than corporate bonds in terms of expected losses, the study finds. Expected losses could reach as high as 46% in the case of BB-rated bonds and as low as 1% for A-rated bonds. In the case of BBB- bonds, expected loss is more than 17%, and investors in BBB bonds could see more than a 9% loss.

Spreads on the CMBX do not reflect the fundamentals and anticipate much higher levels of future defaults and losses on CMBS, according to the study. Based on March 20 CMBX spreads, the implied annual collateral default rate for AAA-rated CMBS was more than 100%.

Han notes, “When applying a worst case 1986 stress-test scenario, spreads on the CMBX 4 index of almost 1,200 basis points over T-bills, were almost twice as high as would have been expected at fair value. This demonstrates the kinds of distortions and limitations of ceding the determination of value of the nearly one trillion dollar CMBS market to an untested and volatile derivatives index during an unprecedented credit and liquidity crisis.”  

So how did the CMBX become a proxy for the cash CMBS market? According to the CMSA study, the positioning of the CMBX is fallout from subprime mortgage market problems. As subprime mortgage delinquencies rose, many hedge funds and other investors in subprime mortgages were negatively impacted, leading to the failure of some hedge funds such as UBS’ Dillon Read and Peloton.

These subprime mortgage investors also had exposure to the CMBS world. In an attempt to recover some money, lenders to these investors seized their CMBS investments and had to sell them into illiquid markets. Buyers kept away from the bonds since they were already facing losses on CMBS bonds whose values had declined in the market. This caused the lenders’ exposures to CMBS to go up.

Lenders and investors began to use the CMBX to hedge their CMBS exposures. They also started to use CMBX spreads to mark their cash bonds. With more investors looking to buy default protection on CMBS than there were sellers of the protection, CMBX spreads soared.

This caused a vicious cycle to set in of “more spread widening, greater mark-to-market losses, new failures, more CMBS to sell, less liquidity in the cash bond market, more hedging needs, and wider CMBX spreads,” according to the study. All of these events in turn attracted speculators into the market, causing spreads to widen yet even further.

The study concludes that based on fundamentals CMBS investors have nothing to fear. For one, new construction has been under control in this cycle, with annual addition of space in the last five years averaging less than 1% for most property types, with the exception of retail, which averaged 1.6%.