This winter and into the spring, bad financial news piled up like so much cordwood, fueling speculation that the current slowdown could unfold as one of the most serious recessions since the Great Depression. Investors looking for ways to capitalize on the downturn have turned to the world of derivatives. Hedge funds banking on huge defaults in various areas of structured finance have created trades to cash in. Last year, it was in the ABX index created from residential mortgages. One hedge fund trader made over $3 billion shorting residential real estate in 2007. Now for commercial real estate, investors have turned their attention to a formerly little-noticed corner of the financial world — CMBX indices.

CMBX indices are based on real-world commercial mortgage-backed securities (CMBS) issuances and are meant to serve as a reference point for structuring credit- default swaps and other derivatives trades. The CMBX indices comprise 25 tranches, each of which are based on single bonds within a CMBS issuance with its own rating, such as AAA. The individual CMBS issuances included in the indices must be worth $700 million or more and have at least 50 mortgage obligations from 10 unrelated borrowers.

Markit, a London-based company, owns and administers the index, which is supposed to closely resemble the current credit health of the commercial mortgage market. Currently, there are four vintages of CMBX indices — two each from 2006 and 2007. The values within the indices are determined by daily trading.

The spreads on the CMBX tranches help determine the prices of structuring credit- default swaps. In theory, swaps are supposed to act like insurance policies designed to protect against risk posed by CMBS bonds. Investors in these bonds can go to the market and buy default insurance from other investors. One party pays another a fixed amount each month for protection against default on the bonds underlying the index or the reference obligation. A trader may pay for protection worth $1 million or $10 million, regardless of what the actual bond is theoretically worth. Each credit- default swap has a market-determined interest rate based on the risk of its class. Pricing is based on the spreads themselves, rather than on any other pricing mechanism.

In calm times, the spreads on the tranches within the CMBX indices matched the real-world default rates of the bonds on which the indices were created. However, as the credit crunch raged on, a huge disconnect emerged. Spreads on the CMBX have widened considerably. For example, the spreads on CMBX.NA.BBB Version 2 were at 55.56 basis points on October 25, 2006, but widened to a peak of 1,576.07 basis points on March 18, 2008 (see chart below).

The spread means that to get $1 million of insurance on a $100,000 debt (which is a real possibility), a trader would have paid an annual cost of $157,600 on March 18, 2008, up substantially from the $5,600 that same trader would have had to pay on October 25, 2006.

The widening spreads reflect a huge number of assumed defaults. Some estimates translate the spreads in the CMBX indices as $200 billion in real-world write-downs. However, most current research on commercial real estate does not indicate that massive defaults are on the horizon. In fact, in the first quarter of 2008, delinquencies for all CMBS bonds were at 0.39 percent — well below historic norms and nowhere near the level of subprime residential delinquencies, which are close to 20 percent.

What some believe is going on is that the indices, originally designed to protect traders from defaults in collateral associated with CMBS, have become the means of speculation. The problem, says Lisa Pendergast, managing director of Connecticut-based RBS Greenwich Capital's real estate finance research department, is that CMBX is being used to reflect the sentiment about the market today rather than as an indicator of true value and of potential losses. “Normally, the market takes its cues from new bonds and how they are priced.” Pendergast thinks things have partly gotten out of control because of the drop-off in new issuances. According to Commercial Mortgage Alert, an industry newsletter, there were only about six billion dollars' worth of CMBS issuance in the U.S. in the first quarter of 2008, compared to $61.2 billion in the first quarter of 2007. “Once you start to see the new [CMBS] issue pipeline, that will start to change,” says Pendergast.

Recently, the CMBX indices have begun to rally, drawing down some of the historic widening on spreads. As of April 10, the spread on CMBX.NA.BBB Version 2 had dropped to 965.5 basis points. Still, spreads remain at extremely wide levels. Darrell Wheeler, an analyst at New York City-based Citigroup Global Markets, Inc., says the recent swing is the market coming to grips with the fact that commercial real estate is not as bad off as the residential market.

Meanwhile, the drop-off in CMBS issuance has created another problem. Markit was slated to release the next batch of CMBX indices on April 25th, but delayed it until May 13 because the volume of issuance has been low this year. As a result, there have not been 25 deals since the last CMBX was created in October. That means the indices will likely have to include some of the same bonds that were included in the last CMBX indices that traders are already shorting.

Coming under fire

The CMBX indices have also come under fire because the credit-default swaps associated with them are not transparent. Buyers of credit-default swaps are not privy to the volume of trades related to CMBX indices. Because they are over the counter, they are not public. Only the traders themselves, who are located at investment banks, have a handle on the volume of trades. But they are not talking. In fact, says one knowledgeable observer, “No one will admit to being a CMBX trader.”

To improve the transparency predicament, some observers are suggesting Markit could provide greater clarity by asking the 14 major dealers who determine the CMBX market to reveal their daily trading volume, Pendergast says.

The Commercial Mortgage Securities Association (CMSA), a trade association that represents the CMBS industry, issued a request to Markit to provide more information. “Given the role the index has come to play in determining the market-to-market value of securities held by financial institutions in the current market environment, greater transparency on the CMBX trading volumes and the number of daily trades would aid investors in assessing the merit of values as indicated by the index,” CMSA president Leonard Cotton wrote in the letter.

But not everyone favors the publishing of such information. “It is the dealer group, rather than Markit, which makes the decision about this,” says Ben Logan, managing director for structured finance at Markit in New York. “It is not for us to lobby one way or the other. There are plenty of people on the buy and sell sides who don't want that information revealed. It is a private market,” says Logan.

But in a November 9, 2007, report entitled “Bond Market Roundup: Strategy — CMBS,” put out by Citigroup Global Markets, which Wheeler contributed to, the authors say that CMBS buyers have been hesitant to buy a derivative product when they don't know the size of the market. “This is an important shortcoming for both the ABX and CMBX markets and one that makes the indexes unattractive investments for traditional real money buyers. Other synthetic indexes that Markit maintains have started to provide desk-by-desk surveys of traded notional,” says the report.

Too much obfuscation?

The CMBX indices fall under the category of the kind of complex structured finance products that many observers are pointing to as a major culprit in the ongoing credit crunch. Michael Greenberger, professor of law at the University of Maryland School of Law, who teaches a course in financial derivatives calls derivatives “glorified casinos,” for example. (During the Clinton administration, he was director of the division of trading and markets at the Commodity Futures Trading Commission.) Greenberger says, in practice, the indices only serve to allow traders to make bets on the CMBS securities — some betting that values will go up, while others bet they will go down, says Greenberger. “Credit-default swaps don't have a market. You can't open the Wall Street Journal and find prices for them,” he says.

When the banks marketed collateralized debt obligations, which may contain credit-default swaps or CMBS bonds, they did not sell them all. Some were rolled into bank-operated hedge funds or off-balance structured investment vehicles. Others that were ultimately supposed to end up in CMBS issuances got stuck on bank balance sheets when the bond market dried up in the second half of the year.

As those CMBS bonds, which even in the best of times don't trade often, sit on bank balance sheets, the assets must periodically be “marked to market.” Banks use recent deals as a proxy for valuing their own portfolios. Now, with many assets believed to be worth quite a bit less than thought, banks are writing down values of their portfolios. The write-downs have largely only happened with subprime residential bonds. But if the CMBX index is to be believed, which Greenberger thinks is accurate, the write-downs will have to spread to the commercial side as well.

And while commercial foreclosures remain at a record low, Greenberger still thinks that subprime mortgages were just the “canary in the mine” and that ultimately commercial real estate will face real issues. Many people think that the CMBX indices undervalue commercial real estate, “because if they have to reflect the thaw in the value [of commercial properties], that can lead to panic and a drop in stock prices.”

While most observers don't share Greenberger's pessimism about the health of the commercial real estate market, nearly everyone agrees that more regulation is in store for the financial system, which would ultimately affect the CMBX market.

Derivatives are in need of regulation, “although I don't have any hope that there will be meaningful regulation anytime soon,” says Greenberger.

Right now, Congress is busy wrestling with containing the damage of the current crisis. Much of the legislation that has been passed or is being discussed has centered on stimulus bills and legislation meant to stem the massive tide of foreclosures.

When the immediate crisis passes, the discussion is likely to move to possibilities of more wide-ranging reforms, such as the ambitious proposal laid out by Treasury Secretary Henry Paulson, which would give the Federal Reserve Bank more sweeping powers in overseeing the financial system.

One challenge is that unwinding credit-default swaps are likely to leave few parties satisfied. After all, a great many investors entered contracts and credit-default swaps on the assumption that the bonds would fail. Such traders stand to reap a windfall from rising defaults. But if the government steps in and bails out troubled borrowers, those gains would be wiped out.

“One of the advantages of an over-the-counter market is that you can do better analysis than your counter parties,” says Logan.

Still, some sort of regulation is likely, which would make observers like Greenberger happy.

“When I was a regulator, I was opposed to the deregulation of derivatives. They were the reason for the Enron debacle, as well as the manipulation of electricity rates in California” a few years ago, says Greenberger. “While derivatives have a proper place within the economy, they have to be regulated,” he says.