The offices of Wall Street's rocket scientists are silent these days, particularly as the work of these number-crunching gurus relates to the real estate arena. The well-paid math wizards created loan and bond structures that became difficult even for seasoned industry executives to understand.
Bond structures today can contain as many as 35 different layers of risk. Take, for example, the Morgan Stanley Capital I Trust 2007 1Q-16 deal. It recently received presale ratings from Fitch. The structure contains 28 different risk tranches, ranging from 15 AAA-rated classes to four non-rated classes.
The concept of a risk for every investor and an investor for every risk ruled the capital markets. But this reign of “conquer by way of confusion” may soon end now that fallout in residential deals has spilled over into commercial, and is threatening to bring the bond issuance business to a grinding halt.
Previously driven by a steady flow of deal originations, as far back as two years ago investors began to worry about the market. At the annual Commercial Mortgage Securities Association (CMSA) convention in June 2006, the trade association revealed a steady disappearance of critical B-piece buyers of subordinate tranches of bonds. The void was quickly filled by high-yield investors who did not adequately price the corresponding risk.
CMSA officers indicated then that investors were spooked by lower underwriting standards and escalating leverage, and urged originators to seek higher-quality loans for bond structures. As a result, issuers had to invent new ways of attracting buyers to their bonds. They did so by opting for extremely complex structures, including a mix of synthetic products such as credit default swaps and other risk-hedging products.
Now that originations have dropped off and CMBS issuance volume continues its freefall from late September, investors are once again demanding that they be adequately compensated for the risk they perceive in today's deals. In turn, these demands have raised borrowing costs for real estate investors, owners and operators. And the result has been a decline in the number of loans that can be written to the standards of the skittish secondary markets.
Even though interest rates remain relatively low, this good news is still insufficient to bring borrowers back into the high-leverage financing marketplace. For instance, the Federal Reserve has taken its Fed Funds rate down to 4.5% and the 10-year treasury notes are yielding even less — a mere 4.07% as of press time.
However, investors' demand for better risk compensation keeps spreads wide, and borrowers have seen a rise in the cost of funds. Therefore, borrowers are holding off on seeking new loans with highleverage features to them, and bid prices for buildings now reflect that sentiment.
With such a shortage of high-leverage products, issuers must rely on plainvanilla financing with loan-to-values of about 50% to 65% to fill their CMBS pipelines. And these loans do not lend themselves to the complex deal structures that have dominated the real estate capital markets over the past five years.
High-yield investors are forced to settle for returns generated by ordinary loans, and they have opted to simply abandon the high-yield market — both for corporate and real estate-backed products. So the market is left with institutional players who are seeking steady long-term income.
“We're right back to August in terms of how optimistic or pessimistic we are to syndicate deals,” says Peter Nolan, managing director of Loan Capital Markets at JPMorgan Securities Ltd. Speaking recently at a Standard & Poor's conference in New York, Nolan remarked, “I don't think we've seen the beginning of a sustained recovery.”
Nolan points to the lack of interest in complex high-leverage deal structures, and suggests that investors will need simpler structures to be attracted back to real estate and corporate bonds.
Nolan is on target with his assessment. Even though these players thrived on slicing up risk in previous markets, the fact that banks are writing down both loans and structured bonds means times are changing. The write-downs reflect anticipation that complex structures may soon go away — ushering in the good old days of simple bonds that average humans can once again understand.
W. Joseph Caton is managing director of Oxford, Conn.-based Hartford One Group, a real estate finance consultant.