The meltdown of the CMBS market last fall followed by its rapid recovery has conduit real estate lenders both breathing a sigh of relief, and at the same time singing the blues, at how fast conduit pricing and underwriting have deteriorated as competition heats up again.
Having spent nearly 25 years managing commodity and semi-commodity manufacturing businesses before founding Capital Lease Funding in 1994, I see several parallels between what is occurring in the conduit lending market and the chronic problems caused by over capacity in mature commodity industries such as paper.
One of the down and dirty industrial commodities in the paper business is linerboard, which is used to make corrugated boxes. The world market for linerboard is enormous - more than 60 million tons annually. It is a capital-intensive product - a world-class linerboard mill can easily cost $500 million to $1 billion - but relatively low tech to produce. Linerboard demand is cyclically driven by the strength of the world economy - more shipping boxes are used in good times than in bad. When the world economy is humming, demand pushes capacity above the magic numbers of 91% to 92%, pricing becomes much less aggressive and profits soar. Everyone makes money and lots of it. But linerboard - like most industrial commodities - is a macho product, where market share is king, management memories are short, salespeople are compensated for volume rather than profits and high-cost capacity never really fully disappears. Sound familiar? As linerboard markets turndown, competitors struggle to feed the machine and avoid costly downtime by cutting prices to the point where often they only cover variable costs. As long as they keep running they can absorb fixed costs. As markets recover and profitability returns, producers seek incremental capacity by restarting older, high-cost machines, speeding up machines and adding new machines. Since it takes 24 to 30 months to plan for and add a new machine, new capacity often comes on stream just as the markets are topping out and turning down.
Larger linerboard producers attempt to partially insulate themselves from downtime by owning their own box plants and integrating them with their mills. While this strategy may enable a mill to keep running longer, it often hides the real economics of the mill since box plants are not able to source the cheapest board available in the market.
Other producers seek to avoid having to meet the lowest price in the market by attempting to differentiate their product in terms of quality and service. While this may delay the inevitable, the impact of falling prices on box maker costs is so dramatic that customer loyalty to quality suppliers is at best limited. At the end of the day, the low cost producer(s) with the deepest balance sheet sets the price.
Competitors who attempt to be pricing statesmen as prices fall invariably lose market share and ironically may prolong the cycle of depressed prices because they are often forced to buy back marketshare later by either selling below market or agreeing to hold low prices longer than recovering market conditions warrant.
As the CMBS market has matured over the last few years, the similarities between commodity manufacturing businesses and CMBS originators have begun to emerge. Wall Street has done an exceptional job in commoditizing CMBS transactions in a very short time. Using standard real estate underwriting techniques and adjusting them to rating agency requirements for securitization, Wall Street, led by Nomura, connected the real estate lending market to the capital markets as never before. After initial investor skepticism, the CMBS market moved from being a limited $5 billion specialty market in 1991 to a $200 billion dollar plus, liquid commodity market in 1998, margins dropped from the 6% to 7% level to less than 2%. Initial profitability attracted many investment banks; many commercial banks and mortgage brokerage firms to set up warehouse lines and begin originating billions of dollars of loans. Since the underwriting technology for conduit-type real estate loans was well established and relatively simple, it was easy for newcomers to rapidly add loan origination and processing capacity by either staffing up or hiring contractors to underwrite loans. Volume quickly became king. As spreads and interest rates began to drop in 1995, volume hungry conduits began to cut lending rates ahead of the curve in anticipation of continued tightening. To offset the adverse effects of tighter margins, conduits did what any linerboard producer would do: cut costs by seeking to increase volume to spread fixed costs over larger pools.
The commodization of conduit loans worked to undercut historic personal relationships and loyalties between borrower and lender. With the market awash in liquidity, price and terms became the only things that mattered. Conduits cut prices to the bone and relaxed underwriting standards to broaden the universe of financeable real estate. At the same time, they held loans on their balance sheets longer to accumulate ever larger multi-billion dollar pools. Bragging rights and Wall Street machoism quickly became tied to deal size. Between 1991 and 1998, Wall Street had built a conduit infrastructure and manufacturing capacity - loan processing capability - which could originate, underwrite and securitize $100 billion a year of CMBS. An everexpanding economy, a recovering and vibrant real estate market and a conduit market that rewarded volume with large bonuses, set the stage to overlook or minimize the growing risk-return imbalance which was occurring.
In retrospect, the warning flags went up with the initial Asian crisis shock in the fall of 1997. While spreads jumped and market conditions became uncertain, securitizations continued to get done and any economic discomfort was quickly forgotten in the first half of 1998 as $45 billion of CMBS was securitized at ever diminishing returns with collateral and loans structures that, in some cases, pushed the limits of prudence. The second jolt - the failure of the Russian economy and several emerging markets last summer - precipitated a worldwide margin call which brought U.S. fixed income markets, particularly the CMBS market, to their knees. Just as with linerboard, when over capacity combined with an economic shock or downturn to highlight the true economic realities and risks of the business, the liquidity jolt highlighted the true economic risks of their business. Treasury rates plummeted, corporates widened, CMBS spreads widened by 150 to 1000 bps overnight and interest rate hedges bled red ink exposing conduits to huge losses. The reality that the conduit real estate business was in fact a low margin commodity business became obvious. With some of the largest Wall Street firms overwhelmed by these conditions and other huge conduits such as Capital America and Conti Financial closing their doors, everyone instantly got religion. Many conduits stopped lending, loan pipelines were repriced and underwriting standards toughened.
Unlike the long down cycles that plague many commodity businesses, the fixed income markets recovered rapidly after their historic meltdown in September and October. As spreads began to tighten in November, deals were getting done, albeit at losses, but the market was functioning. By January, a new sense of confidence had returned and the lessons of September and October 1998 began to fade rapidly, as many rejuvenated and reliquified conduits sought to feed their machines and recapture market share by aggressively cutting prices.
Several prominent conduit lenders attending the Fabozzi Conference in January and MBA in February bemoaned the fact that the fall liquidity crisis didn't last long enough to wash out more marginal players. Ironically, many of the most vocal survivors were at the leading edge of cutting prices to buy back borrowers unhappy with how they were treated when the markets went into turmoil.
As the conduit market recovered, another similarity with linerboard became apparent - capacity never really dies, it just fades away to the next good market. New or rejuvenated conduits began to rise like Phoenixes from the remains of those that left the market in the fall of 1998, each claiming they will originate $1 billion of business in 1999 - even if most market forecasts see CMBS conduit volume declining from $78 billion in 1998 to $50 billion to $60 billion this year. Despite Capital America, Conti Financial and others leaving the market, the conduit manufacturing capacity has not changed much considering that the survivors and new conduits have hired many of the underwriters and loan processors from the conduits that did not make it.
While there are similarities between commodities like linerboard and conduit CMBS, which helps to explain what's going on in conduit pricing and underwriting, there are differences which make the real estate conduit market potentially more risky and volatile than linerboard. Perhaps the biggest difference between linerboard and CMBS is the ability to control key costs. While linerboard and conduit businesses are both capital intensive, investment in capital equipment is much less liquid than the equity margin underpinning conduit warehouse lines. In the capital markets, liquidity is king as capital can be shifted with a few computer keystrokes. When linerboard markets change, capital investment is captive in the mill. Further, the biggest cost of producing linerboard is the cost of fiber, followed by labor and power costs. Because many linerboard mills are integrated with box plants and are owned by companies which either own or indirectly control vast timberlands to supply pulp wood, the cost of fiber is at least partially under a producers control.
This is not the case with CMBS, where the ultimate cost of funds - the key factor in profitability - is determined at securitization and is influenced by domestic and international market factors largely out of the control of the conduit. Last summer dramatically drove home the point when international events completely unrelated to the domestic real estate market pushed the cost of funds through the roof overnight. This summer's spreads have again jumped reflecting investor concern with Y2K, pending Fed action and the enormous supply of corporate debt and other asset backed securities. While conduits attempted at least partially to control the cost of funds through hedges and swaps, to everyone's dismay, these only provided partial protection from the widening spreads - a disastrous result in a business where margins are being driven below 2%. Even if hedge strategies could be developed to fully protect against both interest rate and credit risk, the cost would in many cases be prohibitive given the competitive realities of conduit pricing existing in the market. Hedging market risk still remains a major issue for conduit lenders since no one has yet come up with an economic, foolproof hedge for spread risk.
While integrated linerboard producers may have more control over key costs than a conduit, both can suffer from reporting systems that do not fully capture true costs. For example, mills often view the mill and box plant as separate profit centers, yet if a box plant has to buy linerboard from the company's mills, invariably the true profitability of either operation may be obscured. So too when conduits ignore the true cost and risk of the hedge required to justify a risk-reward ratio based on today's tight margins, or base loan pricing on securitization spreads that do not reflect market clearing execution but rather require the issuer hold 10% or more.
Another difference, which has added to competitive pressures of the conduit market, is that most conduits rely on commercial mortgage brokers to originate loans. Because of the liquidity available to finance commercial real estate in the last three or four years, mortgage brokers have had an ever-increasing number of sources of capital to choose from, which in many cases has reduced correspondent loyalties to any one lender. Deals move between lenders for as little as one or two basis points, putting maximum pressure on margins and making product differentiation difficult. In contrast, industrial products such as linerboard are generally sold directly by the producer to the user on the basis of technical specifications. When brokers are used by mills, it is generally to dump excess capacity - usually solely on price. Box plants that have set their converting equipment to run a particular producer's board and have personal relationships with a mill's sales and technical people, are likely to remain more loyal than conduit borrowers, as long as prices are generally competitive.
Accepting the real estate conduit for what it is - a commodity producer of CMBS securities - and drawing on both the similarities and differences with industrial commodities, one could come to the following conclusions regarding future developments in the conduit market.
Given today's apparent over capacity in conduits, it is likely that margins will remain under severe pressure and not fully reflect the real risk-adjusted cost of underwriting and securitizing real estate loans.
As long over capacity exists in the conduit market, competitive laxity in underwriting is a risk. While investors will attempt to differentiate between those conduits with tight underwriting and those without, this may prove to be difficult given the trend toward teaming between conduits with differing underwriting standards.
The only way capacity will be reduced will be if and when risk capital providers decide the risk-reward ratios are unsatisfactory and reemploy their capital to other opportunities. Large conduits, especially those affiliated with Wall Street investment banks with large overhead allocations and high profit hurdles, are likely sooner rather than later to question whether they want to continue to originate CMBS loans in the United States. These same institutions are moving to originate and securitize real estate abroad where markets are not well developed and margins are more attractive than in the United States.
While Wall Street investment banks may withdraw from the U.S. conduit market, large commercial banks and finance companies such as GE Capital and GMAC, along with specialty lenders with loan origination capabilities, low loan processing costs and a decent balance sheet, are likely to survive the next round of consolidation and growth.
>From a borrower's perspective, the current competitive pressures facing >conduits are likely to continue to provide relatively low cost real estate >financing. However, as the market meltdown of last fall demonstrated, >there is real value to financing with direct lenders rather than relying >on intermediaries who arrange financing on a best-efforts basis and who >have the financial wherewithal and long-term commitment to the business. >This is particularly true when it comes to structuring specialty >financing. For example, when the liquidity crunch hit last September, the >first product line to be shut down by most conduits was CTL lending, and >very few have reentered the market. By contrast, Capital Lease Funding as >a specialty lender is totally dedicated to CTL lending, continued to fund >loans and make commitments throughout the bleak market conditions of last >fall.
Bottom line, capital markets based conduits have and will continue to provide significant liquidity to the real estate market. However, the market has matured into a commodity business and profits are not likely to return to levels enjoyed two or three years ago. In this environment, low cost, well capitalized conduits with quality underwriting and a long-term commitment to real estate lending will emerge as the dominate players, as will technically competent, well capitalized specialty lenders.