Qualifying a CMBS Rebound: What an Explosion of New Deals Implies for Credit Quality
Sam Chandan March 27, 2013, 7 a.m.
CMBS issuers are on a roll. The best January on record has propelled first-quarter 2013 volume past $20 billion, a milestone that has otherwise eluded the market for more than five years. Few issuers expect a slowdown in activity over the next year. Both for fusion deals and single-asset transactions, securitization has become an increasingly more competitive option as spreads have narrowed. The single-asset market has leapfrogged the recovery in multi-borrower deals and is on track to surpass its previous peak. After years of middling progress, the CMBS market overall is reasserting itself as investors’ tolerance for risk-taking recovers.
Higher CMBS volume is welcome news for underserved segments of the market. But an abrupt resurgence in activity, however long in coming, carries dangers of its own. Feeding an increasingly esurient deal pipeline will require that conduit lenders cede ground on the relative conservatism of their underwriting. Rising expectations for issuance implies a larger number of qualified borrowers. But it also implies that the scope of conduit activity will broaden to capture a wider range of lending opportunities. In some segments of the market, that process is well under way. Even with more information at their disposal, investors are only marginally better equipped to gauge the attendant risks.
While life companies have garnered attention for the rapid growth in their market share and the visibility of their largest loans, national, regional and community banks are still the mainstays of property finance. Bank lenders account for the majority of commercial real estate mortgage lending, but they cannot serve the market by themselves. Where the viability of CMBS as a competitive alternative depends largely on the bond market, banks’ capacity for growth is tempered by the size of their capital base and an uncertain regulatory outlook.
Notwithstanding their constraints, improvements in bank lending have been increasingly widespread. As default rates on legacy balance sheets have fallen, reflecting dilution as well as troubled debt restructurings, more banks have re-engaged. Banks’ net exposure jumped more than $20 billion in the fourth quarter of 2013, indicating that a majority of institutions with significant exposure to commercial real estate increased and expanded their balance sheets.
The bisection of old and new is not as clean on the balance sheet as it has been for securitization. Across the board, default rates on legacy loans are significantly lower for banks that increased their net lending in the fourth quarter. That correlation reflects a more navigable supervisory relationship for less encumbered banks. It also captures the fact that investment conditions are very likely stronger in markets where distress levels are declining.
More stable bond markets have been crucial to the improving CMBS outlook. If exogenous shocks from sovereigns or corporate bonds force spreads wider, CMBS activity could falter again. But with a positive baseline projection, a more diverse group of potential B-piece buyers has emerged at the bottom of the stack. With that bulwark strengthened, why believe that credit quality might deteriorate?
Market participants have focused their attention on regulatory initiatives such as risk retention, but meaningful self-regulation and offsets to incentive conflicts remain works in progress. The industry’s advocates have emphasized the conservatism of underwriting in post-crisis issuance. While laudable, this cyclical focus on risk is not a substitute for structural measures that will ensure the long-term health and sustainability of CMBS.
Many of the structural weaknesses of the CMBS market—including conflicts in the incentives of the various parties facilitating each issue—have yet to be fully addressed. In the interim, the absence of structural corrections of weaknesses that range from rating agency compensation to the potential for special-servicer conflicts of interest means that the current bias in favor of conservative underwriting is giving way to inefficient risk-taking as the level of activity normalizes.
Rising competition from the conduit can ultimately undermine loan quality among its competitors, including the regulated banks. CMBS may be underwritten more carefully now than a few years ago, but this cyclical focus on risk is not a substitute for measures that will ensure the long-term health and sustainability of the industry. The structural assessment of CMBS that addresses the range of incentive conflicts with practical and implementable remedies is incomplete. In the best case, industry-led efforts will intensify, limiting or precluding inflexible regulatory regimes and encouraging rather than impeding robust securitization activity. In the worst case, inattentiveness to incentive conflicts will allow the current bias toward conservative underwriting to cede to undue risk-taking later in the cycle. In the immediate future, demand for new issuance will then be taken as evidence of sufficient lessons learned and the cycle will threaten to repeat itself again.
Sam Chandan, Ph.D., is president and chief economist of Chandan Economics and an adjunct professor at the Wharton School. The views expressed here are his own. He can be reached at email@example.com.