Daily Double: Those Who Shorted Mall Debt Have Hit the Jackpot

While many market participants long anticipated an end to the last cycle — and nobody wished for, or planned for, this particular ending — the short sellers’ bet against U.S. mall debt has paid off, big time.

One such investor, New York-based MP Securitized Credit Partners, returned a whopping 47.9 percent return to investors in its $162 million flagship vehicle in March. Billionaire Carl Icahn also jumped into the trade, upping his wager from $400 million in November to $5 billion currently, the New York Post reported —making him the largest short seller today.

One-Two Punch

The slow demise of brick-and-mortar retail was underway long before the COVID-19 pandemic hit U.S. shores, the virus only accelerating a trend already in motion as consumers stayed home and stores forcibly shuttered. While the crisis brought misery for landlords and tenants who struggled to pay debt service and rent, it brought about a hefty payday for certain investors who had chosen to bet against mall debt via CMBX 6, a synthetic index of credit default swaps that references the performance of commercial mortgage-backed securities (CMBS). This particular index has exposure to a number of loans largely originated in 2012 to 2014, when there was some heavy mall lending taking place.

As such, retail loans comprise 40 percent of CMBX 6. Its short sellers are betting on those loans defaulting and subsequent losses, while those going long on the trade are conversely betting on them performing solidly.

Prior to COVID-19, both the long and short sides of the trade could be argued; afterall, not everyone wants to shop online and, hey, mall owners were getting creative with experiential concepts. That logic came to a screeching halt when the pandemic kiboshed public gatherings and paused income for retail assets that were already languishing. And while malls have long been considered a story of haves-versus-have-nots, even stronger malls are being troubled by the tsunami of retail bankruptcies unleashed by the pandemic.

Betting on the BBB-

CMBX indices track the performance of CMBS and reference 25 conduit deals and their various tranches, the highest (AAA) tranches hold the lowest risk and also the lowest returns, while the lower-rated (BBB-) tranches represent higher risk and so give high returns. It’s the subordinate, BBB- slices from CMBX 6 — and to a lesser extent CMBX 7 — that have hit the headlines as the next “Big Short.” Those particular bonds are heavily weighted in retail loans and have far less credit enhancement — a strategy to improve a borrower’s creditworthiness in a deal, through which additional collateral, insurance, or a third party guarantee is often provided.

That potent combination is “where the rubber has really hit the road,” said Manus Clancy, senior managing director at Trepp.

The cost to insure against losses on the CMBX 6’s BBB- tranche has soared since the pandemic hit. The spread premium demanded by sellers of protection on the tranche widened from 662 basis points on March 2 to a high of 2,456 basis points on May 14, before falling to 2,081 basis points as of June 26, according to data from IHS Markit.

Tracking a downfall 

The CMBX 6 shorting thesis began in 2017. Savvy investors realized there was a substantial amount of retail loans—on malls, especially— backing the index and the retail sector was ripe for distress.

While the physical retail sector was in poor health back then, nobody could have had the foresight that a global pandemic would vastly speed up the timeline of store closures and retailer bankruptcies, bringing a far more lucrative and brisker pay out.

The COVID-19 pandemic kick-started another wave of CMBS loans being sent to special servicers as borrowers—with little warning, given the condensed timeline of the virus’ onset— grappled with tenants’ missed rent payments and had to request their own relief from lenders. For several retail owners, it was a fatal kick when they were already down.

Two weeks ago, a Fitch Ratings report stated that $401 million in retail conduit CMBS loans were 60-plus days delinquent and $4.6 billion were 30-plus days delinquent. Further, $1.8 billion of retail loans transferred to special servicing in May alone (comprising 51 percent of total loan transfers). Of those $1.8 billion, 65 percent or $1.1 billion were backed by regional malls.

Four malls that transferred are operated by CBL Properties, four by Pyramid Management Group and one each by Pennsylvania Real Estate Investment Trust, Washington Prime, Starwood (STWD), Simon Properties and Wilmorite. The largest transfer is the $210 million loan backed by the Eastview Mall and Commons in Victor, N.Y., $120 million of which is in COMM 2012-CCRE4 and part of CMBX 6.

Players, place your bets 

In 2017, hedge fund Alder Hill Management was one of the first investors out of the gate to bet that the chickens would soon come home to roost for U.S. malls.

On the other side of the trade from Alder Hill were two massive mutual funds who didn’t buy its bearish thesis and went long instead — namely Putnam Investments and AllianceBernstein.

In November, AllianceBernstein issued a whitepaper “debunking” the short trade, stating that the American shopping mall was evolving, not dying.

“Some of the 37 regional malls represented in the CMBX 6 can’t survive,” the whitepaper read. “But most are dominant within their trade areas, produce ample or sufficient internal cash flow to support both capex and debt service, and have enough sponsor equity to reposition to meet evolving consumer demands.”

AllianceBernstein didn’t see the black swan named COVID-19 lurking around the corner. Flash forward six months to May 2020 and the Financial Times reported that the long trade had inflicted “painful paper losses” on the firm.

Today, Alliance, Putnam, Icahn and MP Securitized Credit Partners are the four biggest names on either side of the trade.

M (V) P

MP Securitized Credit Partners, a structured products-focused hedge fund with a significant portion of its activities in CMBS, was founded by Noelle Savarese and Marc Rosenthal in 2008 on the heels of the global financial crisis. The two started the firm as part of FrontPoint Partners, the hedge fund that became famous for its bets against subprime mortgages in “The Big Short” under Steve Eisman.

It began shorting CMBX 6 in 2018.

Dan McNamara and Catie McKee, a principal and managing director at the firm, recently spoke about the trade on a Trepp podcast.

“Everyone in our market is familiar with the Alder Hill whitepaper that came out in 2017,” McKee said during the podcast. “We can’t take credit for coming up with the idea but we didn’t put [the trade] on at that time; we thought it was a little bit early. The main feedback was the negative carry [when the cost of holding an investment/security exceeds the income earned while holding it] you had to pay between then and the 2022 loan maturities.”

MP Securitized jumped into the trade in mid-2018, confidence buoyed by the fact that the loans were a little closer to maturity. “We also had a basis trade where we were long CMBX 7 and short CMBX 6 so we were more carry-neutral, and also because we’d done the full underwriting. We thought regardless of how bad retail got, that CMBX 7 malls would fare better than CMBX 6 malls. That basis trade worked quicker and better than we thought it would, so at the end of the year we were left with just the short side of the trade.”

McNamara said that MP “went into this fully expecting [the trade to finally pay off] past [loan] maturity…COVID sped up the timeline dramatically.”

Indeed, even with retail being a dirty word for some time, the “longs” were banking on a protracted timeline, and that they would be paid for a long time before real problems arose and losses were felt. Further, even if they did have to pay out a little, it’d be more than offset by the amount of premiums collected over time.

Moreover, most assets were somewhat cash-flow positive before COVID hit. “The guys that were long said, ‘This is great, we have five or six years of collecting these premiums, which will be profitable,’” said Clancy. “And the truth is that even after a loan defaults at its maturity date, often the resolution of the loss doesn’t take place for another two or three years. So they can…collect up to seven or eight years of premiums on this stuff before any of these things go belly up.”

Even those who could tell which way the wind was blowing, like Alder Hill, don’t necessarily want to put up with the carrying costs indefinitely, which was why Alder Hill pulled the plug on their trade in September 2019 before COVID brought true havoc on the retail scene.

Clancy continued: “Before COVID we called it a very fair trade. You could make a really compelling argument for both sides. Nobody was getting ripped off. But now what has happened is all these guys that were modestly profitable and collecting small dividends every month are now modestly negative because of COVID, or maybe significantly negative.”

Handing the keys back isn’t difficult for borrowers when it comes to CMBS debt. The loans are non-recourse, and it’s been happening since the early 2000s. “Even when things were booming in 2005 and 2006, you still were seeing mall defaults because of competition or losses of tenants,” Clancy said. “And you would see even the biggest mall operators say, ‘You know what, this is not strategically advantageous for us anymore. We’re gonna call it a day.’ And there was never really any ramification. There was a time in lending that there might have been a stigma or reputational risk attached to throwing back the keys, but for the last 20 years, that’s not really been the case. There’s been no damage or impact for borrowers.”

And while they are still active in the trade, the shorts’ commitment to the cause is clear. McKee said during the Trepp podcast that she had visited many CMBX 6 malls over the course of the past couple of years. In order to avoid assisting the other side of the trade, her superiors “forbid me from even buying a bottle of water from any mall that’s in CMBX 6.”

McNamara chimed in that they’d had a “lovely lunch at an Olive Garden that was not part of the mall collateral.”

Perfect Storm

Of the top 10 largest retail loans in CMBX, three are in special servicing (with imminent monetary default cited as the reason for their transfer) and a further three are on the servicer’s watchlist, according to data provided by Trepp.

In addition to Eastview Mall and Commons, another mall struggling within CMBX 6 is the Poughkeepsie Galleria in Poughkeepsie, N.Y. Its CMBS loan was transferred to special servicing in May, but, per Trepp data, there were rumblings of problems much earlier. Nine of its tenants including Charlotte Russe, Payless and Bare Escentuals closed their doors in 2018. The departures were partially offset by the opening of four new tenants but the mall faced stiff competition from sister properties The Galleria at Crystal Run and Danbury Fair Mall in Danbury, Conn., both within less than one hour’s drive from the property. The mall received its most recent blow only last week as one of the casualties of JCPenney’s recent round of store closures. The retailer anchors the Poughkeepsie Galleria and accounts for 26 percent of its square footage.

The Next Wee Short?

Retail isn’t the only asset class that’s suffering at the hands of COVID-19, so could there be another shorting opportunity around the corner? “The thesis has been bandied about that maybe people should open up their eyes to look at other CMBX series that have heavy hotel exposure and short those,” Clancy said, adding that he doesn’t know of any active CMBX hotel shorters quite yet but “there has been conversation that perhaps it’s something to look at, because there other series beyond CMBX 6 that have higher hotel exposure.”

Case in point, the CMBX 9 index, which includes 17 percent hotels, with the loans originated in 2015. (CMBX 13 has the lowest combination of hotels and retail combined.)

Seventeen percent isn’t that much to work with, however. “You have 40 percent of retail in CMBX 6 and 36 percent in CMBX 7,” Clancy said. “With 16.7 percent you probably need something else to go your way, because If you’re shorting like that, that is not enough to create the kind of losses that retail might see in CMBX 6.”