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Collateral Damage

This year was supposed to be the coming-out party for the commercial real estate collateralized debt obligation (CRE CDO) market. After topping $35 billion in issuance in 2006, expectations were the market would nearly double to $60 billion this year. And that's how things were playing out until the subprime mortgage market melted down.

The securities — think of it as a more complex and riskier version of commercial-mortgage-backed securities (CMBS) — are pools of loans made on commercial properties divided into tranches with varying yields and levels of risk. The difference is that CRE CDOs offer investors higher rates of return and issuers greater fees than CMBS. And in the industry's short history it has assembled an attractive track record as the market hummed along smoothly.

But CRE CDOs — perhaps more than any other aspect of the commercial real estate industry — have born the greatest brunt of the liquidity crisis that emerged this summer. That's because in part, some CRE CDOs (about 11 percent) included residential subprime mortgages as part of their asset mix. Moreover, as debt investors fled to the safer bets, like 10-year Treasuries, these inherently risky instruments fell out of favor almost overnight.

After chugging along during the first seven months of the year with $21.3 billion in new issuances, the CRE CDO market ground to a halt and has not yet restarted. Not a single new issuance has been brought to the market since then. And while experts believe the CRE CDO machine will eventually restart, no one is exactly sure when that's going to happen.

“I think the CRE CDO market will weather this storm. But I think CDOs will come back simpler in structure and the type of assets they contain,” says Leonard W. Cotton, vice chairman of New York-based Centerline Capital Group and president of the Commercial Mortgage Securities Association.

In addition, when the market does rebound, Cotton expects it to be driven by strong issuers who are using CDOs as a liability management tool — rather than by highly leveraged investors chasing fat returns. That will mean in the future firms like Centerline will limit CRE CDO usage as a way to bundle CMBS paper, but nothing more.

“There is still money out there. But borrowing costs have increased, large dollar amounts are harder to come by, and, of course, you are not going to get theleverage that you did before,” says Phil Weeber, a derivatives consultant for the structured finance team at Chatham Financial Corp. in Kennett Square, Pa.

It wasn't supposed to play out like this.

Though CRE CDOs have been around since 1999, they remained a small, niche corner of the securitized debt world. But an innovation that enabled managers to actively manage the CDOs asset pools — rather than sit on a static collection of assets — suddenly made these much more attractive.

Through the end of July, issuance was up 35 percent over last year's levels — which had been the most productive year to date for the burgeoning industry with $36 billion in transactions. But now investors in CDOs and CMBS have been sidelined as they reevaluate risk and pricing.

While CRE CDOs may seem like small potatoes in contrast to the much larger CMBS market — which had $299.2 billion in issuances last year, its impact is much greater than you might think. That's because CRE CDOs became a popular depository for B-notes and mezzanine capital on CMBS issuances. As a result, shopping center owners and developers seeking high leverage, floating rate loans on value-added properties will see the greatest impact.

“I think it's going to affect that marginal dollar of leverage that is going to be much harder to get,” says Jean-Michel Wasterlain, chief investment officer at New York-based NorthStar Realty Finance Corp.

The CDO basics

Although there are different types of CDOs, CRE CDOs are supposed to be exclusively backed by commercial real estate assets such as CMBS, REIT debt and commercial mortgage loans including first mortgages, mezzanine loans and bridge loans.

The first CRE CDO — a $500 million offering — was issued in 1999, and early deals typically involved a collateral pool of subordinate CMBS and REIT debt. The CDO structure allowed slightly more flexibility than the traditional repackaging of CMBS securities, while providing a long-term, non-mark-to-market financing for CMBS B-piece buyers. Managers of early CRE CDOs were allowed to sell only defaulted or impaired securities.

But the market caught fire five years later when managers introduced an actively managed model. Under this structure, the issuer determines ranges of geographic distribution and property type. For example, they may decide that between 20 percent and 50 percent of the portfolio must contain loans on properties in California or that between 10 percent and 30 percent will be multifamily debt — then, they have the freedom to swap assets in and out.

At the same time, managers began introducing a wider range of commercial real estate loans into CDOs — whole loans, mezzanine loans and B-notes. Today, that kind of debt represents almost 50 percent of all collateral for CRE CDOs issued in 2006 and 2007, according to New York City-based Fitch Ratings.

The CDO structure also provides access to traditionally unrated, unsecuritized commercial real estate assets that do not necessarily fit into the more traditional CMBS real estate mortgage investment conduit structure. (REMICs are investment-grade mortgage bonds that separate mortgage pools into different maturity and risk classes or tranches.)

There are several upsides to this structure.

For investors, CRE CDOs — because of the greater risk — had greater spreads to London Intebank Offered Rate (LIBOR) than similarly rated CMBS. For example, in December of last year — before credit markets started getting wacky — a BBB-rated CRE CDO delivered returns 65 basis points greater than a BBB-rated fixed-rate CMBS, according to data from Wachovia Securities.

Other benefits for investors include the fact that since pools are actively managed, the issuer can swap out underperforming loans and bring in more lucrative ones. Lastly, because there is potential upside — unlike a CMBS where there is no possibility of greater returns — any proceeds beyond targeted thresholds are reinvested into the pool.

That too creates a benefit for the issuer. Because CRE CDOs require constant vigilance and maintenance — unlike CMBS pools, which remain almost entirely static — managers reap greater fees.

The downside is there is now greater complexity in analyzing exposures to the commercial real estate sector that involve multiple layers of pooling and tranching. It is exactly that layer of complexity — and risk — that has sidelined investors, and has many in the industry clamoring for a simpler, more transparent structure.

Pullback in demand

In a time of crisis, the downsides rise to the fore. CRE CDOs are inherently more risky than other kinds of real estate debt. And therein lies the problem. During the credit crunch this summer, investors fled from risk. CRE CDOs got doubly tainted because residential CDOs were hugely invested in subprime mortgages. And, as it turned out, 11 percent of all CRE CDOs dabbled in subprime residential debt, according to Fitch.

The net result is that there is still an ample supply of CRE CDOs that were in the works before the credit crunch kicked in, but there is no demand for these securities right now. “The investor base for CRE CDOs has evaporated,” says Lisa A. Pendergast, managing director of real estate finance at RBS Greenwich Capital in Greenwich, Conn.

One of the big problems is that some of the main investors that had been buying the top end of the capital structure or the super-senior AAA piece were structured investment vehicles (SIVs). SIVs were significant buyers of CDOs and floating-rate CMBS.

Many big banks such as Citigroup Inc. operate SIVs. SIVs are essentially funds that sell short-term commercial paper and medium-term notes to investors and then put the proceeds into longer-term assets. As the short-term notes came due, SIVs would pay them off and raise new funds. The problem is that the short-term commercial paper market is another particularly hard-hit sector and new issuances have become difficult. So SIVs aren't buying.

Meanwhile, investors who traditionally bought further down the CRE CDO credit stack have gone missing as well, as they are concerned about downgrade risks and the ability of some borrowers to refinance these loans given the backup in mortgage rates, reduced leverage and more stringent underwriting standards.

In addition, certain CRE CDO structures simply don't make sense for buyers in the current environment because there are more favorable options. The spreads when compared with similarly rated CMBS deals, for example, have evaporated. Thus, faced with a choice between a less risky CMBS and a more risky CDO promising the same return, investors are opting to invest in CMBS.

Issuers of CMBS Re-REMICs, deals that repackaged BB, B and nonrated pieces, are now garnering such high yields on their B-piece investments already that those investors don't need the CDO execution right now to meet yield targets. CMBS B-piece investments are generating cash-on-cash yields of 18 percent to 19 percent.

Another obstacle facing CRE CDOs is that issuers have little sense as to the clearing levels on these deals. During January, when the whole-loan CRE CDO market was doing quite well, the best AAA credits were selling at spreads of LIBOR + 25 to 30 basis points. In comparison, a BBB-rated deal was selling for about L+300. In July, those spreads were already starting to widen with AAA deals pricing around L+50 and BBBs finding little sponsorship even in the L+500 basis-point area. More than three months later, spreads have widened even further, but no one is certain as to how much spreads have to grow to entice buyers to bite.

Wooing investors

The downturn in the residential mortgage market created a painful pause in the commercial lending market. Bond buyers did not know if their CMBS or CDO contained subprime securities. “If you are afraid of what's in there, or if you have lost confidence in a whole host of things — rating agencies, the issuers, the underlying business model — then you might worry about whether or not you should be buying bonds backed by mortgages,” Cotton says.

The good news is that while the CRE CDO universe was exposed to subprime residential mortgage-backed securities, it's only a small corner of the market. Of the 115 Fitch-rated CRE CDOs, 13 have exposure to U.S. subprime RMBS. (Fitch believes their current ratings reflect the recent downturn.)

The bad news — to which the lack of CDO activity can attest — is that bond buyers are more wary of the lack of transparency then ever. Industry officials have also worried about the flexibility — and lack of transparency — within CDOs for several years, even before this year's problems flared up. So both issuers and investors are now pushing for greater simplicity and transparency.

Possible changes include issuing CDOs with similar asset types, such as all mezzanine loans or all first mortgages. CDOs also might see deals issued that don't sell as far down the credit stack, or are not as highly leveraged. And it is likely that CDOs will boast a more static pool of assets with less exposure to riskier assets like condos and land.

Ultimately, the rebound of the CRE CDO market may be a long journey. “To say that investors won't come back implies that there is no merit in the CRE CDO structure, and I don't think that's true,” Pendergast says. But, “I do think it's a market that is 18 to 24 months away from any real stabilization.”

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