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The Real Deal Online

A behind-the-scenes look at how the commercial mortgage-backed securities market began rising from the dead

January 01, 2011

By Adam Piore

Anthony Orso, CEO of Cantor Commercial Real Estate, intends to bundle, securitize and sell $600 million worth of loans as CMBS in March.

Conditions weren't exactly ideal when Doug Tiesi arrived from London in the spring of 2009 to head up The Royal Bank of Scotland's North American real estate advisory group.

The bankers on his new team were shell-shocked from the recently imploded markets and the layoffs that followed. The market for securitized commercial debt had disappeared. Many believed that it was never coming back.

If Tiesi needed a reminder of the challenges he faced in his new position at RBS, all he had to do was gaze out the window of his Stamford office toward the glistening Long Island Sound. Directly below him, on the other side of I-95, lay a desolate construction site -- a testament to the sorry state of the real estate market.

But Tiesi had run the numbers before he took his new job. And he knew things had to change.

"Anywhere from $1 trillion to $1.5 trillion worth of stabilized commercial real estate loans had to be refinanced over the next 10 years," Tiesi said. "In any given year, banks and insurance companies were probably good for $50 billion. We were so reliant on [Wall Street's] shadow banking system to finance commercial mortgages that we had to find a way to bring the market back."

A year and a half later, the CMBS markets -- in which pools of real estate loans are bundled together and sold to investors -- are indeed showing signs of life. In 2010, there were 12 new multi-borrower CMBS issues nationally, totaling $11.4 billion, virtually all of which went to refinance or renew existing commercial loans, according to Thomas Fink, a senior vice president and managing director at Trepp, a real estate analytics firm that specializes in CMBS.

In addition, there were four single-borrower deals, totaling $1.3 billion.

That's a far cry from the roughly $234 billion in CMBS issued during the market peak in 2007, and 2010's numbers don't begin to meet the demand from borrowers. Still, it's a start, and most expect the CMBS market to continue rebounding. Fink estimates it will rise to between $30 and $40 billion in 2011 -- some less optimistic observers say that number is more likely to be in the $20 billion range -- and $50 to $60 billion in 2012.

Tiesi and his team were among the first to help begin the process of regeneration. In April 2010 they securitized and sold the first package of multi-borrower commercial mortgages since June 2008. The package included six loans backed by 81 commercial retail and office properties in Missouri, New Jersey, New York, Texas and Wisconsin, including a $72.6 million mortgage on Four New York Plaza in the Financial District.

RBS's successful placement of its $310 million worth of securitized debt among 29 investors, said Fink, "was a clear sign to everyone that the process of healing that was necessary for the capital markets to restart was well underway."

He continued, "You can't underestimate the importance of that deal for the market. It was an indication that the markets had stabilized enough and had healed enough that people could get information about what these things were worth and make informed business decisions."

That healing process is evident today across Wall Street, where once-shuttered CMBS desks are active again and new players are hoping to capitalize on an expected deluge.

In 2009, Cantor Fitzgerald announced plans to open a new commercial real estate practice, which now consists of more than 55 people in six different cities. And between June and August, Wells Fargo & Co. added more than 20 bankers and support staffers for their loan origination business. Tiesi's team, meanwhile, has grown about 30 percent since the spring, and he expects to continue his hiring spree in the months ahead.

"In the last two months, we've gotten calls from at least half a dozen to a dozen clients getting geared up to go back into the marketplace," said Fink. "They were out of the market, and a lot of them we haven't heard from since 2007 to 2008. Now they want to re-sign up for our services."

New safeguards

As the market begins to rebound, a constant process of negotiation is underway, as investors, issuers and borrowers factor in new perceptions of risk and haggle over tougher underwriting standards baked into any new deals -- all aimed at avoiding the reckless risk-taking of the go-go, precrash days.

"We are in constant communication with the investors that we are selling bonds to," said Anthony Orso, CEO of Cantor Commercial Real Estate at Cantor Fitzgerald. "The industry is making sure there's much more dialogue and communication between both issuers and buyers."

Caution rules the day this time, industry players claim, in what they have dubbed "CMBS 2.0." Before the crash, some CMBS deals contained as many as 300 assets, and most investors were lucky if they looked at the top 10, said several industry insiders. Most of the recent issues have far fewer assets, and investors are combing through rent rolls, annual reports and market estimates for those properties.

The bonds themselves are also "far more conservatively underwritten," said Lisa Pendergast, managing director for CMBS strategy and risk at Jefferies Group Inc., and the president of the CRE Finance Council, the CMBS industry's main trade group.

In 2007, the average loan-to-value ratio (the size of the loan compared to the appraised value of the property) was about 69 percent. Today, it's about 64 percent, according to Trepp. That might not sound like a large difference, but those 2007 appraised values were hugely inflated. Using current appraisals, the CMBS issued in 2007 would show a loan-to-value ratio of about 77 percent.

Perhaps more important, the debt-service coverage ratio (defined as the ratio of the property's net cash flow to payments due on the mortgage) is much higher. Office and retail properties threw off an average of about $1.42 for every dollar of debt in 2007. In 2010, they generated $2.12 for every dollar of mortgage money owed. Most of the new issues are priced off current cash flows -- while during the boom, many issuers set prices based on future cash flows, including overly optimistic assumptions that rents would rise.

Meanwhile, the structures of the securitizations have become far simpler. Deals in 2007 routinely had 20 different classes of bonds. One recent securitization by Goldman Sachs had eight classes of bonds (plus an interest-only bond), while a larger JPMorgan Chase deal had 10 classes (plus two interest-only bonds). The caution is paying off. That $1.1 billion securitization by JPMorgan in October was two times oversubscribed -- meaning demand twice stripped what was available.

Many of the new issues also include new provisions calling for majority votes and greater outside oversight over decisions like whether to foreclose, restructure loans or hire and fire new special servicers in the event of loan defaults -- to help prevent the infighting between lenders that's ensued since the credit crash.

Whether these modifications will be enough to lure back the thousands of investors who were burned when the market crashed remains to be seen.

Darrell Wheeler, a senior managing director at Amherst Securities Group LP in New York, which trades in CMBS, noted that despite technological changes, mezzanine debt information is still not available electronically, and the market doesn't have "the best oversight for the investment-grade investors."

"Some prefer the old, simpler method, where we knew who was in charge" in the event of default, he said. "Now they've set it up so that the majority votes and they have a senior trust advisor or operating advisor. Until the market lands on a standard, it's actually confusing enough that some real money investors probably stayed away from the deals."

Falling knives

In the darkest days that followed the burst bubble, it seemed the pain would never end. The rating agencies were downgrading bonds, shattering their values; Washington was discussing new regulations; and every quarter, banks were writing down their portfolios.

Pricing the loans, said Wheeler, "was like trying to catch a falling knife."

The prices got ugly, with buyers demanding yields of 10 to 12 percent, or even 14 percent, on bonds that had yielded 5 to 5.25 percent during headier days.

"You [were] wondering how could you ever reissue CMBS that people would buy, when AAAs in the secondary markets were trading at double-digit yields?" Tiesi remembered.

Then the U.S. Federal Reserve stepped in. In late November 2008, the Fed announced the Term Asset-Backed Securities Loan Facility (TALF), a program that many in the industry credit with helping to revive the markets. TALF promised to issue up to $1 trillion in non-recourse loans backed by the Small Business Administration. One part of the program provided financing to investors willing to buy existing AAA CMBS bonds. A second part of TALF would back investors buying any new CMBS.

The Royal Bank of Scotland's trading floor in Stamford, Conn.

The higher return offered by the TALF program lured more investors off the sidelines, making it easier for banks to get rid of some of those "legacy loans" stuck on their balance sheets, and move discounted CMBS issues.

Tiesi and his team began to see the first stirrings of life in mid-2009.

Volume on the RBS trading desk had been high for months, as investors and institutions in desperate need of capital liquidated their CMBS portfolios at fire-sale discounts, and RBS traders found new buyers willing to take the risk.

Once those discounts began to abate, Tiesi and his team took several packages of existing CMBS bonds, separated out their component pieces into different groups of securities based on risk, then passed them on to the trading desk to sell to investors -- a process known as a "re-remic," or resecuritization of real estate mortgage investment conduits.

These re-remics -- from RBS and other big banks -- were another key to getting the bond markets going again, and provided an early test of investor appetite for new issues.

"When you start to move that backlog of bonds, you start to relieve the pressure on the market. Things start to relax, and then the possibility of a new issue becomes possible," Tiesi said.

In November 2009, the REIT Developers Diversified Realty, a mall owner, became the first company in the country to try to take advantage of TALF funds with a new CMBS issue. The firm brought in Goldman Sachs to help it raise $400 million, secured by 28 of its assets. Demand was so strong that Goldman lowered the yields on the bonds to 1.6 percent from 1.75 percent -- itself a dizzying fall from yields that were as high as 14 percent during the worst of the crisis.

Fortress Investment Group followed less than two weeks later, issuing $460 million in CMBS through Bank of America to refinance part of a $1.6 billion loan they had used to buy out a railway operator and the property company Flagler Development. One week later, another REIT, Inland Western Retail, issued $500 million in CMBS through JPMorgan.

But all of those deals were single-borrower, multiproperty offerings, lacking the complexity required by vehicles for mass-mortgage restructuring. Only by pooling multiple loans with different characteristics could the industry begin to service smaller- or medium-size REITs, or clients with only one property.

Tiesi and his team decided they would be the first to issue a traditional CMBS product. But they took an unorthodox approach that underscores just how shaky the markets were.

Normally, investment banks issue the loans, and carry them until they can securitize and sell them to investors. But RBS didn't want to get stuck with an additional hundreds of millions of dollars in debt if the issue flopped. So Tiesi and his team approached clients and offered to securitize and bring their loans to market on a "best-effort basis." If no buyers wanted to purchase the securities, they would simply call off the deal. In exchange for signing on, the clients wouldn't have to pay the underwriting fees customarily paid to a bank, and RBS would collect a smaller placement fee.

Tiesi initially managed to recruit borrowers offering around $1 billion in collateral. Then his team began discussions with potential buyers. In the end, 29 investors signed on.

The days leading up to the deal closing were harrowing, Tiesi recalled. Not all the borrowers could meet the timeframe for the deal, while others found banks or insurance companies to refinance their loans faster, or on better terms. As a result, a number of borrowers dropped out -- changing the mix of the loans to be securitized.

Every time the mix changed, RBS had to go back to the rating agencies and get them to recalculate the overall rating on the package. Then they had to reach out to every borrower and explain how the defections affected the deal.

As the weeks passed, the mix continued to drop from its initial level of $1 billion -- shrinking more than two-thirds. "It was nerve-racking," Tiesi said. "There was a point where if we lost enough loans, there wouldn't be critical size. Up to the last moment, we were planning. We had a contingency for pretty much everything."

By the end, some members of Tiesi's team were "sleeping at their desks," he said.

"We had a matter of literally days to get it right," he said. "Every appraisal had to come at exactly the right time, every engineering report, every rating level. We had mezz buyers committing to buy the mezzanine debt, independent of the process; if any one of them fell away, it could pull that whole loan out of the process, or delay the process. If we had lost a few more loans it could have been difficult."

But the issue went through, and more soon followed. JPMorgan followed RBS's initial multi-borrower issue with a far more ambitious pool of 36 loans on 96 properties -- their own $716 million CMBS issue in June 2010. Goldman Sachs, Bank of America and Credit Suisse, among others, have all since gone to market with CMBS products.

New players

One of the most promising signs of the renewed CMBS market may be the willingness of new players to buy a seat at the table.

Cantor Fitzgerald, which had long been known for working in the bond market, made its ambitions clear in September 2009, when it hired Orso, Michael Lehrman and Steve Kantor from Credit Suisse to build its real estate practice, Cantor Commercial Real Estate.

"Bear Stearns, Lehman Brothers, Merrill Lynch were all no longer there to provide liquidity to the markets," said Orso, a longtime industry veteran. "It left a big hole."

Before the crash, he added, "a lot of middle-market real estate was also procured through regional banks. But many of those banks now are either out of business or on watch lists."

Orso spent his first year at Cantor building a CMBS team from scratch. So far he's hired 55 people and opened offices in New York, Los Angeles, Chicago, Dallas, Atlanta and Washington, D.C. He may soon open additional offices in Boston and Miami, and plans to hire between 15 and 20 more people in the coming months.

Cantor closed its first loan in November: $146 million worth of office-building financing for 14 assets in seven states, all 100 percent occupied by the federal government. Meanwhile, last month, they closed on a $52.5 million loan for a large retail property in upstate New York, and six apartment deals in New York City.

All told, Orso said Cantor is expecting to bundle about $600 million into a large securitization they will issue in March with another bank he declined to name. They've already looked at $15.7 billion worth of deals and are actively poring over $9.6 billion more.

"We expect that the total [CMBS] business [this] year will be about $50 billion," he said. "And we're hoping to do about $5 billion."

Accumulating debt again

Today, with the markets returning, Tiesi said lenders are dividing the loans coming up for maturity into three rough categories: those with loan-to-value ratios of around 75 percent and below, which generally find ways to refinance; deals where the ratio is 120 percent and higher -- which most in the industry consider "terminal" because they're being foreclosed upon and sold; and everything in between. Many in that last category are being extended.

"We generally look at loans up to 70 or 75 percent LTV across all property types," Tiesi said, noting that his group is now looking at about 10 to 15 potential deals a week, issuing loans on some, and accumulating debt on the RBS balance sheet in preparation for a new CMBS issue later this year.

Today, he said, the positive direction of the market is a lot easier to see. On a recent morning, he looked out his window toward the Long Island Sound, and his eyes lit upon that vacant lot on the other side of I-95. Construction had restarted.

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