News

The Language of Capital Markets- by Kyle Ladewig

June 3, 2009

On Tuesday, March 24 Jesse Lowe spoke to ULI members about “The Language of Capital Markets.” Lowe is the Associate Director for the Middle Markets Finance Group at Cushman & Wakefield. He has been with Cushman & Wakefield since 1997. After serving as an analyst, he has originated more than $400 million in debt financing for office, industrial, retail and multi–family properties in the Western U.S.

HISTORY

Lowe began by giving explaining how the real estate capital markets have evolved over the last 40 years. According to Lowe, the real estate game changed dramatically in 1970. Prior to 1970, real estate was financed by portfolio lending – savings banks and life insurance companies making loans for specific properties. Long-term investments in commercial real estate made sense for these companies because they matched the long-term liabilities on their balance sheets. And until 1970, these companies faced little competition in the commercial markets.

In 1970 the U.S. Department of Housing and Urban Development created the first mortgage backed security (MBS), issued by the Government National Mortgage Association (Ginnie Mae). The other major public/private mortgage entities, Freddie Mac and Fannie Mae, followed suit with their own MBS issuances in 1971 and 1981, respectively. The creation of mortgage backed securities was a definite paradigm shift for the real estate capital markets, as these new instruments opened the doors to enormous pools of new capital.

Lowe identified 1986 as a second major milestone in the evolution of the capital markets. In this year, Tax Reform of 1986 effectively spurred the growth of the commercial mortgage backed security (CMBS) market. The new legislation changed tax rules for real estate investors, allowing for the creation of Real Estate Mortgage Investment Conduits, or REMICs. These entities were “pass-through” trusts, meaning they managed pools of mortgages and distributed payments to investors, but did not themselves earn returns. With the advent of REMICs, the infrastructure was in place to support a large MBS market, although it is hard to imagine anyone knew exactly how large this market would become. By 1996 the market had grown to $2.1 trillion.

MECHANICS

The securitization process for mortgages has been discussed in virtually major newspaper and on virtually every news program. While some of these explanations make little sense to the average reader or viewer, Lowe described the process as having four distinct components.

1) Pooling – Typically an investment bank pools roughly $1 billion of individual mortgages. These mortgages can differ greatly in terms of the property types they are collateralized with (e.g. hotels, office buildings, or warehouses), the property locations, the loan sizes, the credit worthiness of the borrowers, etc. Or, in some cases, the mortgages may be very similar – ultimately this depends on what sort of risk/return profile the issuer of the MBS wants to create.

2) Tranching – After the bank has bundled the mortgages, it divides the pool into different asset classes, or tranches. Tranches vary in terms of both interest rate and riskiness. The higher the interest rate paid, the higher the risk. By “tranching” the mortgages, the bank allows investors to specify the level of risk they want to take. Holders of the riskiest tranches are paid last in the event of default or foreclosure, but are compensated with a higher interest rate.

3) Rating – After the bank has divided up the pool of mortgages, it sends the information to a rating agency. These companies then rate each tranche on a scale from AAA (the highest possible rating) down to B (unrated, or “junk”). These ratings are supposed to reflect the relative riskiness of each tranche so that investors can better understand how safe the underlying mortgages are from default.

4) Servicing – Once the bank has received ratings, the MBS is ready to sell. The bank markets the security to investors, who purchase individual tranches. When a payment is made on a particular mortgage, a REMIC (“servicer”) receives the payment and distributes it to the investors.

PROBLEMS

The collapse of the real estate capital markets involved many complex factors. In an effort to explain the mess we have now, Lowe pointed out three key reasons for why the market came to a grinding halt, bringing the rest of the economy down with it.

1) The “Lenderless Loan” Dilemma – Since REMICs were designed as “pass-through” entities, they were never intended to be heavily involved with individual properties. They were, more than anything, set up for legal purposes. This wasn’t a problem when foreclosure rates were low – payments were being made, investors were happy, and servicers didn’t have to do much. In good times, the master servicers ran the show. These groups are the first line of defense, collecting mortgage payments and reporting on the performance of individual assets.

When defaults became a reality, special servicers became involved. These groups, the last line of defense, only see deals when things go wrong. They specialize in workouts (renegotiations of loan terms), foreclosure proceedings, and other functions aimed at maximizing return for MBS holders.

So where is the lender in all of this? After all, the servicers certainly did not originate the loans. Technically, every MBS holder is a lender. But the problem with tranching loans is that investors are not all created equally. Since the holders of riskiest tranches are the first to be wiped out if a mortgage isn’t paid, they have the most interest in protecting the asset. The responsibility goes “up the waterfall,” as Lowe describes it, until the AAA holders face the possibility of losing money. The end result is that mortgages aren’t serviced in the most effective way, and as lower tranches are wiped out, the person dealing with the problem changes.

2) Underwriting “Out the Window” – In the 2000’s, when CMBS issuance skyrocketed, most loans were non-recourse, meaning the borrower made no personal guarantees. Developers and buyers of real property were essentially without liability. This lack of accountability fueled excessive risk-taking.

At the same time, the rating agencies were treating risky loans the same as safer loans. This came about as agencies became increasingly loyal to the investment banks that paid their fees. In attempting to please the banks, rating agencies failed to accurately label the different tranches in each security.

These two factors together created a market in which ratings could not be trusted. Nevertheless, investors continued to poor massive amounts of money into the CMBS market – at its peak, 80% of the commercial property market was financed by CMBS.

3) Tricky Derivatives – As the CMBS market took off, bankers began to test the limits of financial instruments. From what they were seeing, securitization was doing wonders for the real estate market and there were plenty of investors with large appetites for the latest and greatest products to come out of Wall Street. In this frenzy, two three-letter phrases were born that are now synonymous with economic disaster – CDO and CDS.

CDOs, or collateralized debt obligations, came about as a way of securitizing commercial loan assets that couldn’t be securitized before. In other words, banks and other financial institutions wanted to take the MBS idea one step further, by pooling B-notes and mezzanine debt – the riskiest pieces of mortgages. CDOs started as static pools of loans, but eventually evolved with introduction of “revolving transactions,” in which managers replaced collateral when loans were paid off earlier or otherwise. In simpler terms, the institutions would throw new assets into the pool when others were paid off.

There were two major problems with this practice. First, according to Lowe, bondholders didn’t know what they owned. Second, managers were racing to replace assets in a market without enough good assets. When good collateral couldn’t be found, construction loans and eventually sub-prime loans were packaged into CDOs.

CDS, or credit default swaps, were created in part as a response to the growing MBS and CDO markets. Savvy investors realized that they would face huge losses if rating agencies “downgraded” the securities or if the assets went into default. CDS are essentially insurance against either of these events. If a tranche was downgraded, the holder was to be paid in full.

The problem came when risky loans stopped performing and CDS holders wanted to cash in their insurance policies. At the same time, speculative investors were purchasing CDS to “bet against” the risky loans – even though they didn’t actually own the loans themselves. This massive wave of redemptions hit and it became obvious that there was not enough money to go around. This is precisely what led to the collapse of AIG.

LOOKING FORWARD

Since the beginning of the collapse, CMBS issuance has slowed to a trickle. Lowe presented the figures below, which show how quickly the capital markets changed directions.

Lowe continued by pointing out several lessons to be learned from the current recession. First, the entire market was based on the idea that the market (investors, banks, developers, etc.) could accurately assess and price risk. But this idea failed because everyone assumed they were protected. Lowe argues that this was due to a lack of understanding about even the most basic financial instruments. It is important to realize, he says, that all financial instruments are “derivatives,” or bets on some secondary asset. Even a savings account is a bet that your bank won’t fail and that, if it does, the government (FDIC) will reimburse you for your losses. This might be an extremely safe bet, but a bet nonetheless. The only real difference between a savings account and a credit default swap is the risk/return profile, and perhaps the amount of information readily available to evaluate the risk.

So where do we go from here? Is this the end of securitization for the real estate capital markets? Lowe doesn’t think so. He says we’re probably near the end of the residential collapse and only beginning to realize the problems on the commercial side. However, even with more potential problems on the horizon, Lowe doesn’t see CMBS going away any time soon. He sees some potential opportunities in vintage CMBS – those issued before underwriting went south – and believes CMBS will come back strong in 2-3 years. When asked why, he said it’s still the most efficient way to purchase commercial real estate.