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CDOS HURT BY U.S. SUBPRIME MORTGAGE MESS

By Dees Stribling

What now for commercial real estate collateralized debt obligations as the subprime meltdown turns into a credit squeeze? Nobody knows for sure, but as the summer unfolded, things got increasingly unnerving for this new darling (or will that be former darling?) of the real estate finance world.

“There’s been a sea change recently in terms of the willingness of buyers to accept these securities,” said Gary Gabriel, executive director of Cushman & Wakefield’s metropolitan-area capital markets group. “There are no bids. It’s a reflection of the overall aversion to risk in the credit markets, or at least of a newfound hesitancy regarding corporate and real estate debt instruments.”

Roll the calendar back to the beginning of this year (an eon ago in real estate finance terms), when CDOs were the next big thing in real estate finance. The first commercial real estate CDO was issued only in 1999, but since then, issuance has ballooned into a multibillion-dollar business, with the biggest names in finance — Bear Stearns, Deutsche Bank, Goldman Sachs and Wachovia among them — getting in on the action.

Not that the CDO itself is anything new. Long before real estate assets ever got involved, the CDO had enjoyed a distinguished pedigree. Simply put, CDOs are structures that pool assets of various kinds and then sell bonds deriving their income from that pool, or sometimes from the trading of the assets themselves.

As a tool for real estate finance, CDOs offer features that commercial-mortgage-backed securities do not. Most notably, the assets in a CDO can be bought and sold over the life of the structure. The CMBS pool, by contrast, is fixed. Getting a loan out of a CMBS involves the time and expense of defeasance. “For real estate, CDOs still are a more flexible vehicle than CMBS,” said Donald Kalesky, senior vice president of loan servicing and asset management at KeyBank Real Estate Capital. “Not only that, asset types that haven’t been securitized before, such as construction loan portfolios, can be. That, in turn, benefits lending institutions that have diverse product groups.”

The advantage of flexibility was only one reason for the meteoric rise of the commercial real estate CDO. Given that the object of a CMBS pool is to create stable income for bondholders, riskier deals tend to be turned away. CDOs are much more open to the inclusion of riskier loans. And that has in fact turned out to be a serious problem for commercial real estate CDOs. “The reason that CDOs gained the popularity that they did was, in large part, due to lax underwriting,” offered Gabriel. “They were seen as a no-risk way to parcel off exposure. But at the end of the day, these things do carry risk.”

How much risk? It can be hard to say, because of that aforementioned flexibility, says Gabriel. A CDO with fewer risky assets in its early days can, over time, evolve into one with more risk.

Real estate CDOs — all CDOs, in fact — have been compared to snowflakes, in that no two are ever going to be alike. CDOs typically hold hundreds of bonds, loans or other assets, divided into classes of risk. Naturally, the riskier the asset (the riskiest are known as the “equity” pieces), the better the return, unless, of course, there are too many defaults attached to the underlying assets, in which case the results can go pretty far south.

By March the subprime mortgage meltdown got under way in earnest, with less-than-creditworthy residential borrowers beginning to default on their ill-conceived mortgages. It soon became clear that a lot of subprime residential mortgages had been included in some very prominent CDO issuances. How many was anyone’s guess, but for the buyers of equity CDO pieces, high returns had been promised, while the high risks were de-emphasized. As long as the returns came in, the band played on, but the music stopped suddenly with that meltdown. Most notably (so far), two Bear Stearns hedge funds came to the brink of collapse because of heavy exposure to CDOs infected with subprime loans.

More ominously, the buyers of these CDOs were insurance companies, banks, and mutual, hedge and pension funds. If all the riskiest pieces of these CDOs lost most of their value, the losses to these investors would be in the multibillions.

In July Moody’s Investors Service said it was considering a downgrade of its ratings on slices of some 90 real estate CDOs. Not long afterward, Fitch Ratings issued a report that warned of rising defaults on some commercial real estate loans. These would be the result of faulty underwriting: interest-rate-only loans, high loan-to-value ratios, overly optimistic expectations for rent increases, negative leverage. If all of this sounds familiar, it is — it was the recipe for the meltdown on the residential side.

Commercial real estate CDOs may not be the same following these shocks, as investors lose their appetite for the vehicles, even those with little exposure to the subprime mess. And yet this does not necessarily spell the end, some say. “It’s a significant bump, but it will be temporary,” said Tom MacManus, who heads Cushman & Wakefield’s debt and equity group. “Eventually, the market is going to recognize that subprime exposure isn’t the defining characteristic of many real estate CDOs.”

Gabriel agrees — somewhat. “The current lack of liquidity isn’t a long-term trend, but it’s likely that the market will be compressed going forward,” he said.

And Kalesky sees a mixed picture at best. “Most of the impact we’re seeing, including on CDOs, is directly related to spill-over from the subprime meltdown,” said Kalesky. “But now we’re even seeing the CMBS and the [residential-mortgage-backed securities] markets slowing down, and I don’t know that’s all attributable to the subprime problems. The overall slowdown in residential real estate probably is a contributing factor as well.”

Some say the short-to-mid-term fate of commercial real estate CDOs is uncertain, but the long view still holds promise. Over the long term, though, Kalesky says he is bullish on the vehicle. “It’s too useful,” he said, “to be completely discarded by the real estate industry.”