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Glenn%20R.%20Mueller,%20Ph.D.%20

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Title: Glenn%20R.%20Mueller,%20Ph.D.%20


1
U.S. Commercial Debt Markets Evolution
Dislocation
  • By
  • Glenn R. Mueller, Ph.D. Professor
  • Kyle Cascioli Adjunct Professor

2
Why Real Estate Fits A Portfolio - Size U.S. Real
Estate vs. Other Asset Classes - 12/06
Most US Institutional Investors have an
allocation to Commercial Real Estate between 5
20
Source Pension Investments, October 30, 2006
and Prudential Real Estate Investors, December
2006.
3
All Real Estate Half - 12/06
U.S. Real Estate Values 33.3 Trillion
Institutional Investors do NOT buy homes
individuals buy them to live in they do NOT
produce income
Only 5 of all home mortgage loans are
sub-prime loans
Source Prudential Real Estate Investors,
December 2006.
4
CAPITAL
  • DEBT is Major component of Real Estate
  • Historically private loan sources (Banks, Ins
    Cos)
  • Major access to public CMBS markets in 1990s
  • Cross boarder investing grows in 2000s
  • Size and health of markets drives future values

5
Real Estate Has 2 Sectors Residential
Commercial
  • Residential Mortgage Backed Securities
    (RMBS) Started in the 1960s
  • All prime RMBS investors take same risk

RMBS Pool
Investor Investor Investor Investor Investor Inves
tor Investor Investor Investor
Home Mortgage Home Mortgage Home Mortgage Home
Mortgage Home Mortgage Home Mortgage Home
Mortgage Home Mortgage Home Mortgage Home Mortgage
All investors share equal risks



6
PRIME Residential Debt Market Works because
  • Standard Underwriting on all loans
  • 80 Loan-to-Value (LTV) or debt maximum
  • 28 of borrower income to pay monthly debt (known
    as PITI) principal, interest, taxes insurance
    debt coverage
  • Credit Check on Borrower must have minimum
    credit rating- or FICO score
  • 64 of U.S. population meets prime criteria

7
US Government Enhances Credit Reduces Risk
through The Fairy Godmothers of the Residential
Mortgage Market (Quasi-Government Agencies)
they do NOT make sub-prime loans
8
SO How did sub-prime loans start?
  • A LONG story
  • Starts with CMBS in 1989
  • CMBS evolves or mutates to CDOs in 1999
  • Was function of cheap circa 2005
    http//yegsz.com/Yieldsz/index2.html
  • Creative Wall Street Bankers figure out how to
    put junk into CDOs and get part of the CDO
    traunche rated as AAA, AA, A bonds

9
COMMERCIAL CMBS is DifferentMany Types of
Commercial Loans in CMBS
  • Multifamily Housing
  • Retail
  • Office
  • Industrial / Warehouse
  • Hospitality
  • Health Care
  • Self-Storage
  • Mobile Home Parks
  • Credit Tenant Leases
  • Mixed-Use

10
Commercial Debt Market CMBS Works Differently
  • Complex Underwriting
  • 75 Loan-to-Value (LTV) or lower debt level
  • Look at leases to see if cash flow income can
    cover debt payments need 1.2x debt service
    coverage ratio (DSCR)
  • Owner/Borrower does NOT guarantee payments
    (called non-recourse lending)
  • Local market knowledge important

11
Commercial Debt Market Works Differently
  • Commercial Mortgage Backed Securities
    (CMBS) Started in the 1988
  • 1980s Savings Loan debacle (they made bad
    commercial loans)
  • Congressional enactment of the Financial
    Institutions
    Reform Recovery Enforcement Act of 1989
    (FIRREA)
  • US Government creation of the Resolution Trust
    Corporation (RTC) used CMBS
  • CMBS investors each take different risks in each
    Traunche

AAA Investor AAA Investor AAA Investor
Apt Mortgage Office Mortgage Retail
Mortgage Hotel Mortgage Industrial Mortgage Apt
Mortgage Office Mortgage Retail Mortgage Hotel
Mortgage Industrial Mortgage
CM B S Pool Traunched

AA Investor AA Investor
Each investor takes different risks !!
A Investor
BBB Investor
BB Investor
B Investor
N R Investor
12
CMBS Has Grown Substantially
Source Commercial Mortgage Association
13
Commercial Mortgage Historical Default,
Delinquency Loss Rates1st Quarter 1988 2nd
Quarter 2006Trend Analysis Used to benchmark
Traunch levels
Delinquency Foreclosure Data Source ACLI,
Stifel Nicolaus
Average loss percentage calculated assuming 65
recovery on defaulted loans Source American
Council of Life Insurance Companies (ACLI)
14
Basic CMBS Structure
  • Sequential Pay
  • Time-tranched AAAs
  • Fixed-rate bonds

Avg Subordination
Total Pool
Senior I
AAA
17
83
IO
AAA
14
AA
3
Senior II
A
10
Senior III
4
BBB
6
4
Subordinate I
BB
Subordinate II
4
2
B
Subordinate III
2
2
NR
First Loss
0
2
AAA bonds get paid first then AA, then A, then
BBB, then BB, then B finally Non Rated which is
in the first loss position.
15
Structural View CSFB pool 2002-CKP1
  • Class Current Type Rating WAL
    Window
  • A1 54,044 SEQ AAA
    2.5 06/02 - 11/06 PPPPPPPPPPPPPPP
  • A2 112,435 SEQ AAA
    7.4 11/06 - 08/11 . . . . . . . . . . .
    . . . . . . . PPPPPPPPPPPPPPP
  • A3 601,059 SEQ AAA
    9.5 08/11 - 01/12 . . . . . . . . . . . .
    . . . . . . . . . . . . . . . . . . . . . . .PP
  • B 39,715 MEZ, SUB AA
    9.7 01/12 - 02/12 . . . . . . . . . . . .
    . . . . . . . . . . . . . . . . . . . . . . .P
  • C 13,652 MEZ, SUB AA-
    9.8 02/12 - 02/12 . . . . . . . . . . . . . .
    . . . . . . . . . . . . . . . . . . . . . .P
  • D 26,063 MEZ, SUB A
    9.9 02/12 - 02/12 . . . . . . . . . . . . .
    . . . . . . . . . . . . . . . . . . . . . . .
    .P
  • E 14,893 MEZ, SUB A- 9.9
    02/12 - 03/12 . . . . . . . . . . . . . . . . .
    . . . . . . . . . . . . . . . . . . .PP
  • F 13,652 MEZ, SUB BBB 9.9
    03/12 - 03/12 . . . . . . . . . . . . . . . . .
    . . . . . . . . . . . . . . . .. . . . . .P

Note that A1 gets paid principal back (P) each
period for the first 2.5 years, then A2 gets
principal (P) and so on Q gets paid last in
year 10
16
CMBS Accepted in US Globally
Non-US CMBS started a decade after US markets
were started
Source Real Capital Analytics rcanalytics.com
17
Commercial Mortgage Market 2007
( Billions)
Commercial Loan Originations continued even when
Default rates were 7
Sources 2Q 2007 Federal Reserve Flow of Funds
Release (9/17/2007) 2Q 2007 American Council of
Life Insurance ACLI Mortgage Loan Portfolio
Profile (8/9/2007)
Government Service Entities GSE
18
Commercial Mortgage Market 2Q 2007
CMBS has grown to 25 of annual commercial loan
originations
Source 2Q 2007 Federal Reserve Flow of Funds
Release (9/17/2007)
19
CMBS Market Delinquency Rate
CMBS loans performing well with VERY LOW
Delinquency rates currently
Sources Morgan Stanley Trepp
20
CMBS viewed as less risky in the marketAAA
Subordination Levels
MORE of each CMBS pool have been rated as AAA
each year as they were found to be less risky
(less chance of delinquency or default) from 70
in 1997 to 88 in 2007
Source Merrill Lynch
21
BUT more risk with Interest Only
LoansInterest-Only Loans in Conduit CMBS
Expect less interest only loans in 2008 as
credit markets tighten up. Lenders now want full
amortization
Source Bear Stearns Research
22
BUT Markets dont know how to pricenew
risksCMBS Spreads to Treasury
AAA rates jump from 75 to 200 BBB- jump from 125
to 400
AAA rates jump from 75 to 125 BBB- jump from 150
to 525 !!
CMBS AAA risks not very high
Source Citigroup Global Markets
23
CMBS vs. Other Fixed Income
CMBS AAA only 10 BP over Corporate AAA
Sources Citigroup Global Markets Morgan Stanley
24
Opportunity Funds as CMBS Buyers
CMBS Purchased by Opportunity Funds
Opportunity Funds like the risk/return relationshi
p of CMBS
Source Morgan Stanley
25
CMBS has worked for 20 years
  • The risk in the NR traunch was underwritten by
    Crimmie Mae a mortgage REIT for the first 10
    years - 1988 to 1998
  • Crimmie Mae bought all NR traunches, but they
    reviewed and approved all loans and also took the
    special servicer position fee thus Outside /
    Independent oversight worked well
  • When REIT prices declined in 1998 Crimme Mae
    stopped purchasing and Wall Street Banks were
    stuck with the NR traunches
  • In 1999 a Wall Street Bank invented CMO
    (Collateralized Mortgage Obligations) and placed
    all their NR traunches of CMBS into the CMO.
    (CMOs investing in securities NOT real estate)
  • They convinced rating agencies that not all the
    NR traunches could go bad so some of the CMO
    could be rated AAA, AA and A (and sold to low
    risk investors)

26
CDO created to securitize JUNK
  • The CMO idea was so popular that CDOs
    (Collateralized Debt Obligations) were created to
    put other risky debt investments into a traunched
    security. CDOs can have credit card debt and
    other high risk / high loss debt in them
  • Looking for more high risk investments the Wall
    Street Banks created Sub-Prime Mortgages and
    started selling them through unregulated mortgage
    brokers, home builder mortgage companies and
    residential home brokers mortgage subsidiaries
  • They worked to enlarge the AAA traunch of the
    high risk CDOs by purchasing bond insurance to
    improve traunch ratings
  • Without a NR traunche buyer the Wall Steet
    Banks kept the NR traunche on their books Banks
    currently taking all their losses
  • NO PROBLEMS while the residential market was
    going UP but bad now that the market is going
    down

27
New Debt Innovation (First-Step)
  • Combine Low Quality Debt Loans
  • Package them like CMBS
  • Collateralized Debt Obligations Started 1999
  • Each CDO investor takes different risk

AAA Investor AAA Investor
CDO Pool Traunched
BB CMBS Credit Card Debt B Debt NR CMBS Debt BB
CMBS Credit Card Debt B Debt NR CMBS Debt
Each investor takes different risks
AA Investor AA Investor

A Investor
BBB Investor
BB Investor
B Investor
N R Investor
It cant all go bad! ? So some must be good !
28
New Residential Innovation (2nd-Step)
  • Give Bad Credit Borrowers Loans
  • (including credit card and sub-prime
    residential mortgage debt)
  • Package them like CMBS
  • Sub Prime Mortgage Started in the 2000
  • Each CDO investor takes different risk

AAA Investor AAA Investor
CDO Pool Traunched
Sub Prime Mortgage Sub Prime Mortgage Sub Prime
Mortgage Sub Prime Mortgage Sub Prime
Mortgage Sub Prime Mortgage Sub Prime
Mortgage Sub Prime Mortgage Sub Prime
Mortgage Sub Prime Mortgage
Each investor takes different risks
AA Investor AA Investor


A Investor
BBB Investor
BB Investor

B Investor
N R Investor
29
CDO Market Pricing Changed Quickly
Spreads 12/31/06 vs. 8/31/07
Investors perceive higher risks in Lower Rated
Traunches
12/31/06
Source Merrill Lynch
30
CDO Market Flat Issuance Growth in 2007
( Billions)
3Q 7.8B
Source Wachovia
31
Market Disruption PL Impact on Conduits
1 Billion Portfolio
AAA Spreads (70 of Capital)
BBB Spreads
(bp)
8/31/07
7/1/07
7/1/07
8/31/07
Investors perceive higher risks in Lower Rated
Traunches
32
Insurance Companies saw more Risk in 2007!CMBS
vs. Insurance Company Mortgage Originationsthroug
h First half of 2007
( Billions)
Sources Commercial Mortgage Alert 2Q 2007 ACLI
Mortgage Loan Portfolio Profile (8/9/2007)
33
(No Transcript)
34
Commercial vs. Residential
  • Commercial Mortgage Markets - OK
  • professional people who know what they are doing
  • AAA debt still trading in the marketplace
  • Commercial Real Estate fundamentals still good
  • BBB at high premiums due to uncertainty market
    will adjust
  • Residential Mortgage Markets need to settle
  • Prime residential loans still - OK
  • Sub-Prime loans in trouble (but only 5 of total
    market!)
  • Banks hold lowest traunch where first loss is
    taken
  • U.S. Government stepping in to help resolve
    problem
  • At least one year till resolution and market
    settles

35
Conclusions
  • CMBS gives liquidity / lower cost to Real Estate
    debt
  • CMBS lower B traunches are mis-priced today
    (the opportunity)
  • CDO created way to repackage / improve rating on
    high risks
  • Most CDOs have securities NOT assets behind
    them!!
  • Sub-prime residential debt hurt ALL debt markets
  • (dis-location creates opportunity)
  • BUT sub-prime is only 5 of all US mortgages
  • Only 13.5 of sub-prime mortgages are in default
    (less than 1 of all mortgages)
  • Markets will recover just like after Russian
    debt crisis in 1998
  • Rational long term investment focus can take
    advantage of dislocation!
  • Markets are TRANSPARENT lots of information
    available good decisions can be made
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