Does CMBX Reflect Industry Fundamentals?

Is there smoke without fire in the commercial-mortgage backed securities market, or is a doomsday forecast on the future performance of CMBS bonds justified? Industry participants allege that the activities of hedge fund speculators are causing spreads to widen to new highs as these speculators bet that industry fundamentals will deteriorate. However, recent spread tightening in the CMBX may serve to ease some industry concerns about the impact of the index on the CMBS sector.

The CMBX, maintained by London-based Markit Group, was initially introduced in 2006 to help CMBS market participants hedge their exposure to commercial mortgages. The CMBX is a series of credit default swap indices referencing U.S. CMBS that provide investors with exposure to CMBS of a particular vintage. Each CMBX index references a basket of 25 of the most recently issued CMBS deals rated by one of the major rating agencies.

In addition, the deals must have a minimum size of $700 million and secured by at least 50 different mortgage obligations made up of a minimum of 10 unrelated borrowers. A new series of CMBX is issued every six months and the next is due on April 25. Dealers of the index include 17 major Wall Street CMBS participants.

“The CMBX has not traded in a way that is consistent with the underlying cash instruments or the fundamentals of risk behind the underlying cash instruments,” says Ed Adler, co-head of Citigroup’s U.S. CMBS and real estate finance group. “A lot of nonprofessional real estate buyers came into the market and started shorting the CMBX because they believed that the CMBX is similar to the ABX.” The ABX is an index similar to the CMBX that references asset-backed securities, including subprime mortgage loans.

As a result, the CMBX began to reflect this short interest — rather than the fundamentals of the commercial mortgages backing the bonds — and spreads on the CMBX tranches went up to “irrational levels,” according to Adler. Some investors even decided that they could get better returns on the CMBX than by investing in CMBS, which meant that issuers found it difficult to get takers for CMBS securities.

Two weeks ago, according to Adler, the AAA tranche of the CMBX index was a lot tighter, with spreads between 124 and 140, compared with cash bonds, which were trading at spreads in the low- to mid-200s. Consequently, Adler believes there has been some amount of “decoupling” between the CMBX and the cash bonds. This is causing those players with short positions to get out as as they find their expectations of further widening may not be justified, which would cause them to lose their bets.

Adler believes that commercial real estate fundamentals will ultimately prevail. “That [CMBS] market is still open whereas many structured product markets are not open,” he noted. And while CMBS is likely to see some defaults and losses in case of a U.S recession, Adler doesn’t believe that the losses will hit the senior tranches of CMBS debt.

Lisa Pendergast, a CMBS analyst/managing director with RBS Greenwich Capital’s real estate finance group, also noted that there has been some improvement in CMBX spreads after the index hit a low point in mid-March. “I don’t think the environment is stable enough to say that we won’t go back and test those lows again or go lower,” says Pendergast, who also believes that speculators who made money shorting the ABX then turned their attention to the CMBX. “They’re assuming that if, in fact, enough people think negative thoughts about CMBS, then the price will continue to deteriorate. If you short something, you make money as prices fall, or as spreads widen.”

And while an assumption of loss on bonds rated ‘BB’ or ‘BBB-’ is not unreasonable, the loss expectations extend to the highest-rated bonds, too.

To make matters worse, this situation has come about during a period of low commercial mortgage originations and CMBS securitization, which means that the CMBX has become a proxy for pricing CMBS. “Until you have a more robust primary CMBS market and far less skittish investors on the secondary cash market front, you are probably going to see significant volatility,” says Pendergast.

At this point it has become “a very expensive proposition” to short the CMBX, which has caused some decline in the speculative activity. “The market has determined that there’s no fire up the credit curve in ‘AAA’ and ‘AA’, but there may be a fire in ‘BB’ and ‘BBB-.’ So the market is better reflecting what’s going on and what’s likely to occur in these bonds in terms of defaults and losses,” according to Pendergast.

Earlier this month, the Commercial Mortgage Securities Association (CMSA), a trade association representing the CMBS industry, issued a request for more transparency on the CMBX index. In a letter to Markit, Leonard Cotton, CMSA president, noted, “Given the role the index has come to play in determining the ‘mark-to-market’ value of securities held by financial institutions in the current market environment, greater transparency on CMBX trading volumes and the number of daily trades would aid investors in assessing the merit of values as indicated by the index.”

Dottie Cunningham, CEO of CMSA, also expressed concern that “in a volatile market, this mark-to-market process becomes a self-fulfilling prophecy, driving prices down based on index trading activity rather than asset fundamentals.” As some market participants rely on “a distorted value,” it perpetuates a cycle of “no issuance, erroneous spread widening and additional mark-to-market writedowns.”

Asked for comment on these concerns, a Markit spokeswoman responded that the CMBX trades on the over-the-counter derivatives market and that Markit does not have access to trading data on volumes and number of daily trades. The spokesperson also noted that trading volumes have never been published for older, over-the-counter derivative products such as commodities and foreign exchange. Hence, there is no precedent for releasing CMBX data.

As for concerns that the index distorts the industry reality, Markit’s position is that “the index is a transparent, liquid trading tool that allows institutional investors to gain or hedge exposure” to the U.S. CMBS sector.

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