An Introduction to CMBS
When I first heard of CMBS, it was New Year's Eve 2009, almost 2010. I was over at the house of one of my parent's friends. We played board games ate food and participated in all the other customary New Year's activities. Then, late into the night my dad's friend, a financial guy said he wanted to show us something; He told us it was something called Commercial Mortgage Backed Securities (CMBS). I don't remember much about what was said that night in specifics, but I do remember being intrigued at the both the opportunity and complexity.
Later, when I was studying Finance in college, I was looking for internships and applied for a semester-long co-op at a large-public financial company. I interviewed for their commercial real estate department and they told me all of these different areas, but one stuck out to me as I remembered back to a few years earlier when I first heard about CMBS.
So, I found myself working for 8 months in the world of CMBS. I want this lens to be an introduction to the history and structure of CMBS. I will try to write this to the person that is interested enough to know more, but not with such complexity that you need a Ph.D to understand it. Read on below!
"To create a mortgage-backed security (MBS), a large number of mortgages are pooled together; the mortgage-backed securities each have claim on payments made on those mortgages. The net effect is that each investor in the MBS owns a tiny piece of each mortgage, distributing each mortgage's risk of default among a large number of investors" (13 Bankers).
It all started in 1968 with Ginnie Mae. She's not my crazy aunt, in fact she's a government entity less glamorously known as Government National Mortgage Association (GNMA). Ginnie Mae was created by the US government to "promote home ownership". We'll talk about the specifics later, but it took a bunch of home mortgages, put them all in a large pool, and then sold the pool to investors. And since it was backed by the US government, it was super-safe. Salomon Brothers, in the early 1970's tried to create private mortgage backed securities, but ran into problems with government regulation.
Then came Lewis Ranieri. This guy has quite a story. He was born in Brooklyn and had aspirations to be an Italian chef. He pursued becoming a chef until he realized his asthma wouldn't allow him to spend his time in smoky kitchens. He instead got a job at the Salomon Brothers mailroom and moved his way up. In the late 1970's he was promoted to the head of Salomon's new mortgage trading desk. In 1977 he created the first private mortgage backed securities. Ranieri didn't even have a college degree, but he realized that he needed technical expertise. He hired math PhD.'s to develop the structure of these new bonds. Securitization is a term that Ranieri first used to describe the process of turning mortgages into bonds.
In 1983 Fidelity Mutual Life Insurance sold $60 million of commercial mortgages to three other life insurance companies, with Salomon mediating the transaction. The reason this is significant is that Fidelity actually serviced the mortgages and passed on the interest and principal to the "beneficial owners". There were a few more deals similar to this in the mid 1980's, but portfolio commercial mortgage loans overshadowed CMBS for at least the next 10 years.
The decade beginning in 1990 saw an in increase in the CMBS market and the real-estate bubble helped to fuel the new issuance to an all-time high of $230 Billion in 2007.
But in 2008, CMBS issuance fell off a cliff with only 5% of the 2007 issuance. The decade of the 2000's saw a "streamlining" of mortgage underwriting standards. There was a general optimism that the commercial real estate market was permanently changed. Innovation had created new wealth and access for all parties. Risk was perceived as low.
As we all know, this optimism did not rise forever. Commercial real estate, like residential crashed. In 2009 the new-issue CMBS market was effectively zero. The CMBS market has since recovered and with new regulation and underwriting continues what some say is healthy market.
The graph above is the best way I have found to describe CMBS. The whole rectangle represents a full CMBS bond.
The height represents interest rates; the width represents the total amount of a CMBS bond. The yellow and green columns represent the different classes or tranches of the bond. So the A1 class represents a tranche with a small proportion of the bond's balance, and a rate of less than 1%. The A4 tranche has a significantly larger proportion of the balance with an interest rate of about 3%. Most tranches have a fixed rate, but some tranches have a variable rate.
The real beauty of CMBS structuring through, is the seniority system. The rating agencies create a certain cutoff for subordination (let's say 30%) above which they will rate AAA. This means 70% of the bond can receive the highest rating. This creates a hard line for the securitizer. They can create whatever tranches they want, but above the 30% line, all trances will be rated AAA. Below this line is known as the B-piece. This B-piece is usually sold privately (not listed on the public market).
The tranches on the right are senior to the ones on the left (meaning the A-classes receive payment before the B-class). This works very well to manage risk match supply to demand. If a bond investor want more return, they can have it as long as they are willing to receive their payment last. Liquidation is also passed first from right to left. This structure is many times described as a waterfall with cash flow flowing from the most senior classes down.
There are also other factors not represented in this graph, such as maturities and credit rating.
CMBS is an amazing investment. Not only is there the yield of fixed income, there is a structure steeped in real estate. In a relatively small investment there is a great amount of diversification. One bond can hold mortgages from a variety of borrowers, geographies and property types.
CMBS deals can be widely variable in their unique structure, but generally they follow these guidelines: 50-500 loans (with the top 10-20 loans representing more than half of the deal value) $1-5 Billion total value.
Like all debt holders, CMBS bondholders don't really care about the upside; CMBS bondholders care primarily about the downside, risk. Both a mall that performs average and a mall that performs really well pay the mortgage. A mall that is losing money will not be able to pay the mortgage and may default.
For CMBS, there are two main risks. The first is apparent, liquidation risk. The risk is that a borrower will not pay the mortgage. The second is less obvious, prepayment risk. The risk is that a borrower will pay the mortgage, but pay it early. There are many protections against both types of risk built into the structure that is CMBS.
How exactly do you turn mortgages into a bond again? - Oh, thanks. I forgot it was so simple.
Legacy and Growth
CMBS had a cautious resurgence 2010 and after. But these new bonds were smaller, safer and the underwriting was much different. Many people call this CMBS 2.0 (or 3.0).
There has been a flurry of new regulation in the financial market including the all-encompassing Dodd-Frank. One proposed measure of Dodd-Frank, the Credit Risk Retention Rule would require any bank or financial institution to keep at least 5% of the credit risk of any security they securitize. This measure would most likely shut down the CMBS new-issue market in its current form and has been lobbied against repeatedly by the major U.S. banks.
CMBS has been and continues to be an essential part of US commercial property financing. About 1/4 of all commercial mortgages are securitized (that is put into CMBS). CMBS is the ultimate free-market innovation. It allows for originators and investment banks to do what they do best in the mortgage process and creates a security. This security is sliced up into products that are sought after by investors in a wide array of sectors.
And CMBS is not only in the U.S. There is major CMBS activity in the European Union, Japan, Hong Kong and Singapore. The domestic and foreign markets continue to expand.
For More Info - (my sources)
- CMBS 2012 Report
Very helpful for some overall statistics on the CMBS market as a whole
- Fusion Deal
A description of fusion type CMBS deals and a very simple description of CMBS basics
- Lewis S. Ranieri Businessweek Article
More info on the life of Lewis Ranieri.
- American Bankruptcy Institute
The best short history of CMBS.
- 13 Bankers: The Wall Street Takeover and the Next Financial Meltdown
A book that describes MBS in the context of the US financial history and especially the 2007-2009 financial crisis.
- CMBS 2.0: What is it?
A slideshow from 2012 explaining the resurgence of CMBS and why its called 2.0.