Regardless of the level of success of the federal financial market rescue plan, including the U.S. government's $250 billion equity investment in banks, an elephant remains in the room: the commercial real estate industry and its ability to survive the current credit market crisis. If nothing is done, an onslaught of maturing loans in 2009-2012 will overwhelm the system and produce a meltdown in commercial real estate similar to what we are seeing in residential today. The creation of Securitization 2.0, coupled with a revision of mark-to-market accounting, could forestall the crisis.
Some $44 billion of loans making up commercial mortgage-backed securities need to be refinanced next year, according to Moody's Investors Service. As loans mature, what options will be left for borrowers? Consider that in 2007, 10 major banks and investment banks were responsible for 53% of the total $230 billion in domestic CMBS issuance. Seven of those institutions are no longer in existence. Year-to-date 2008 domestic CMBS issuance stands at a paltry $12 billion. The industry needs roughly $100 billion from CMBS lenders to maintain the required level of liquidity needed for acquisitions and refinance needs. So where is the liquidity coming from? Not from the life insurance industry. Insurers have severely cut back their appetite to lend on commercial real estate in this environment. Money-center banks and regional banks are for the most part on the sidelines, dealing with issues in their residential books. And Fannie Mae and Freddie Mac's appetite for lending on apartment properties might be significantly reduced in coming years.
Today, virtually the entire real estate lending community is shut down. Larger real estate funds that rely on financing from CMBS sources are unable to finance anything right now.
The biggest problem is impending maturity defaults. Lower valuations and more stringent senior debt underwriting criteria will make it difficult for operators and owners to extend their existing loans or refinance. The U.S. commercial mortgage market is valued at $3.44 trillion. There is an estimated $720 billion of loans maturing each year. With an estimated 10% reduction in available debt proceeds, a $72 billion annual shortfall is created. And that is for the gap equity piece alone.
Properties facing maturity defaults will require mezzanine loans or preferred equity to fill the “gap” between their existing debt and the amounts lenders will provide. Heretofore, banks and other lenders have been restructuring and extending loans, kicking the proverbial can down the road. This is no longer possible, as agencies such as the Federal Deposit Insurance Corp. are pressuring banks to reduce their exposure. An influx of more expensive equity will put downward pressure on valuations. Recently funded distressed debt funds and opportunity funds will attempt to fill this void, but it is a large cavity to fill.
A solution to these problems is the return of the CMBS lending market, which will provide lenders with the capacity necessary to satisfy current loan demand. Wall Street (what's left of it), banks, the Treasury, the Securities and Exchange Commission and the credit-rating agencies need to work quickly to arrive at a new securitization model that can be implemented by year's end. Whatever form securitization takes in the future, the originators of the paper must maintain a first-loss position or ongoing interest in the loan, and the rating agencies need to be truly independent and held accountable for their ratings. The ultimate form of securitization needs to be a fusion between the fundamental retention of risks and prudent underwriting that is inherent in a portfolio loan, with the efficiency, transparency and term financing that comes from the securitization model. The end result will be a less risky (and less profitable) model, but one that works better in a world that will undoubtedly be characterized by greater accountability.
The concept of covered bonds, widely used in the German residential markets, was floated for the residential market, but Bush administration officials have said they are not interested in using covered bonds for CMBS. In a covered bond model, banks retain the underlying mortgage loans on the issuing bank's balance sheet. A variant of the covered bond model for the commercial mortgage market could entail the issuing banks retaining the below-investment-grade tranches of these pools of loans while holding risk-based equity capital against these loans (hence covering them), selling to bond buyers the lowest risk and most highly rated securities. The bond market will be relying less on the rating agencies and more on the issuing lender's underwriting, thus re-establishing an appropriate alignment of interests in the process. A version of the cover bond seems to hold the answer, and can be implemented in short order.
The shift will be tough for many to swallow. Banks have become heavily reliant on the securitization model. That model allowed them to shift from a portfolio lending model, where lenders remained on the hook for any losses during the life of the loan while the bank earned single-digit yield to maturities, to a model in which banks transferred risk to others while earning yields in the mid- to high teens. At this point, banks will have to be the originators and intermediaries of loans, as I don't see Wall Street replicating the origination platforms they created over the past 15 years.
Then there is the issue of mark-to-market accounting, which is having a devastating effect on lenders' balance sheets. I can think of no more severe example of the law of unintended consequences. Presently, there is virtually no secondary market for CMBS. When there is no market, marking to market takes on an abstract dimension. CMBS have underlying value and viable cash flows. But an illiquid, no-bid market is artificially depressing values, causing “virtual unrealized losses.” Yet, these securities are performing well, as noted by their low delinquency rate. Another methodology for valuing these securities in an illiquid market must be enacted that will permit financial institutions to report the value of their financial assets in a method that would not rely solely on “liquidation” value but would also recognize the intrinsic long-term value of the assets. Mark-to-market accounting is forcing a ongoing wave of “write-downs” that are not initiated by actual losses, but by a rather subjective and vague pricing model with no commensurate realization. As a result, the banks are hoarding cash to offset further deterioration of their balance sheets, thus compounding the illiquidity issue. Irrespective of what form this takes, once re-enacted, mark-to-market accounting needs to be revised so that realized transactions can be used as comparables for pricing purposes.
These steps to fix the system are absolutely necessary. If they aren't enacted, the elephant in the room won't be sitting back, it will be rampaging and causing much more damage than what we saw during the commercial market meltdown of the early 1990s.
Paul C. Dougherty is the president of Perseus Realty Partners LLC, a Washington-based real-estate investment management company.
