We all watched in horror as the residential mortgage market collapsed over the past few years. Mortgage problems seemed isolated to residential mortgages due to the causes: subprime borrowers, wacky mortgage products, poor underwriting standards and unemployment. That last factor -- unemployment -- has also had drastic effects for the rest of the economy, increasing credit card charge-offs, slowing consumer spending, and now affecting the commercial mortgage market.
U.S. banks have been charging off soured commercial mortgages at the fastest pace in nearly 20 years, according to an analysis by The Wall Street Journal. At that rate, losses on loans used to finance offices, shopping malls, hotels, apartments and other commercial property could reach about $30 billion by the end of 2009.
How much does this matter? The WSJ also explains its relevance:
The commercial real-estate market, valued at about $6.7 trillion, represents 13% of the U.S.'s gross domestic product. But the recession and scarce credit are pushing more commercial developers and investors into default. Meanwhile, property values continue to decline, and banks are required to record a loss on any troubled real-estate loans where the appraised value falls below the amount owed.
And what's worse is that this will affect the commercial mortgage-backed securities (CMBS) market. You know all those mortgage-backed securities that plague banks' balance sheets? Well those were primarily residential mortgage-backed securities (RMBS). CMBS may be the next big problem for banks.
CMBS is a little different from RMBS. First, CMBS tend to be a lot cleaner, devoid of the wacky mortgage products and high loan-to-value ratios. In fact, CMBS pools almost always have loan to value ratios below 100%, which is good news.
Just like RMBS, CMBS deals are all very different, so it's impossible to say all deals will be problematic. But some of those differences could present problems:
RMBS pools usually contain thousands of mortgages. That creates decent diversity, because quite a lot of those mortgages have to go bad for the deal to incur serious losses. In CMBS, much greater property values -- in the tens or hundreds of millions of dollars instead of hundreds of thousands -- mean fewer loans. That results in less diversity. As a result, some CMBS transactions can have only a few hundred, or even a few dozen, properties. If a few huge properties go bad, so will the deal.
Due to the diversity in RMBS transactions, they also tend to generally have pretty good geographic diversity. Not so in all CMBS. For example, one deal I looked at had over 40% of its commercial properties located in Los Angeles, CA. If things are bad in a highly concentrated geographic location that can also ruin a CMBS deal.
Single Tenant Concentration
Another concentration problem can be with a single tenant. For example, if a CMBS deal was heavily concentrated with Circuit Cities, then that's a problem.
Property Type Concentration
Property type might be a little less of a worry if all commercial property is suffering. But some types might be worse than others. For example, a deal could have 43% office property, 30% hotel property, 20% retail property and the rest "other." In that case, if office space, travel or retail sales suffer disproportionately, so will this transaction.
Finally, unlike with residential properties, for commercial properties balloon mortgages dominate. In a balloon mortgage all, or most, of the mortgage principal is due at some later date several years in the future. Some of these balloon mortgages are structured as interest-only loans. That means, even in times of distress, most of these mortgages should be able to make monthly payments pretty easily, since those payments are only interest. Of course, that also means that if property values and rents fall, coming up with that large balloon payment in a few years might not be so easy. Someone I talked to familiar with the market told me that it could be as late as 2012 before we really see CMBS collapse, due to defaulted balloon payments.
But fear not. Another bailout is in the works, from the WSJ article:
Rep. Carolyn Maloney (D., N.Y.), who heads the House's Joint Economic Committee, said she is working with Treasury Department officials on a plan to try to head off rising defaults on commercial mortgages before they cascade into a crisis.