On a CMBS conduit loan, how do banks make their profits? I believe it because the bank receives more bond proceeds than the underlying collateral they are contributing - is the the correct mechanism of profitability?
Why would bond investors pay more than the value of the underlying loans? Relatedly, why do some super senior AAA bonds trade at a premium?
I have heard most of CMBS conduit loan profitability is in the IO class. What does this mean?
Thanks
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Hi bballman27, the silence is deafening, sorry about that.... Any of the threads below helpful?
More suggestions...
You're welcome.
I am on the originations side but work closely with securitization, so can speak on this a bit. Your assumption is incorrect. It’s not about bond proceeds. It’s about spread.
Say for example you have a $10mm loan that you closed at 300 spread while baking in one point of profit (14-15 bps on a 10 year loan equals one point). Break even pricing based on current CMBS spreads at loan closing was 285. So you closed this loan to make one point of profit ($100k in this scenario) assuming bond spreads in the market at the next securitization stay the same. The loan has closed and now it goes into a securization pool that launches 2 weeks after loan closing. Say in those two weeks, CMBS spreads tighten significantly. Say the new break even on this loan is now 250 spread. Since the loan is closed and the rate has been locked, you’re not gonna change the spread from 300. So now when the new securitization pool launches, you have made 3.3 points of profit ($333,000 - 300 subtracted by 250 so 50/15 which is 3.33). Because CMBS spreads tighten from loan closing to actual securitization, that loan that was supposed to make just one point of profit made 3.3 points. Now the actually pricing is more complicated and we use a special pricing model for that. Let me know if this doesn’t make sense.
By the way same thing can happen in the inverse, if CMBS spreads widen, we could lose a bunch of money on that same $10mm loan.
Is it common for the securitization team to allow naked exposure to spreads adjusting? Figured this was more market neutral and a volume business.
Thank you, that's very helpful. I understand it's basically all about being able to distribute the risk at a tighter spread than the loan was originated at. The part I'm having trouble completely grasping is how do loan originators make that money upfront?
In your example of the loan with a +300 spread being sold into the market at +285 yielding 1 point of profit, the bank makes that one point of profit upfront, right? Not by clipping 15 bps of extra coupon each year, but that profit is made at the point of securitization. What's the mechanic by which that happens? I think my question is more one of bond structuring than loan pricing, but would love to hear any insight you have.
Thanks
Hey - Work at a structured products hedge fund focused on CMBS so should be able to help out here.
The way it works is banks (or a group of banks - syndicate) will originate loans at some loan spread. The originators have to think that this risk is 1. Attractive enough to the CMBS market that traders are still interested in bidding various tranches without them having to widen out significantly and 2. attractive enough that it won’t take a massive loss as they are required to hold 5% of the risk given risk retentions rules from 2016 in either horizontal or vertical form… though it can also be sold to a TPP…perhaps that’s a different post though.
So after they close on the loan, they warehouse it and try to hedge the spread risk and rate risk via rate swaps and CMBX AAA. CMBX is a basket of 25 individual CDS on a variety of tranches all typically of one vintage (ie all backed by 2022 vintage AAA tranches) (not always true and mostly not true for recent vintages).
Alright, so they’ve attempted to hedge their spread and rate move and they’ve gathered together enough loans that they can now pool them all together and sell them. By the magic of securitization, certain investors are willing to pay more for more “targeted” risk. IE maybe at a HF I wouldn’t want to buy the whole loan I only want exposure to the bottom 10% - the risk return profile fits me better. This tranching of risk return makes it so the overall spread across all tranches is lower than the W.A. of the loans. But where does the excess go? It goes like you said to the IO. Now the actual most important tranches from a bank profitability standpoint are the aaa because SSnrs are 70% of the stack, but the IO is the price of the excess, and it grows as the AAA get better execution.
Thank you so much, CMBS_HedgeFund. So am I correct in sayinig that basically the 'secret sauce' of CMBS that enables profitability is the time tranching? Ie. by creating tranches of various risk profiles that appeal to different bond buyers the sum of the parts becomes worth greater than the whole loans individually.
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