Hi guys,
I have been working on sizing loans. While I work on comps, cash flows, pre lim underwriting, I dont get to work on structuring/pricing a loan. So, I am trying to learn how CMBS loans get priced.
We have a break even spread in our model. Right now, its 180-185 bps for a lot of my loans sized. I get that it is market driven, but can anybody ELI5 the math behind how that is derived? or even what the break even spread is actually is? I am assuming this varies across product types?
Secondly, based on the break even spread of say 180-185, I think my structuring team comes up with the all in spread of 210-220 bps. I also see references to a "15 bps per point". I dont know what this is, but I think this helps the team come up with the 210-220 bps.
If somebody can walk me through the math behind this, I would really appreciate it, thank you!
To add to what some others have said, in CMBS business, Break-Even spread helps calculate the loan coupon at which the bank will neither make nor lose money after securitizing the loan. Most CMBS loans are 10 year loans these days. So the spread is a spread over 10 year swap rates. If 10 year swap rate is 3.00%, a break-even spread of 185 means that if teh bank makes a loan at 4.85% (3.00% + 1.85%), it will not make or lose money. If it makes the loan at a higher spread, it will make money. For 10 year loans, generally 14 basis points results in profit of 1 point or 1% on the loan amount. So, if the bank prices a 10 year loan at a spread of 213, it will make a profit of 2% (i.e. (213-185)/14). 7 year and 5 year loans are less common. For 7 year loans, 20 bps is 1%, and for 5 year loans 25 bps is one point.
To price a loan/debt with pass-through structure, the method proposed by David Lee has been widely used. You need to estimate a Hazard Rate Function and use it to derive the survival function, then simulate default and prepayment time.
The risk of default and prepayment will be well incorporated into the spread data in an efficient market, that's for sure. But it's been less welcomed to price MBS cash flow and a "macro" or aggregate level since the 2008 crisis. Both industry and academics have been making progress to model the cash flow at loan level, which requires tons of advanced math stuff.