CMBS Vs. CDOs

cre123's picture
Rank: Senior Gorilla | 751

For someone who doesn't live in this world but loves this stuff::: Difference between a CMBS and commercial real estate CDO?

CMBS: Incorporated domestically? More commonly first mortgage loans and only mortgage debt is allowed here--no derivatives. Investment grade but can be below investment grade. More transparent. Collateral cannot cycle in and out.

CDO: Incorp0orated offshore? More commonly floating rate loans and can be backed by an array of commercial real estate collateral--CMBS, preferred equity and construction loans within the CDO. Exotic debt and unsecured loans are commonly found here (along with some secured debt too). Short term and long term derivatives mixed in. Riskier debt--usually below investment grade and almost never an interest only tranche. Collateral can cycle in and out here.

Who are the common purchasers for each type? I assume there is some crossover.

We're seeing spreads 140+swaps from CMBS (in my market) --- anyone else seeing these high spreads?

Comments (26)

  • Anonymous Monkey
  •  Dec 8, 2015

140+ swaps pricing is not high. That's a tight spread. Also tighter than by 30-40 bps than current CMBS spreads.

Dec 9, 2015

You guys are talking about two different thinks.

AAA 10 yr bond pricing is Swaps+140
CMBS LOAN pricing is Swaps+~250

Dec 9, 2015

I agree with you on the CMBS Loan pricing generally carries a spread of +- 250 bps, but as of right now, a lot of CMBS shops are using treasuries instead of swaps.

Dec 9, 2015

The collateral that is allowed to be in a CMBS deal is very specific. For the most part it is fixed rate 10 year mortgages.

CDO's for the most part haven't been issued this cycle. Historically, the major CDO market was non-investment grade CMBS bond buyers ("b-buyers") such as LNR, would securitize the b- bonds that they held.

Dec 9, 2015

swaps=treasuries +~10 bps, no?

Dec 10, 2015

Generally, you would be correct, cre123. As of right now, the Swap Spread is currently negative, so technically a 10 year swap rate is roughly 210 bps and the corresponding treasury is roughly 221bps. These rates change everyday; it drives borrowers crazy during due diligence and underwriting.

Most CMBS fixed rate term sheets will state that they will use the greater of treasuries or swaps, so the Swap Spread is never negative.

Dec 10, 2015

What do you use to track swaps personally? Bloomberg or do you have a link?

Dec 10, 2015

I'm curious if I'm correct: my elementary understanding is that a CDO is a bond BACKED BY a shitty chunk OF cmbs.

So, the CMBS is backed by commercial mortgages.

The CDO is backed by the CMBS, which is backed by commercial mortgages. (specifically, it's backed by the shittiest/bottom 10% of 10 different CMBS deals)

Can someone confirm or deny this?

Dec 10, 2015

That could be what the cdo is made up of but it doesn't have to be. Could be IO cmbs chunks (secured or unsecured) with other exotic debt and derivatives. Cdo is sort of a blanket description. What isn't is high quality first mortgages.

Best Response
Dec 12, 2015

There are a lot of different products here, I'll try my best to give a brief summary of it.

Fixed-Rate CMBS - This is the typical things you see when you talk about CMBS. We're talking around a hundred 10 year, fixed-rate, stabilized loans pooled together in a "conduit". This is a static, unchanging pool.

Single-Asset/Single-Borrower CMBS - Backed by a single loan, to 1 borrower, which may be collateralized by a single asset, or a portfolio of assets. Can be fixed or floating. It is tranched out at various leverage attachment points, as dictated by the rating agencies on the deal. This is a static, unchanging pool.

CRE CLO/CDO (a k a Large Loan Floater) - These are always floating-rate, at a spread of 1M LIBOR + 300 to 600 bps. They are often transitional properties, with a value-add component. The sponsor generally has a business plan for lease-up, repurposing, and/or repositioning, and has an initial term of 3 years to execute it, with usually something around 2 one-year extensions. Also common is something called a "future funding obligation", which is an unfunded reserve which can be released to the borrower later for leasing (or sometimes cash-out) if the lender is satisfied with the borrower's progress.

Now the key point here is static vs. non-static pools. Most CRE CLOs issued today are static pools. That means the loans you see in the pool initially are the only loans that could ever be in the pool.

During the 2000s, and for a few one-off securitizations today, pools may not be static. There are certain features that allow the collateral manager to shuffle collateral in and out of the deal. These features include:

1) Ramp-Up. The pool may start with about $200M across 15 loans, and ramp-up to $300M across 25 loans. There are covenants on leverage and concentration that prevent the collateral manager from putting a shitty loan. To put it in layman's terms, these covenants make sure that any loan that is put in the pool is at least as good as the loans that are already in the pool.

2) Re-investment . This is short-term, transitional financing. There is a short initial lockout term followed by complete open prepayment. This means that loans can pay down quickly as they are refinanced, typically with permanent fixed-rate financing. Instead of returning this cash to investors, whose yield and asset-liability matching consequently suffers, it can be re-invested in new, additional loans. There may be a term of something like 5 years during which the asset manager can use the money to purchase new loans for the trust.

3) Refinancing/calling. After a certain point during the life of the deal, the notes may be refinanced. The CLO manager will issue a new deal, and use the proceeds to retire the old deal. The transaction docs will prevent this from happening after X number of years.

As a testament to their commitment to the deal, many asset managers will voluntarily retain some or all of the equity tranche of their CLO (soon this will be required by law).

To see most of what I said in here at full force, I would not look at the CRE securitization market, because today that is predominated by fixed-rate and/or static pools. I would instead look at the leveraged loan market, where CLOs are a key source of financing for loan originators. The are less restrictions on the asset manager's ability to shape the pool, both initially and on an ongoing basis.

    • 2
Dec 12, 2015

As a follow up as to whether CDOs are backed by shitty CMBS. Yes and no. Back in the day, this was somewhat the case. A CDO can contain anything, which includes:

1) Transitional floating-rate first mortgage loans
2) Mezzanine loans
3) B-notes
4) Preferred equity
5) Land
6) CMBS subordinate bonds (b-pieces)
7) Non-CMBS debt
8) Synthethics - there are no hard assets, it uses CDS to track an asset or asset class

Besides #1, most of the things here are "shitty". However, today, you will not see anything except #1 in a new CRE CLO deal.

Dec 17, 2015

"New regulations from the Dodd-Frank reforms will come into play next year. Either the originating lender will have to hold a certain piece of the loan longer, and/or the B-piece buyer will have to hold the paper longer. B-piece buyers are not really set up to hold the paper. So if they do have to hold the paper and set up processes to do that, there will likely be an increased cost that could get passed on to the borrower in the form of higher spreads"

Can someone explain to me the B-piece buyer part of the above paragraph outlining the new Dodd-Frank regulations? Who might taht B-piece buyer be and why are they not long term holders in the first place? What might having them hold onto the CMBS paper longer do for the economy and ensuring less liquidity of the secondary CMBS market? They didn't underwrite it so why make them hold it for longer?

Dec 17, 2015

The talk is the that someone has to hold a sliver (from what I hear 5.0%) of the trust for five years means they will demand a higher yield in exchange for the higher risk they will hold onto.

In addition, it looks like they will be buying higher up the capital stack of the trust as well. So as before they were purchasing B- and BB- paper, they will likely be purchasing BBB- and up as well. Given that those pieces are larger portions of the bonds sold, the fear is you are now pushing up those yields as well; thus, increasing spreads on the entire capital stack.

B-Piece buyers are generally the special servicers.

This is not supposed to go into effect until December 2016, essentially 2017.

Dec 17, 2015

I get most of what you said but what's tripping me up with the B Piece buyer definition. "Either the originating lender will have to hold a certain piece of the loan longer, and/or the B-piece buyer will have to hold the paper longer". So you're saying the B-piece buyer is the special servicer? They are hired by the originator to be the special servicer but they have to buy a piece of that capital stack? Does that make sense? Can a B-piece buyer be someone other than the special servicer (the b-piece buyer that is referenced at least)?

Dec 17, 2015
Dec 20, 2015

Usually a b-piece buyer (as long as they are part of the trust structure) is controlling class if the deal goes to special. So while the buyer of those bonds themselves might not be a special servicer, they get to direct special servicing actions (assuming they don't get appraised out).

For single asset/sponsor deals, I don't think that the rule is going to have too much impact. For a deal to be brought as single asset/sponsor, it pretty much has to be institutional quality. Since a lot of institutional players/large funds buy the lowest classes (or mezz) for these deals anyways, and they are yield-to-maturity players, the 5 year hold isn't going to be an issue. Most, if not all, will already have the capital reserves necessary to meet those rules. In theory, the pricing should remain competitive for these deals. That was part of the argument to exclude single-asset deals from the new rules.

However, on large mixed pools, pricing for the lowest classes are definitely going to widen. Early reports are projecting 40 bps - 50 bps. IMHO most underwriters are pretty good about predicting property cash flows for about 3 years, so what I would be looking for is a pricing premium for being locked from trading for the last 2 years. On first glance, 40-50 bps doesn't seem that far off.

Dec 21, 2015

What is the purpose of forcing the b-piece buyer to hold long term? It creates stability how?

    • 1
Dec 21, 2015

The original intent of the rule was to make the loan sponsor keep the slice for 10 years (or the whole term of the bond if shorter). Regulators thought this would make underwriting standards tighter, because if the sponsor had to eat the first losses of any deal that they put into a pool, they were going to make damn sure that there was no sloppy underwriting.

It is basically an additional protection of the senior classes, which are generally thought of as less sophisticated buyers. Investment grade bond holders tend to buy based on rating agency research/placement books and a rating - they may underwrite the top 5 deals, but they will not actually underwrite each deal in a pool. A b-piece buyer is different because they are first loss - they tend to be more sophisticated in the way they price risk/underwrite pools, looking through every deal in a pool before investing.

    • 2
Dec 21, 2015

Because of the downturn, banks tightened underwriting standards for some time, which is what froze the credit markets. At some shops, some of the "lessons learned" have already been forgotten, and you are seeing things that wouldn't have been done 2 years ago - spec construction financing, LTVs reaching into the 75-80% range, interest only deals, etc. Regulators are trying to find a happy medium - enough risk taking that the market is liquid, but not so much that we have another Great Recession.

Higher spreads are a given because of the holding risk. The thing is, that previously nobody really looked at the specific source of a deal when underwriting a large pool. The sources we always listed in the book, but I don't think anyone really tracked it closely. Buyers are going to start tracking that information though. And if there is a source that consistently has deals that blow up, there is going to be a lot of pressure for them to change their ways or to be cut from contributing to pools.

Dec 21, 2015

While I do believe that loan source is extremely important, I also believe that most investors do not care. It may be more important on the secondary markets, but during the original issuance, I do not believe investors really pay attention to the originator of the loan. If you look at the original issuance spreads, all the new issuances generally go out the door lock step at the prevailing benchmark, as of right now 140 on the AAA and the 500-600 on the BBB/BBB-.

I think there are some excellent conservative shops, generally the larger ones, and there are finance companies and banks (generally smaller) who originate and securitize loans under the cover of the better quality assets in the trust. I just do not believe it translates into different spreads or pricing. A lot of the AAA buyers, generally, read the rating agency presale and the term sheet, and these guys are really the biggest drivers of the overall spreads. That only covers the top ten or fifteen loans, which in my opinion are underwritten with the highest standards. That leaves about forty loans that are hardly looked at.

As for the single borrower/ single borrower securitizations, I think the pricing will be increased given that there is now a need to carve off a piece of the loan as a B-Piece. I completely agree with you that most of the time the collateral for these loans is institutional quality, but I think that because these single asset securitizations are generally smaller than a traditional conduit loan, a price increase in that small slice will have a greater effect on the entire capital stack.

Dec 21, 2015
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