Business Management Executive Q&A
Sept 16, 2007
Executive editor Russ Colchamiro spoke with Tad Philipp, managing director for Moody’s Investors Service’s commercial mortgage finance group, about the CMBS market correction that has followed the recent subprime concerns and about the correction’s long-term fallout.
CPN: What impact have the subprime problems had on the CMBS market?
Philipp: A couple of things have occurred. A positive is that the market has renewed its focus on credit. Underwriting quality had been seriously slipping through the first half of this year, with more high-leverage and interest-only loans. We’ve already begun to see some signs of improved loan quality. A negative is that the volatility in the capital markets has caused some investors to move to the sidelines. Not all of the newly originated CMBS bonds are clearing, which reduces the funding available to issuers and causes them to slow down their lending pipelines.
CPN: What about investor confidence?
Philipp: CMBS has a strong track record but has been impacted by the broad reassessment and re-pricing of risk taking place across the debt capital markets. Property fundamentals are generally sound, but the contraction in liquidity will cause cap rates to back up, which may put some pressure on loans needing refinancing.
CPN: Will this be a short-term correction, or do you foresee long-term fallout?
Philipp: There’s a lot of uncertainty about the potential duration of this correction. The most analogous recent market disruption was caused by Russia defaulting in 1998. However, this one may take longer to play out, as the residential mortgage sector is both large and adjacent and the financial system in general has become more leveraged and interconnected.
CPN: How have the lending terms shifted from a few months ago?
Philipp: Fewer securitization shops are quoting loans, and those that remain active are seeking meaningfully wider spreads. And higher spreads combined with recently improved underwriting standards are resulting in lower loan proceeds for borrowers.
CPN: Has there been an overreaction in the CMBS market?
Philipp: The credit pendulum typically swings too far in one direction, then too far in the other. It may have just swung from being a borrower-driven market to being a lender-driven market.
CPN: Does this correction expose any structural or fundamental flaws in CMBS, or is it a subprime issue?
Philipp: This is primarily about the CMBS market getting caught up in subprime spillover, but the renewed focus on credit will ultimately lead to better-structured loans and deals, helping mitigate the risk of future credit problems within the CMBS sector.
CPN: How will the correction affect the way sponsors structure CMBS pools?
Philipp: For at least several quarters, we expect CMBS deals to be fewer and smaller. And with higher subordination levels, Moody’s-rated deals will be better structured. As the market correction runs its course, we will likely see more plain-vanilla assets and structures.
CPN: How does the correction compare with previous ones?
Philipp: This one isn’t over yet. Each correction is similar in some ways and different in other ways from previous corrections. This one may play out in ways that have not yet been determined. In particular, some of the loan and deal structures created since the last correction have yet to be put to the test.
CPN: So if there is a total reduction in CMBS originations, will the total number of real estate transactions decline, or will the flow of capital simply come from other sources?
Philipp: CMBS is significant but certainly not the only source of commercial mortgage funding. Life companies and banks may have an opportunity to increase share. However, I would not be surprised to see investment sales and defeasance activity diminish as cap rates start to back up, affecting origination volumes for all lenders across the board.
CPN: Will the subprime issues prevent megadeals like the Equity Office Properties Trust portfolio sale, or will the market find new, more stable ways of funding deals of that size?
Philipp: The public-to--private conversion process will most likely slow down if not entirely stop for the near term. They are capital-intensive deals in a capital-constrained marketplace.
Executive editor Russ Colchamiro spoke with Tad Philipp, managing director for Moody’s Investors Service’s commercial mortgage finance group, about the CMBS market correction that has followed the recent subprime concerns and about the correction’s long-term fallout.
CPN: What impact have the subprime problems had on the CMBS market?
Philipp: A couple of things have occurred. A positive is that the market has renewed its focus on credit. Underwriting quality had been seriously slipping through the first half of this year, with more high-leverage and interest-only loans. We’ve already begun to see some signs of improved loan quality. A negative is that the volatility in the capital markets has caused some investors to move to the sidelines. Not all of the newly originated CMBS bonds are clearing, which reduces the funding available to issuers and causes them to slow down their lending pipelines.
CPN: What about investor confidence?
Philipp: CMBS has a strong track record but has been impacted by the broad reassessment and re-pricing of risk taking place across the debt capital markets. Property fundamentals are generally sound, but the contraction in liquidity will cause cap rates to back up, which may put some pressure on loans needing refinancing.
CPN: Will this be a short-term correction, or do you foresee long-term fallout?
Philipp: There’s a lot of uncertainty about the potential duration of this correction. The most analogous recent market disruption was caused by Russia defaulting in 1998. However, this one may take longer to play out, as the residential mortgage sector is both large and adjacent and the financial system in general has become more leveraged and interconnected.
CPN: How have the lending terms shifted from a few months ago?
Philipp: Fewer securitization shops are quoting loans, and those that remain active are seeking meaningfully wider spreads. And higher spreads combined with recently improved underwriting standards are resulting in lower loan proceeds for borrowers.
CPN: Has there been an overreaction in the CMBS market?
Philipp: The credit pendulum typically swings too far in one direction, then too far in the other. It may have just swung from being a borrower-driven market to being a lender-driven market.
CPN: Does this correction expose any structural or fundamental flaws in CMBS, or is it a subprime issue?
Philipp: This is primarily about the CMBS market getting caught up in subprime spillover, but the renewed focus on credit will ultimately lead to better-structured loans and deals, helping mitigate the risk of future credit problems within the CMBS sector.
CPN: How will the correction affect the way sponsors structure CMBS pools?
Philipp: For at least several quarters, we expect CMBS deals to be fewer and smaller. And with higher subordination levels, Moody’s-rated deals will be better structured. As the market correction runs its course, we will likely see more plain-vanilla assets and structures.
CPN: How does the correction compare with previous ones?
Philipp: This one isn’t over yet. Each correction is similar in some ways and different in other ways from previous corrections. This one may play out in ways that have not yet been determined. In particular, some of the loan and deal structures created since the last correction have yet to be put to the test.
CPN: So if there is a total reduction in CMBS originations, will the total number of real estate transactions decline, or will the flow of capital simply come from other sources?
Philipp: CMBS is significant but certainly not the only source of commercial mortgage funding. Life companies and banks may have an opportunity to increase share. However, I would not be surprised to see investment sales and defeasance activity diminish as cap rates start to back up, affecting origination volumes for all lenders across the board.
CPN: Will the subprime issues prevent megadeals like the Equity Office Properties Trust portfolio sale, or will the market find new, more stable ways of funding deals of that size?
Philipp: The public-to--private conversion process will most likely slow down if not entirely stop for the near term. They are capital-intensive deals in a capital-constrained marketplace.
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