In our previous discussion on CMBS called CMBS balloon risk looming, we covered the refinancing risk for commercial mortgages. These mortgages form the collateral pools for CMBS bonds, creating significant risk that these securities will default on part or all of their principal. That risk however varies dramatically based on the seniority of CMBS tranches.
Here we refer to CMBS securities in terms of ratings, which represent the level of seniority (the actual ratings themselves are fairly meaningless for CMBS at this point). The chart below shows spreads (from Morgan Stanley) for the highest seniority tranche (super-senior AAA) and a junior tranche (BBB).
Super-senior AAA and BBB spreads over US Treasuries (spreads are on two different scales - see left and right y-axis)
Since the start of the financial crisis, the spreads have blown out on these securities in part because of increasing delinquencies, but mostly due to refinancing risk. However as the credit markets stated rallying, the senor tranche spread has narrowed, while the junior tranche stayed at distressed levels. The junior tranche is priced based on coupons it may pay, assuming that it will not pay any of it's principal. In fact in some instances these tranches are expected to pay only a portion of their expected coupons.
The super-senior AAA is different. Even in an environment of highly depressed real estate values, the tranche (for many CMBS deals) is expected to pay a significant portion of it's principal due to substantial subordination "beneath" the tranche. When properties are liquidated (because mortgages can not be refinanced), there may be enough to pay down the AAA, but the market does not expect there to be much left to pay the junior tranches. The diagram below illustrates how the market views the risk on these bonds:
Some view the most senior tranches of CMBS as a potential investment opportunity. Even if not all the principal will be recovered (though some market participants think many of the senior tranches are money good), the discount (or effective spread) may justify the investment. But 500 basis points over Treasuries for securities that are 5-10 years in maturity is not a great return for many investors who are taking this risk.
But the Fed came to the rescue to bump up the return, by providing leverage on the senior CMBS tranches via TALF. This is the riskiest component of the TALF program for the Fed (and that's why the leverage on CMBS is lower) Thus CMBS TALF has started doing some volume.
However, this is still a drop in the bucket, given the $700 billion CMBS market. Also these TALF transactions are secondary CMBS only. The big question remains, is whether TALF will stimulate any private financing of new properties. So far new CMBS activity is nearly non-existent, but there are some deals in the works to take advantage of TALF. From the WSJ:
Vornado Realty Trust, one of the U.S.'s largest real-estate investment trusts, is planning on raising between $550 million and $600 million through a bond sale that would qualify for a key government program aimed at resuscitating the commercial-property market, according to people familiar with the matter.
Participants are banking on a larger TALF operation in September to move some of the massive existing inventory and possibly do some primary deals.