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In violent storms, cracks in vessels suddenly reveal themselves. The same can be said for the nation’s commercial mortgage-backed securities market, as it faces a month of wider spreads and liquidity fears. The pain points emerging are not a surprise to Mosaic Real Estate Investors’ Ethan Penner, who is credited with creating the CMBS market for commercial real estate some 30 years ago. He thinks the whole system needs an update.
“I think people are often surprised when I criticize CMBS, and that I am not a big fan [of it] as an investor,” Penner said while speaking at a Bisnow webinar Thursday.
The problem is CMBS was created as a stopgap to fix the liquidity crisis of the early 1990s, and it was structured to focus on immediate concerns, not future disruptions or long-term relationships between borrowers and lenders, according to Penner.
“CMBS back in that early period was built to fill a void,” Penner said. “There was a massive void. Real estate borrowers back in the early 1990s had no access to even first-mortgage capital.” Turning CMBS into a vehicle that can easily steer through market rises and disruptions was not in the cards in the ’90s even though Penner believes it should be in the cards going forward.
“CMBS was born out of necessity, and I think there were shortcomings,” Penner said. “When you rapidly create something to fill a void and serve a need, it’s not perfected. And, I think the CMBS model that was built in the early 1990s had certain imperfections built into it that are still limiting factors to making [CMBS] its best version and its full value proposition.”
The biggest flaw in CMBS is borrowers have little ability to create short-term solutions to sudden liquidity freezes or market downturns like the COVID-19 crisis, Penner said. While traditional borrowers have lenders to call for modifications and work-out solutions to buy them valuable time, CMBS borrowers often find themselves in downturns without a sympathetic ear to listen.
“CMBS doesn’t facilitate that, there is no lender to talk to,” Penner said. “There is a master servicer, who as long as the loan is not in default, is your go-to relationship. But that’s not really a relationship that is going to be fruitful for you if you’re the owner.” Relationships between special servicer and borrower are fraught with conflicts and can be unpleasant, Penner said. Bisnow Moderator Walker & Dunlop’s Jeff Hudson interviews Mosaic’s Ethan Penner.
Penner also sees the legal structure underpinning the operation of CMBS as riddled with issues that need to be remedied at the federal level. “The legal issuer of the CMBS is a REMIC [real estate mortgage investment company] and there was a law passed to facilitate these kinds of mortgage securitizations,” Penner said.
“It prevents any active management, so when a borrower has problems, they can’t be resolved and a loan cannot be modified without violating the REMIC legislation and changing the tax-benefited pass-through structure.” That’s why Penner believes lawyers need to redesign the structural deficiencies of CMBS going forward and work with the IRS and government officials to remedy these flaws.
Although desirous of changes to CMBS, Penner does see CMBS spreads tightening eventually, particularly among Triple-A rated bonds. In fact, Triple-A is one of the few CMBS classes that Penner expresses some confidence in when it comes to value and the ability to navigate tough markets. “Triple-A’s have enough credit margin for error with 30% subordination or whatnot,” he said. “They are a good value proposition.” “I think below Triple-A and as you go deeper below Triple-A, you are in gambling mode more than in investment mode,” he said.
Penner watched closely as the Federal Reserve expanded its Term Asset-Backed Securities Loan Facility to include the ability to pledge Triple-A CMBS along with the previously included government sponsored enterprises-backed CMBS as collateral in exchange for cash flow. He also isn’t surprised that lower-rated CMBS is not included just yet, and that the Fed is taking its time before launching bailouts.
“This incremental approach is the right choice here inasmuch as they must balance their role in insuring the financial system continues to function and at the same time trying hard to avoid bailing out those who have lived by the sword of short-term debt, have benefited for so long, and who probably now are faced with paying the piper,” Penner said.