If It Doesn't Quack Like a Duck

CMBS, CMBS TALF, and What the New Deals Mean for Credit

The funding requests for new CMBS, totaling $72.2 million, are a modest sum as compared to legacy CMBS requests that have run into the billions of dollars since the New York Fed's window expanded to include legacy issuance in July. Still, as the first new issue under the auspices of TALF, DDR1 has been received with cautious optimism in a market thirsty for new sources of credit. At a minimum,TALF is no longer a terra incognita for other REITs planning the foray. As far as implications for broader liquidity, the market has been more reserved in its assessment of DDR1. In fact, spreads on AAA-rated CMBS widened last week, rising by approximately 25 basis points from the week before.

While some market participants have hailed the new deal as a harbinger of robust securitization activity in the coming months, the implications of forthcoming deals for the broader commercial real estate credit market must be considered carefully.

In key respects, DDR1 is unlike the CMBS that the market had grown accustomed to preceding the downturn. It is of no surprise that the deal's underwriting is markedly more conservative than its antecedents. But at the same time, the parties to the transaction and the underlying debt itself are somewhat removed from the locus of the commercial real estate credit crisis. DDR is by no means the perfect borrower: its issuer debt rating was downgraded by Fitch to BB with a negative outlook in May. Still, DDR1 succeeds precisely because it does not overlap with or directly address the most pressing challenges in today's financing market. Nor does its structure countenance the inherent problems of agency and information asymmetry that still sully investors' appetite for fusion CMBS.

As of pre-sale, the $400 million issue includes $323.5 million in Class A AAA-rated bonds. The issuer-reported debt service coverage and loan-to-value ratios are 1.93 and 51.7 percent, respectively. These margins provide a much larger cushion for deterioration in cash flow and value than was the case for issues from the cycle's upswing. Securing the debt, the issue is supported by 28 retail properties, ranging in size from just over 50 thousand square feet to just under one million. The observable vacancy rate of the properties varies from zero percent to more than 25 percent.

As compared to the large fusion deals from years past, DDR1 is relatively much smaller, both in terms of its principal balance and the number of properties. These features lend themselves to a far more tractable analysis: the relative transparency of the deal lowers the investor's own cost of information gathering and investment assessment, tempering his or her reliance on the ratings agencies and limiting the potential for untoward transfers of risk.

While conventional approaches to risk assessment (at least one rating agency has applied criteria established in its early 2007 single-borrower rating guidelines) will point to the the risks of borrower concentration and sector concentration, the absence of diversity in this deal is one of its strengths, at least as concerns its ability to attract investor interest. Without a large number of borrowers across a range of property types, the deal is less opaque and information gathering is less costly. Given that many of the mechanisms for assessing and communicating risk have been undermined by the last two years' developments, the minimization of these sources of investor anxiety will be important in bringing future deals to fruition. This will be particularly true when investors are finally asked to take up deals that rely on the market's own capacity to determine its equilibrium.

In facilitating DDR1, the parties to the deal have undoubtedly helped our industry take an important step forward. But characterizations of the deal as a breach of the securitization floodgates are not likely to bear out. The principal impediments to the fusion deals and small-balance transactions that might alleviate some of the market's real strains are deemphasized by a highly-facilitated single-borrower, single-loan transaction where few real market-clearing mechanisms are at work. Until such time as we address the basic problems of agency, information asymmetry, and incentive misalignments that confound the securitization process, we cannot reasonably expect that CMBS activity will reemerge in a way that directly benefits those for whom the credit constraints are binding.