07/17/2009

Anticipating Demand, Dealers Snap Up CMBS

Major banks and brokerage firms are engaging in a commercial MBS buying frenzy, loading up on bonds expected to be in high demand when they qualify for U.S. government financing.

The rally started late last week, after the U.S. Treasury Department moved closer to launching its Public-Private Investment Program and shed light on how the Federal Reserve will finance purchases of CMBS through its Term Asset-Backed Securities Loan Facility. In a conference call last Friday with market players, Treasury officials said all but 5% of CMBS issued before this year would likely qualify for TALF financing if it already met the general criteria previously released by the Fed.

That announcement went a long way toward easing widespread fears that investors could be turned down for Fed loans after buying CMBS they hoped to finance via TALF.

Yesterday, investors requested $669 million of Fed loans that would be collateralized by legacy CMBS they have purchased since July 2. The Fed will decide which of those loans to approve by the funding date of July 24. Demand for TALF loans is likely to increase next month, because most buysiders didn't have enough time to digest the new Treasury pronouncements about qualifying for the program prior to yesterday's loan-application deadline.

Market players now expect an abundance of commercial-mortgage bonds to pass muster in Washington. In a report issued last week, Barclays estimated that up to $250 billion of CMBS issued before Jan. 1 could be eligible for TALF financing, and that $416 billion of outstanding CMBS would be eligible for PPIP.

"The government's goal was to increase prices and lower discount rates, and that seems to be happening for the time being," one trader said.

For example, 9.6-year super-senior bonds from Credit Suisse's CSFB Mortgage Securities Corp., 2005-C5, were trading this week at a price that yielded 275 bp over swaps, down from 475 bp two weeks ago. That spread-tightening reflected a nine-point jump in price, to about 96 cents on the dollar.

The Credit Suisse bonds are likely to be TALF-eligible because they aren't on watch for rating downgrades, among other reasons. The average swap-based spread on similar 10-year "super-duper" bonds from 2005 deals narrowed by about 50 bp over the last week to just under 300 bp. Meanwhile, comparable yields on the five- and seven-year tranches of 2007 deals contracted by about 200 bp, to a range of 400-450 bp over swaps.

The spread tightening was driven by demand from dealers, rather than insurance companies and other traditional buyers. Trading volume soared early this week as more than $2.5 billion of outstanding bonds changed hands. That's largely because a number of insurers took advantage of rising prices by selling their bond holdings to Bank of America, Credit Suisse, Goldman Sachs and other TALF-authorized dealers, who were squirreling away the securities for later sales to TALF borrowers and PPIP fund managers.

Such trades promise to be profitable for dealers because the securities are likely to rise in value over the next few months, as they are snapped up by investors who want to exploit the availability of federal financing. For now, however, the dealers themselves are propping up demand and driving down yields.

This week's rally would have been stronger if not for S&P's downgrade of a number of top-rated CMBS issues. But the agency, which is applying a new rating methodology, affirmed a few other issues. Over the next six months, S&P is expected to re-evaluate a slew of other deals that it has on watch for potential downgrades.

S&P's controversial change in its criteria has frustrated investors because watch-listed deals are ineligible for TALF financing, and PPIP managers won't pay as much for senior bonds if they are downgraded. By keeping so many issues on watch, "S&P seems especially determined to prevent its ratings from being used to determine eligible collateral for government programs," a fund manager said.

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