High TALF Approval Rate Bolsters Market
The Federal Reserve's decision to approve applications for TALF loans on legacy bonds from 35 of 36 commercial MBS deals buoyed the market this week, undoing some of the upheaval caused by a shocking about-face by S&P.
Spreads on super-senior bonds averaged 525 bp over swaps yesterday, in from 550 bp a week earlier and 675 bp two weeks ago. Secondary-market trading volume fell substantially from the $4 billion-plus of paper that changed hands last week. But volume was still on pace to top $1 billion - well above average for the year.
CMBS traders expect the rally to continue for at least two to three weeks, as dealers and investors jockey for bonds that will be financed via the second monthly installment of the Fed program, formally called the Term Asset-Backed Securities Loan Facility. The next loan-application deadline is Aug. 20.
Demand is expected to rise because of greater confidence among investors about which bonds are eligible for TALF loans. Another factor: Investment groups operating under the U.S. Treasury Department's Public-Private Investment Program, or PPIP, are preparing to make leveraged investments in CMBS as early as next month. The groups can tap TALF for some of those purchases.
The Fed initially said that super-senior CMBS rated triple-A and not under review for downgrade would be eligible for TALF financing. But it reserved the right to kick out even bonds that meet those criteria, leaving uncertainty about whether investors would be able to obtain financing for specific bonds. Complicating matters, investors had to purchase bonds before learning about the eligibility.
The Fed's decision this week to accept loan applications for bonds from 35 of 36 transactions under the first round of TALF funding gives investors greater comfort that the Fed won't prove to be heavy-handed by unexpectedly rejecting applications. That should encourage them to apply for financing for bonds from a wider range of CMBS transactions.
The Fed didn't specify why it rejected one transaction: J.P Morgan Chase Commercial Mortgage Securities Corp., 2007-LDP10. But market players speculated it was because the $5.3 billion issue has an atypical super-senior structure.
"They turned it out due to concerns about the structure rather than credit," one trader said. So the Fed's move bodes well for obtaining TALF loans to finance purchases of super-senior bonds from deals that have collateral pools with iffy loans, he added. In fact, the Fed approved loans on bonds from deals that some market players didn't think would make the cut. Among them: a $2.7 billion Credit Suisse deal (Credit Suisse Commercial Mortgage Trust, 2007-C5), which is beset by relatively high loan-delinquency rates.
The average spread on super-senior, 10-year portions of TALF-eligible securities contracted by about 25 bp from last week, to 285-290 bp over swaps.
Meanwhile, market players were buzzing about the policy reversal by S&P, which upgraded some super-senior classes from three deals just seven days after downgrading them. The flip-flop was actually welcomed by market players, but provoked widespread derision of the agency, which has been implementing a tougher credit policy that it says will result in sweeping downgrades of triple-A bonds - rendering them ineligible for TALF financing.
On July 21, the agency reversed itself on downgrades to the A-2 and A-3 classes of Credit Suisse Mortgage Trust, 2007-C3; GS Mortgage Securities Trust, 2007-GG10; and Morgan Stanley Capital I Trust, 2007-IQ16. S&P also reversed its downgrade of the A-AB tranche from GG-10, which Goldman Sachs and RBS brought to market in June 2007.
S&P characterized the about-face as a "minor refinement" of its new criteria, saying that it reconsidered the downgrades based on immediate feedback from the industry. But numerous market players said S&P was forced to correct itself because its analysts didn't fully understand how the payment streams of super-senior bonds worked in the first place. Traders and investors lauded the turnabout, but complained that the agency injected more confusion into the troubled market.
"How does a rating agency so badly miss the mark? That's disturbing" said a CMBS specialist at a structured-product advisory firm. "It's reflective of the brain-drain at the rating agencies," he contended, referring to the scores of securitization analysts that S&P and its rivals have let go during the credit crunch.
S&P released a five-page amendment to its new CMBS criteria this week. The change centered around how recoveries from liquidated collateral loans are distributed to bondholders as principal repayments.
The key difference is that the agency now acknowledges that the recoveries could be paid out to holders of super-senior bonds on a sequential basis, rather than across the board uniformly. That means that shorter-term triple-A bond classes would be paid down sooner than longer-term ones, mitigating the risk of losses to those tranches.
In most cases, the proceeds of liquidated collateral wouldn't be paid out evenly - that is, on a pro-rata basis - to holders of super-senior notes until all of the subordinate securities are wiped out. After S&P issued its downgrades last week, it was criticized for incorrectly assuming that principal repayments would be made on a pro-rata basis.
It's more likely that collateral losses will dribble in over time. So the short-term classes have a greater likelihood of being paid off, with the long-term A-4 classes absorbing most, if not all, of the resulting losses. Most market players didn't object to the downgrades of the A-4 classes - which remain in place - but howled that S&P should not have downgraded the shorter-term classes.
S&P "didn't take into account the timing of recoveries and the nuances of the triple-A bonds," said Alan Todd, J.P. Morgan's head of CMBS research.
Industry sources said they pointed out such issues to S&P before it released its new methodology. The agency declined to comment on why it didn't act on that advice earlier. In a statement this week, it said: "In the course of implementing our new CMBS criteria, we determined that it would be appropriate to adjust the way we apply certain loss and recovery assumptions used in our 'AAA' stress scenario."