07/01/2011

New Markit Index May Solve Hedging Woes

Markit, which runs the CMBX index of credit-default swaps tied to commercial MBS, is close to rolling out a new index that could address a big problem for securitization shops: the difficulty of hedging warehoused commercial mortgages.

The need for better hedging techniques was acutely highlighted last month when spreads on new-issue CMBS abruptly blew out. That drove down the value of loans awaiting securitization, cutting into profit margins or causing outright losses.

“Everyone is down and has taken a hit,” said Rob Cestari, who runs CMBS trading at Cohen & Co. “Anyone who tells you they are fully hedged against market movements is lying.”

In simplest terms, securitization shops seek to originate loans at one rate and then securitize them at a lower yield, pocketing the difference. Loan coupons are based on prevailing yields in the CMBS market. The risk is that the two components of CMBS yields — Treasury rates and credit spreads — will rise before loans can be securitized, eating into or even wiping out profits.

Effective and cost-efficient hedges on Treasury rates are well-established. And before the market crash, securitization shops could also effectively hedge against shifts in CMBS spreads via total-return swaps based on the Lehman Brothers U.S. Aggregate Index.

But that index, now run by Barclays, is no longer effective for hedging CMBS. The reason: It is restricted to publicly offered bonds, and all of the CMBS deals floated since the market revived have been issued privately under the SEC’s Rule 144A.

Many lenders have resorted to hedging warehoused loans by taking the short of side credit derivatives based on the oldest CMBX series, believing that the loan standards of the referenced 2005-2006 CMBS transactions are closest to what now prevails. They also rely on swaps tied to Markit’s corporate-bond indices or specific benchmark CMBS. But the deal characteristics and price movements don’t match up perfectly with newly originated loan pools, making it difficult for lenders to hedge their positions accurately.

“The high cost and lack of a reliable hedge resulted in some lenders not fully hedging against the risk of the recent spread-widening,” said Malay Bansal, a managing director of New York advisory firm CapitalFusion.

Because CMBS spreads were tightening for most of the year, inadequate hedging wasn’t a problem. But when spreads blew out last month, CMBS shops got hammered, heightening concern.

At the beginning of the year, Barclays launched an index tied to the new generation of commercial mortgages, but the tool — called “U.S. CMBS 2.0 Index” — has failed to gain much traction so far, for reasons that are murky.

Now market pros are turning their sights to Markit’s new index of total return swaps. The London research firm expects to launch the second generation of its so-called TRX index within a month or two.

“This is the most efficient way for dealers to hedge their warehouse loans prior to issuing CMBS deals,” said Harris Trifon, a CMBS analyst at Deutsche Bank. “Most of the dealer community would like it to be the solution, and I think it will be.”

The new index, dubbed “TRX.2,” will track daily price movements on triple-A bonds, with weighted average lives of 8-12 years, from CMBS transactions floated since last year. Markit has already identified almost $6.5 billion of bonds from 16 multi-borrower transactions that meet prescribed terms.

The index will provide a basis for creating and pricing total-return swaps. That will enable lenders to short outstanding senior bonds from the latest crop of deals in order to hedge long positions — loans stockpiled for securitization. The idea is that swap counterparties would take opposite sides of derivative transactions referencing the same pool of assets tracked by the index.

To be sure, the arrival of Markit’s new index likely won’t cause an immediate wholesale shift in hedging strategies. And it’s possible that dealers may have trouble, at least initially, finding enough counterparties to take the long side of TRX swaps. But demand on the long side could be generated in part by small investors and money managers who want to buy new-issue CMBS but can’t compete for allocations when transactions come to market.

The referenced securities for the new TRX index will come from the most-recent qualifying CMBS offerings to hit the market. Markit intends to “rebalance” the portfolio by adding new deals at the start of each quarter, replacing an equal number of the oldest transactions in the index. The index will track 25 deals, once there are enough qualifying transactions.

Markit will rely on 12 major Wall Street dealers to provide daily price benchmarks for its new TRX index, just as it does for the current TRX and CMBX indexes. They are Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche, Goldman Sachs, J.P. Morgan, Morgan Stanley, Nomura, RBS, UBS and Wells Fargo. Only those dealers are licensed to trade swaps based on Markit’s indices.

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