03/09/2012

Outstanding CMBS: Down 25% and Still Falling

The balance of outstanding U.S. commercial MBS continues to fall, as issuance lags behind the pace at which seasoned paper is being retired.

The balance last month dipped below $600 billion, down 25% from the peak of almost $800 billion at yearend 2007, according to Trepp. And as the universe has shriveled, so has the CMBS share of the fixed-income market. CMBS now makes up just 2% of the widely followed Barclays U.S. Aggregate Bond Index, well below the high of about 6% in early 2008.

The steadily decreasing volume of CMBS in the hands of investors hasn’t yet sunk to an alarming level, analysts said. Indeed, the pinch in supply has even served to prop up prices on recent offerings.

But the decline is certainly not a sign of the sector’s health. And market pros said the risk is that the balance will eventually fall to a level too low to sustain the interest of investors. “I think it’s in the back of everybody’s minds,” said Richard Parkus, a CMBS analyst at Morgan Stanley.

Opinions vary widely about what that threshold might be. But there is agreement that it will be breached if the issuance machine doesn’t get revved back up in 3-5 years — when the tidal wave of securitized mortgages written in the market’s go-go days are scheduled to mature.

The CMBS universe has shrunk by an average of $25 billion every six months since the beginning of 2008, when the market entered a steep downturn that led to an 18-month issuance halt. The biggest slide came in the second half of last year, to the tune of $41.8 billion, according to Trepp.

Market pros expect the shrinkage to continue at a somewhat slower rate over the next two years. Based on the current pace of mortgage payoffs and liquidations, about $72 billion of CMBS will be retired annually in 2012 and 2013, according to Parkus. He expects bond issuance to offset that reduction by half this year and possibly more next year. Under that projection, the balance of outstanding CMBS would decline to roughly $540 billion by yearend 2013.

After that, there is a potential for sharper drops if issuance doesn’t pick up. The reason: Huge volumes of 10-year loans were written at the market’s peak in 2005-2007. As those loans roll off, the volume of outstanding CMBS will drop precipitously without new supply. In a worst-case scenario, the balance could bottom out in the neighborhood of $250 billion to $300 billion, by some estimates.

“The market can reach a tipping point where it gets too small for investors to dedicate resources to the sector,” said Jeffrey Berenbaum, a CMBS analyst at Citigroup. “But we’re years away from that, if it ever happens. The large amount of loans coming due in 2015-2017 will be the test.”

Opinions vary as to what that tipping point would be. One asset manager cited $500 billion as a key psychological barrier. “I’m hoping new issuance will crank up before then,” he said.

“If outstandings fell to $300 billion, it would be an unavoidably less-liquid market,” Parkus said. At that point, some investors would no longer find it worthwhile to commit the personnel and systems necessary to focus on CMBS, he noted.

Investors who tailor their purchases to mirror the composition of the Barclays U.S. Aggregate Bond Index could be among the first to lose interest in the sector. The current 2% CMBS component of the index is already being viewed as near rock bottom. If the level falls much lower, the influence of CMBS on the index might be so inconsequential that investors wouldn’t bother to buy the paper, analysts said.

Whether CMBS issuance rebounds significantly depends on a number of variables, including the strength of the bond market and the impact of a bevy of financial-regulatory reforms tied to the Dodd-Frank Act that are due to take effect within three years.

In the meantime, the decreased supply has contributed to the recent rise in CMBS prices, also fueled by pent-up demand for new issues and a general rally in the broader stock and bond markets. “It’s a net positive for CMBS spreads,” said Citi’s Berenbaum. “There’s still demand for the product, and there’s less of it around.”

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