Discuss Future for the Securitization of Commercial Property

Commercial property is one of the major sources of business in this competitive world. If we own or rent office space, property costs will be the largest business overhead expenses along with the unknown price movements of these properties due to some micro and macro economic factors such as inflation, GDP, interest rates etc. For these reasons securitization of these assets are given more importance.

Commercial mortgage backed securities (CMBS)

The CMBS are debt securities that use commercial assets as collaterals and the income obtained by these property assets will be used for paying back the interest and the loans. Property assets are converted into the CMBS by the special purpose vehicle (SPV) and the sale proceeds from these securities will handed over to the original owners.

The CMBS collateral are commonly secured by commercial real estate such as apartment buildings, shopping malls, car parking, warehouse facilities etc. These loans neither recourse to the borrower nor do they form guarantee. Since the borrower looks for repayment, analysis of the cash flows will be very critical. There are thousands of small loans in residential mortgage loans which have a huge competition for the commercial mortgage securities.

Main features of the commercial mortgage backed securities.

Excellent call protection

Reduced credit risk

Average life stability

Good and supportive collateral

Differential time periods for maturity

Falling property prices and the rising interest rates may have a negative impact.

Property location / local economics for CMBS

A geographical dispersion of properties is desired for securitization due to the unexpected price fluctuations in the field of real estate and also builds a very successful portfolio by reducing the risk. It is also recognised by the credit rating agencies by doing so. A 40 % concentration in a single state is considered as significant investments.

Multifamily loans:

Multifamily loans constitutes 34.5% of the total outstanding commercial real estate loans and are considered to be most desirable because of its short term leases, strong historic credit experience, limited leasing risk, transparent financial reporting.

Securities based on Retail property:

Retail property ranges from regional malls to community stripe centres. Analysis of relationship between lease rent and the market rent will be very crucial and important task for every investor. An anchored retail property like shopping malls and supermarket are less risky than unanchored retail properties like car parking, corner and open spaces in the malls.

Office properties: office properties also form the main sources of the CMBS. Office properties with central business districts will vary from the suburban office properties. Office properties will provide steady cash flows and generally have longer term leases than other property types.

Health care and related properties: are also largely operating business and have a different price controls. Properties such as cold storage and car washes are highly credit worthy.

Hospitality: it requires a separate underwriting discipline. Occupancy rates will be highly volatile and depends upon consumer travel budget.

Composition of earlier CMBS

Multifamily - 21.9%

Hotel - 11.2%

Ware house /industries - 6.5%

Nursing - 3.3%

Mobile home Park -1.3%

Retail - 27.3%

Other - 4.4%

Benefits of CMBS

Lower pricing

Improved liquidities

Diversification on lenders

Non-recourse to parent company

Release value while retain future growth potential

Off-balance sheet financing

Asset backed securities

Asset-backed securities are based on pools of underlying assets. These assets are normally illiquid in nature. The "pooling" of assets will make the Securitization large enough to be economical and to diversify the qualities of the underlying assets. A special purpose trust or instrument is set up which takes title to the assets and the cash flows are "passed through" to the investors in the form of an asset-backed security. The types of assets that can be "securitized" range from residential mortgages to trade receivables and even music royalties. The asset-backed security usually qualifies for a top rating and enables the issuing company or bank to raise funds at a very attractive rate, while freeing up capital and retaining customer relationships and servicing revenues.

It is very important that securitization of this commercial property is an essence for every investor and they should also familiarize with some common real estate terms:

Lease:An areement through which the owner of the property ( the "lessor")grants the the right of control to a occpant ( the "lessee") over a particlar period ( the "term") for a fixed amount of money( the "rent").

Lien:A A legal claim that which filed against a certain property for payment of obligation. During this ongoing process if a property owner fails to pay a creditor, a lien can halt the sale of a property.

Sale-leaseback:A a process of transaction in which an owner sells a propert to an investor , who inturn leases the same property to the same owner undedr prearranged terms. These deals the original owner freed- up capital and tax breaks and here the investor a guranteed appreciation and return.

Sublease:A lease which is given by a tenant for some or all of a rented property. For example, if a tenenat rents 50,000 square feet but here he uses only 30,000 squre feet of space , so he thinks to sublet the remaining 20,000 square feet for some or all of the remaining period of the lease, only if they continue to occupy and pay rent for the property.

Asset valuation: Asset valuation plays a vital role in determining the value of the underlying securities and enhances the buyer to buy that particlar secrities or not.

Sub-prime crisis origin

The real estate property is regarded as one of the most valuable asset for individuals. Currently its value became the biggest puzzle over the world economy and financial system. Over the period of time Wall Street built trillions of dollars market for Mortgage Backed Securities (MBS) and sold them worldwide on two commonly-accepted beliefs that the value of the USA real estate would never fall in USA, and people would always able to make their mortgage payments without any defaults.

Sub-prime crisis originated in US .US Banks & finance companies started lend money to the subprime borrowers who are first time borrowers with low income and poor credit history. With this loan borrowers bought properties. Banks & financials bundled this debt & converted this debt into Mortgage Backed Securities (MBS) & they sell this to investors around the world as they thought that house price will rise continuously. As house prices went-up MBS price shoot-up as well. Later interest rate rise, cheap loans disappeared & defaults on the mortgage payment rise heavily resulted in the collapse of the housing bubble in turn resulted in heavy decline in the MBS prices & stock market crash around the globe. This made Banks & lenders to write-off billions of dollars & huge employee lay-offs, loss of millions jobs worldwide. After this cost of borrowing went-up & lending became scarce, this affected credit flow around the globe

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Financial crisis and Securitization

Securitization is the process of collecting different types of debt and loan obligations and packaging them as various types of securities which are sold to investors. The interest and principal on the underlying security will be paid to investors on a regular basis. Securities backed-up by mortgages are called as mortgage-backed securities and securities backed by other types of debt are known as asset backed securities. Below chart explains the process of securitisation.

In this context securitization refers to the issue of a financial security backed-up by the assets where the investor has no recourse to the seller of the asset. The typical securitization process has two-step which includes an originator/seller establishing a special purpose entity (SPE). Then the originator/seller sells the assets that will be considered as collateral for the asset-backed securities (ABS) so as to attain true-sale and to consider it as an off-balance sheet item. These assets are normally handed over to a second entity to a qualified SPE (QSPE) or trust that then issues the securities.

Two step process is followed to legally separate the collateral from the originator and his general assets. The separation ensures that the assets serves as collateral and cannot be consolidated with the general assets of the originator in the bankruptcy event. Due to bankruptcy remoteness of the assets allows the securitization process to achieve a higher credit rating than that of the originator. The issuer is able to achieve higher credit rating by incorporating varying levels and forms of credit enhancement.

Source: Federal Deposit Insurance Corporation (FDIC)

Benefits of securitisation

Securitization removes the assets from the balance sheet, freeing equity capital. Due to capital relief, more funds available for new credit.

Efficient management of capital and asset-liability structure

Optimizing YTM for both assets and liabilities.

Efficient credit risk and interest rate risk management by creating off-balance sheet items and mitigating sector concentration.

Access to new source of funding and a vehicle enhance income and return on assets

Below are the subdivisions of the different asset classes and chart showing various types debt. There are 3 main types Asset backed securities.

Mortgage-Backed Securities (MBS)

Collateralised Debt Obligations (CDO)

Asset-Backed Securities (ABS)

These main types are again dived into Commercial MBS (CMBS), Residential MBS (RMBS), Collateralised Loan Obligations (CLO), and Collateralised Bond Obligations (CBO).

Source: Federal Deposit Insurance Corporation (FDIC)

The Wall Street Journal estimated that the impact and size of the subprime crisis is devastating on world economy. This cost more than $4 trillion to the global economy and includes the loss of value of the housing stock that is a result of the credit crunch and this crisis fuelled by securitization.

Subprime crisis is the first of its type which is magnified by securitization. Investors bought bundles of mortgages which were so complex in nature. Investors relied upon ratings agencies. Nobody seems to know what these mortgage bundles are worth, how much has been borrowed using the bundles as collateral, who owns them, how deeply their value has declined and what extent the banks capital affected with the resulting write-downs.

Some analysts blame it on the securitization of real estate loans rather than the poor credit quality of these loans. The problem is that the credit rating agencies didn't rateA these assets then the things started going bad and were very slow to react.

Due to deregulation of the financial sector, the banks found new ways of converting debt into tradable instruments and sold those securities to institutions worldwide. To fund these, the banks lent more debt by expecting that the return on the instruments will be normally above their cost of borrowing, so the banks have planned to sell these securities as per the originate and distribute model. The system was difficult to understand for many as what was going on or how these assumptions were justified. As much of the action were recorded only on the banks off balance sheet in a shadow banking system.

The very low interest rates in US during 2001-06 were highly profitable to the banks, allowing them to lend more money, expand its volume and improve business. They sponsored hedge funds, private equity buyouts and issued mortgage financial instruments, fresh bonds, and offered lines of credit to their own structured investment vehicles (SIVs). These bets were usually leveraged by extra topping-up of the debt, with some institutions like hedge funds and investment banks borrowed to buy assets worth 30 times of their capital. This is how the 2007-08 crisis became heavily on leveraged concerns often and indebted to one another.

The central banks around the world gathered huge amount to rescue the banks from their own folly and the banks were bailed out with huge bail-out packages. The use of tax payer's money or public resources to achieve this should carry a price and a lesson and need not to encourage a repetition of moral hazard and such behavior.

Future of securitisation

Whether securitization played a role in the subprime crisis and credit crunch?

In case of MBS where a portion of the coupon is risk-based and represents a premium, which reflects the default risk carried-out by the each borrower. The premium is calculated in such way that a full business cycle has been encapsulated when there exists for the investor a potential credit arbitrage as the risk premium is over-valuated and other times there is no arbitrage opportunity the risk premium is then under-valuated. In first case securities will be attractive due arbitrage opportunity where as in second type they will not. During the latter the product's appeal depends on the effectiveness of its credit enhancement and robustness of the cash flows from the junior certificates to the senior ones. If this structure is deficient, the product would lose its appeal and its market would dry up in no time as occurred in this credit crisis.

As such, securitization is therefore not to blame in the subprime crisis. It's the in-efficient structuring of the different securities that caused the problem. Now the task is that it should be structured correctly.

MBS future is depending upon the product getting immunized against the hazards of the real estate's cycle. Credit scoring and rating reflects differences between borrowers and to that extent it ranks them satisfactorily but it don't have ability of expressing the impact on their credit behaviour of a full business cycle. This turns out to be a major defect of any credit rating or scoring. The scoring system turns out to be unable of assessing objectively the risk as the score conflates within single number a consumer's credit ability, the good health of the real estate sector as well as that of the global economy. Mortgage-Backed Securities viability would then be determined by the capacity of insurers in that specialized field to absorb the shocks resulting from alternating phases of the business cycle.

Securitization models in the future should be priced heavily based upon existing equity rather than existing credit scores. The 3 C's of credit are: Collateral, Capacity and Character are all important in structuring of the security

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Policy changes required for the success of the securitization

1. New model of bank with modern principles of finance is not sustainable

Unwillingness of the mortgage banks to analyse the risk profiles of the borrowers and lend on the basis of risk in a regime of low interest rate made financial system very fragile. Many lenders had to relax their credit standards due to competition. And most of the mortgage lenders in the US sell their loans within a month or two, their primary aim was to generate as many loans as they could and then sell them quickly. This was major reason they lacked strong incentives for credit checks. There should be strong policy to curb this kind of activities.

2. Disciplining the rating agencies: Investment bank pays the rating agencies to rate Collateralised Debt Obligations (CDO) securities. Investment banks and rating agencies work closely in structuring the transactions. Rating agency staff crosses over to "dark side "to work for investment banks. One option is for the government itself to regulate rating agencies.

3. There should be more transparency about the structured products. One reason behind market failure relates to information asymmetry. It is argued that sellers have more information then buyers about what they are selling. In the sub prime episode, Investors increasingly did not know what they were buying and what the security is worth. The following steps are necessary to ensure more transparency about the structured products.

Consistent valuation of assets across firms to be ensured by the regulator

Dissemination of information on the asset-backed commercial paper, price and performance of privately traded asset-backed instruments.

Greater standardization of structured products

4. Capital Cover: Its been argued that subprime default rates would not have spiked if loan originators had been forced to set aside capital to cover say 10% of each securitized pool.

The important area which requires reform is accounting, dominated by few large companies and accounting standards, where the 'mark-to-market' approach has been 'pro-cyclical' encouraging the boom-bust cycle. Public audit agency and a diversified accounting standards will be able solve the problems of an industry where auditors are too often in cahoots with the auditee. Likewise allowing only expert publicly owned bodies to work as hedge funds and converting private equity into public equity.

The solution to the huge problems explained above is not to abandon finance but to embed them in a properly regulated system and to progressively transform companies and banks in terms of ownership and functioning. The shadow banking system should be controlled effectively and new policies to be followed by all those who offer derivatives. Strict margin requirements to be enforced on all existing and future contracts and a global network of publicly owned Derivatives Boards should be established with a monopoly on derivatives trading.

Conclusion

The future of the securitisation is very hard to determine in this changing environment. However the study made have suggested some of the ways in which the future for these securities can be safeguarded against the falling prices and increasing rates. Following are the suggestions for protecting the future of these toxic debts.

Diversify the investments

Build an portfolio of investments

Get good rating for securities from rating agencies.

However time differentials, lack of prepayment risks and the economics of commercial property security markets will support the growth of the toxic debt in the future.

Securitization was a revolution that brought huge gains. The transformation of sticky and immovable debt into something more tradable. As it comes under surveillance, the debate should be about how this system can be improved, not discarded. The challenge before the Fed and worldwide central bankers is to regulate and control securitization without hurting the beneficial outcomes of increased flexibility. The government will need to step in and look at the success of the securitization by bringing in more transparency in the process of securitisation with the below policies and regulations.

Credit Rating Organization (CRO) Reform: This should incorporate two main elements. (i) Withdrawing government blessings from their work (ii) improving CRO accountability for ratings decisions

Lender Reform: Loan officers' compensation must be directly associated to long-term performance rather than to short-term profits. Originators must bond more effectively the quality of the loans they review. Governments can ensure market discipline by assisting in the disclosure of information about contract evolution by encouraging development of better information systems.

Improve Government Accountability: For better crisis-management decisions should taken in open debate outside of an actual crisis. Accountability can be improved by regulators by analysing and regularly testing a benchmark plan for crisis resolution. The events of the current crisis confirm that not planning for crises prolongs and deepens the disruption by tempting regulators to subsidize loss-making institutions at taxpayer expense.

Regulators need to track market signals to help them to mitigate risk. It is necessary to strengthen the safety net by making authorities more accountable for its costs. This requires the development of a system of fair-value accounting for intangible safety-net subsidies.

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