Unstable Value Funds (5 – CMBS Edition)

Over the last two months, the assets underlying most stable value funds have done well, and short ABS, CMBS, and RMBS bonds have rallied.  Insurance debt as well.  But just when you think you can relax, S&P comes in to jolt confidence.  Here are some articles:

You don’t have to read all of these.  The main ideas are:

  • Super-senior AAA CMBS is not bulletproof.  From the S&P report, “In particular, 25%, 60%, and 90% of the most senior tranches of the 2005, 2006, and 2007 issuances, respectively, could be downgraded.”
  • Some view S&P’s new criteria as draconian.
  • Rents from properties underwritten in the boom period 2005-7 are definitely declining.   The stress tests impose a 25%-ish haircut for rents in everything but multifamily, whose haircut would be around 6%.  These would be adjusted for geography and quality.
  • Prior to the announcement the quote  in Markit CMBX AAA 4 — 2007 super senior exposure was in the low $80s.  Now it is in the low $70s.
  • That’s more than a 1% move up in yields.
  • Many maturing loans will not be able to refinance at the same principal levels.  Property owners will need to feed the properties, and equity capital is scarce.
  • This undermines the Fed’s efforts to expand the TALF to some legacy CMBS that will be downgraded below AAA.

There’s one more knock-on effect.  This review by S&P will also incude a review on how CMBS Interest Only [IO] securities will be rated.  The old philosophy was “Since IOs have no principal, they can’t lose principal, and securities that can’t lose principal are AAA.”  But when I would review CMBS securities 1999-2001, my models would indicate credit risk akin to BBB or BB securities.  Underwriting standards were much higher back then, so the new ratings for CMBS IOs will likely range between BBB to CCC.  Think single-B and below for vintages since 2005.

Though it won’t change the underlying cash flows of the CMBS IOs, it will change the ability of regulated financial institutions to hold them, particularly if Moody’s and Fitch follow along, which I think it makes sense to do.  With lower ratings, financial instutions will have to hold more capital against them, which lowers their desirability.  The regulatory arbitrage goes away.

So what then for Stable Value funds?  It’s a PR, marketing and a liquidity issue.  AAA CMBS plays a large role in stable value, particularly the short stuff that could be financed by the TALF.  If TALF is off the table, then prices have slipped considerably.  That doesn’t affect cash flows of the securities, but it  does mean that:

  • The difference between book and market widens.
  • Any SV fund with a need for liquidity can’t find it in their CMBS, because it is likely below the amortized cost.
  • There will be optical problems for current and prospective clients as they see the credit quality of the SV fund decline.
  • Those with a significant allocations to CMBS IOs (I hope there aren’t any) will see those assets go to junk, fall in current value, and be even harder to trade.

This is just another issue for Stable Value Funds — by itself, it is not likely to be enough to break the funds.  That would require something really nasty, like a quick run upward in short- and intermediate-term interest rates, or credit stress beyond this.  For the former to happen would require the FOMC to begin tightening, and absent a major dollar panic, they are not doing that anytime in the near term.  As for the latter, we have not yet seen the impacts from Alt-A recasts and resets, and the declines in commercial property values.  We will wait, pray and see.