By Robert Sun, Carnegie Mellon University
Mortgage-backed securities.
Ask anyone what started the Great Recession and those words are bound to be in the explanation. Residential MBS risk was not clearly understood by those buying and selling them, and those who did understand that risk were so far removed from the game, they could care less. Underwriters loosened their standards, if they still had any by the peak of the mania. After all, in the end, everyone wins when home prices can only go up. Of course, the rest is history.
But now, with the markets stabilizing in a fragile existence, MBS is back in vogue as investors desperately search for yield. Yet one area still remains a huge concern, with whispers around Wall Street that we could see another painful bubble burst – commercial MBS.
As a brief background, mortgage-backed securities represent a claim on the cash flows of the underlying mortgages. While many mortgages do trade on the market individually, it is far more common to securitize the mortgages through pooling many mortgages together and therefore diversify the risk. It is silly to think that the entire housing market could fall, right?
In CMBS, the securities are backed by commercial mortgages, which could be hotels, retail stores, multifamily apartments, and so on. Whereas in RMBS space, investors typically look at the household income of the borrower, in addition to a host of other factors, investors in the CMBS space look at the net operating income generated by the property to see if the borrower will have a steady enough cash stream to pay off the mortgage.
For a while, it looked like the worst was over for the CMBS market. Plunging as low as 40% from its peak in 2007, commercial real estate prices began to stabilize. Coupled with yields from safer assets like Treasuries in microscopic levels, and yield-hungry investors flocked back to both the higher-yielding residential and commercial MBS.
But more recently, the CMBS has again seen signs of struggling. According to the Mortgage Bankers Association, delinquencies of commercial mortgages soared nearly 140 basis points in the 2nd quarter, rising to 8.22% from 6.83% in Q1. In fact, commercial delinquencies are at the highest levels since the association began keeping record in 1997. Data for August showed delinquencies up to as has as 8.48%. The key area of concern is from the hotel sector, with a delinquency rate of 20.8%.
Some trends in the commercial real estate sector show that apartment leases, and multifamily spaces as a whole, tend to have more volatile streams of net operating income, which lead to outperformance in peaks and underperformance in downturns. Hotels, by an extension, can be analyzed as large multifamily spaces with single-day or very short term leases. During market upturns and downturns, their movements tend to amplify the effects seen on other areas.
