Taking Stock of Bonds

January 11, 2008

The Creepshow

The credit mess that began with problems in subprime mortgage debt has in five months enveloped Wall Street, sucking the life out of many disparate business lines. There are signs that the commercial mortgage backed securities market is the next victim.

CMBS spreads widened in the fall because investors were demanding a greater yield premium for all types of risk. But there are signs that the CMBS markets problems are more than just a drop in investor confidence. Increasingly investors have worried about the loans -- specifically their underwriting standards -- backing CMBS. While credit was cheap a borrower could readily refinance a mortgage or borrow more money and put less down when buying a property.

The dynamic in commercial real estate is slightly different than residential mortgage finance but both arenas experienced aggressive underwriting that is now being put to a test. The economy has shown increased signs of a slowdown and this means retailers will see a drop in income. Goldman Sachs in announcing their prediction for a recession noted that consumers will curb their spending. Fewer dollars spent in restaurants, retailers and other users of commercial space  means the tenants will have a tougher time paying their bills.

The signs are already out there. UBS analysts in a December 14 report noted that writedowns at Lehman have drifted beyond sub prime and into CMBS. Earlier this week Moody's downgraded a 2006 commercial mortgage bond because a loan pooled in the security soured because a borrower filed for bankruptcy.

Bankruptcies are generally expected to rise because of the poor retail sales this Christmas. Some stores and business that are tenants may lick their wounds and get through the economic downturn. Others will not. The slowdown in spending has impacted a diverse range of businesses. McDonald's announced in December that same store sales in November were at 4.4% versus 5.1% a year ago.

Michael J. Kowalski, chairman and chief executive officer at Tiffany's, noted this week that US sales softened after robust growth for much of the year. The chief executive for the jeweler noted that a 10% increase in New York flagship store sales in the holiday period was driven by foreign tourist spending. This probably was tied to a weak US dollar that encouraged spending by tourists.

"We believe a recent pullback in US spending likely reflected a more cautious attitude among customers about the near-term direction of the economy and related factors," the jeweler's CEO noted. Right about now investors holding CMBS should take another look at their folios and size up who their tenants are, where the properties are concentrated, what the loan terms are and how the tenants are faring in this economic slowdown.

Also, the bond holders should check and see if there is enough subordination -- a cushion against losses -- in their deals to manage any late payments or failed mortgages.