Crisis As Opportunity: Investors Must Understand What Portfolio Managers Do Horrifyingly Wrong
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
Commercial real estate mortgage-backed securities (CMBS) have become increasingly popular as an investment option over the past several decades. These securities are pools of commercial real estate loans that are packaged and sold to investors. However, CMBS can also be a weakness for lenders, as well as portfolio managers, particularly during times of economic downturns.
Why CMBS Creates Sometimes-Hidden Risks
The structure of CMBS makes it vulnerable to market fluctuations. The underlying loans are typically non-recourse, meaning that the borrower is not personally liable for the debt. In addition, the loans are often interest-only, with a balloon payment due at maturity. This structure makes the loans attractive to borrowers, as they can generate cash flow without paying down the principal. However, it also exposes lenders to significant risks.
During economic downturns, the value of the underlying properties can decline due to declining rent payments, making it difficult for borrowers to refinance or sell the properties to repay the loans. This can lead to default, which in turn can trigger a wave of losses for the lenders who hold the securities. The 2008 financial crisis provides a clear example of how MBS (residential in that case) can pose a significant risk to lenders. When the real estate market crashed, MBS issuers, as well as portfolio managers suffered large losses as many borrowers defaulted on their loans.
One of the key issues with CMBS is that the loans are often grouped together and sold as a single security, in a process known as securitization. This means that investors are exposed to the risk (as well as receive the benefits and diversification) of multiple loans, rather than just one. The complexity of the securities and the lack of transparency in the underlying loans can make it difficult for investors to accurately assess the risk of investing in CMBS.
Managing Fixed Income Duration Risk Is Similar To The Need To Regularly Renovate A Home
The analogy of managing a home renovation can help to illustrate the risks of CMBS. Just as changing tastes and new technologies dictate semi-regular home renovations, any fixed-income portfolio must be actively managed to maintain a short throw between rate levels. Just as allowing the distance between renovation levels to stretch too far can make it prohibitively costly to update the home for sale, allowing rates to move too far without hedging can make it nearly impossible to refinance, extend, or even walk away from CMBS securities once they turn toxic. In other words, if lenders do not actively manage their portfolios, they may find themselves unable to respond effectively to changing market conditions, and instead, be at their mercy.
Past Solutions Have Met With Only Partial Success
To address the risks associated with CMBS, regulators have implemented a number of reforms. For example, the Dodd-Frank Act required issuers of CMBS to retain a portion of the securities they create, in order to align their interests with those of investors. In addition, new regulations have been introduced to increase transparency in the underlying loans, making it easier for investors to assess the risk of investing in CMBS.
Despite these reforms, the risks associated with CMBS remain significant. As the global economy continues to grapple with the impact of the COVID-19 pandemic, the commercial real estate market has been hit hard. Many businesses have closed or are operating with reduced capacity, leading to a decline in demand for certain types of commercial real estate. This has put pressure on the value of underlying properties and, by extension, on the value of CMBS.
CMBS Can Be A Strength Or Weakness Depending On Economic Forces
Commercial real estate mortgage-backed securities can be a weakness for lenders, particularly during times of economic uncertainty. It is essential for lenders to actively manage their portfolios and maintain active hedging between rate levels to avoid being caught in a wave of losses. As the market continues to be volatile, lenders must remain vigilant in managing their CMBS portfolios to mitigate the risks of default and loss.
CMBS Feature Unique Risks
One of the challenges in managing CMBS portfolios is the lack of transparency in the underlying loans. The loans are often grouped together and sold as securities, making it difficult for investors to assess the risk of investing in them. In addition, the loans are often complex, with various terms and conditions that can be difficult to understand. As a result, investors may not have a clear understanding of the risks they are taking on when investing in CMBS.
CMBS Regulators Have Some Unique Solutions
Regulators have taken steps to address this issue by requiring issuers of CMBS to retain a portion of the securities they create, in order to align their interests with those of investors. This has helped to increase transparency in the market and improve risk management practices. However, there is still a need for greater transparency in the underlying loans to help investors assess the risks of investing in CMBS.
Another challenge in managing CMBS portfolios is the lack of liquidity in the market. CMBS are not traded as frequently as other types of securities, making it more difficult to buy and sell them. This can make it difficult for investors to exit their positions quickly in the event of a market downturn. As a result, investors may be more likely to hold onto their CMBS investments, even if the market conditions are unfavorable, which can lead to significant losses.
But They Are Not Enough: Your Portfolio Is Yours To Protect
To address these challenges, lenders must remain vigilant in managing their CMBS portfolios, but beyond that, individual investors must take responsibility for tossing managers when they fail at their duties, and must educate themselves to know when this is the case. This means actively monitoring the underlying loans, assessing the risks of default, and ensuring managers are maintaining a reasonable ability to float between rate levels. Lenders must also work to increase transparency in the market and improve liquidity, making it easier for investors to buy and sell CMBS.
Commercial real estate mortgage-backed securities can be fantastic investments during economic expansions, but a weakness for lenders during times of economic uncertainty. The complex structure of CMBS, combined with the lack of transparency and liquidity in the market, make these securities vulnerable to market fluctuations. Lenders must remain vigilant in managing their CMBS portfolios, working to increase transparency and improve liquidity, and implementing effective risk management practices. By doing so, lenders can mitigate the risks of default and loss, and help to ensure the stability of the financial system. By educating themselves about finance, individual investors can better hold managers accountable.
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