July 2019 CMBS Research The Last 25 Years of CMBS: From Mega Deals to Miami Beach The Twists, Turns, Near-Misses and Memories of Building an Industry from Scratch By Manus Clancy You might say, where there’s blood, there’s also rumor. The scuttlebutt in the CMBS industry was that some Heading into the summer of 1998, those who of the issuers were sitting on huge mark-to-market losses. The early issuers, like today, would warehouse helped create the CMBS market had every loans until they reached critical mass for bringing a deal reason to feel optimistic about the industry’s to market. They would hedge for interest rate risk, but future. The market was now several years old, spread-hedging was either non- existent or tricky. They also tended to warehouse for longer periods of time a number of banks had started “shelves” for than they do now, so the balance of loans on the firms’ issuing CMBS deals and the types of issues books would swell. had evolved from deals with just a few large As spreads blew out late in the summer of 1998, the loans to deals made up of hundreds of loans value of the loans being warehoused plummeted. The and balances totaling in the billions. spread widening was underscored by the miserable execution of Morgan Stanley Capital I Inc., 1998-CF1 (MSC 1998-CF1), which priced in August 1998 near the Lehman Brothers Commercial Trust, 1998-C1 (LBCMT height of the storm. 1998-C1), which amazingly still remains outstanding But the CMBS industry was not one to turn its back on more than 20 years later, was a case in point. It a good time, and Penner’s 1998 confab would go on in was issued in March 1998 and had 259 loans at the face of the tumult. securitization with a total balance of more than $1.7 billion. It wasn’t unique as other investment banks, The Father of CMBS including JPMorgan, Citigroup, DLJ, Credit Suisse First Boston, Merrill Lynch, Morgan Stanley and Goldman If Lewis Ranieri was the father of mortgage-backed Sachs, each had launched their own. Soon to follow securities and collateralized mortgage obligations, would be Bear Stearns, Prudential Financial, First Ethan Penner was the father of CMBS. Union, Deutsche Bank, Salomon Smith Barney, Paine Webber and Wachovia Securities. The beauty of residential loans, as far as securitization was concerned, was their homogeneity. There were By the time most of the industry assembled for CMBS no tenants to worry about; prepayment restrictions did pioneer Ethan Penner’s annual post-Labor Day fete not exist; borrower names could not be revealed; and that year, the CMBS market was already facing its first loans had similar terms. An investor might know only existential threat. The Russian debt crisis that August a few pieces of information about a loan, its balance, had resulted in the collapse of Long-Term Capital rate, whether its coupon was fixed or floating, its term, Management. The hedge fund buckled the following location of its collateral and the property type. There month and a consortium of 16 banks cobbled together wasn’t much more than that. more than $3 billion in bailout funds to keep the LTCM default from turning into a financial market epidemic. As Things were messier in the CMBS market. The one CMBS Founding Father said at the time, “there’s Resolution Trust Corp. (RTC) was started in the late blood in the water.” 1980’s to help liquidate assets the federal government www.trepp.com 1 CMBS Research July 2019 had inherited from failed savings and loan institutions. The 1998 version of Penner’s gala was not lacking in star The market for securitizing residential loans had been power. Even as the foundations of the CMBS market established years before the S&L crisis with the issuance rocked, nothing at the San Francisco party hinted at the of MBS and CMOs. concerns. Comedian Bill Maher hosted the opening session. Other guests included former Presidential The same couldn’t be said for commercial mortgages. candidate and later California governor Jerry Brown, as well as San Francisco Mayor Willie Brown. The first night’s dinner entertainment was provided by Diana Data for the sector was considered Ross. On night two, Robin Williams served as the warm- lumpy, idiosyncratic and incomplete. up act. He’d be followed by Joni Mitchell, Stevie Nicks, Don Henley, Michael McDonald and Gwen Stefani, Nonetheless, the RTC found success among others. creating securities backed by these You could say that the San Francisco blowout was the “noisy” assets. end of phase one of the CMBS market. Nomura would suffer a $2 billion quarterly loss, but it wasn’t alone. Others, who entered the market because of the sizable Data for the sector was considered lumpy, idiosyncratic profits to be had, took a beating as well. and incomplete. Nonetheless, the RTC found success It would not be the last time the market would face creating securities backed by these “noisy” assets. adversity and certainly not the first time the industry’s That gave Penner his opening. But credit for the structural resilience would be called into question. With that nuances of CMBS must go to the RTC. Its deals included introduction, we offer up a 25-year retrospective of the both a master and special servicer, for instance, which CMBS industry—the highs, lows, mistakes, innovations, became a staple of CMBS deals. near-death experience and revival. Some of Penner’s early deals came with the moniker Phase I – 1994-1998: The Early Days “mega.” The deals contained a small number of large While Ethan Penner was at the center of the founding loans— hence the “mega” name. The first such deal of CMBS, he was hardly alone. Lehman Brothers and was Nomura Asset Securities Corp., 1994-MD1, (NASC Credit Suisse First Boston were also aggressively 1994-MD1). Others could lay claim to having done the building teams to support the new financing vehicle. first CMBS deal, but earlier deals were either single- asset or single-borrower transactions. NASC 1994-MD1 The early deals were tricky for several reasons. First, was backed by nine loans against properties owned the data was messy. Issuers struggled with how to by different sponsors. It was the first private-label, represent lockout provisions. Even stickier were yield multiple-borrower transaction. Despite having only nine maintenance calculations. No two calculations seemed loans in its collateral pool, the deal was structured with to be the same— and describing the nuances in a 15 bond classes. prospectus was burdensome. Profits from early CMBS deals were sizable. After all, Interestingly, some of the early Nomura deals included few lenders were actively competing for loans. Penner extremely intensive calculations. In an effort to accurately used some of those profits to throw terrific parties that distribute yield maintenance charges, the calculation are still talked about today. At one event, he talked the called for all bonds’ cash flows to be projected, first Eagles rock band into reuniting for the entertainment assuming the prepayment did not take place and then of his audience. He would raffle off cars to lucky assuming the prepayment of the loan. The difference winners. Bob Dylan would be coaxed into singing for the in cash flows between the two scenarios would be commercial real estate “man.” discounted and served as the basis for distributing yield www.trepp.com 2 CMBS Research July 2019 maintenance. As a result of the complexity, a prepayment confidence to the fledgling market that intricate deals scenario could take 20 minutes to calculate. The method such as this could get issued. was noble, but impractical for traders. It was phased out after a few deals. One sign that the CMBS market was ready for prime time was that Jack Kemp, then vice presidential Then came the issue of how much could be disclosed— nominee, was tapped as keynote speaker at the Tenant names? Borrower names? Lease expiration industry’s 1996 conference, just two days following that dates? Net operating income? Occupancy? year’s presidential election. Money managers were hesitant to allocate a great Also advancing the market was the emergence of new deal of capital to the asset class because of the lack of data and analytic providers. Conquest and Trepp (which transparency and liquidity in the space. At the time, data owns Commercial Real Estate Direct) began to develop were transferred not by email, but through the distribution websites and data sources that were better contoured of floppy disks via overnight mail or messenger. to the nuances of commercial real estate. The tools gave investors better transparency into collateral data. They One of the most noteworthy contributions to the early also provided trading- quality data and models to bond evolution of CMBS was the formation of what then traders and developed analytical tools for investors, was the CSSA, the Commercial Real Estate Secondary allowing them to stress bond cash flows. Market and Securitization Association, which in 1999 changed its name to the CMSA, or Commercial Mortgage Issuers, trying to lure borrowers, briefly offered and Securities Association, and more recently to CREFC, or underwrote “buy down” loans. In a nutshell, a borrower Commercial Real Estate Finance Council. would make an upfront cash payment in exchange for a lower coupon, effectively buying down the interest The trade group was overseen by members from banks, rate. But that made the loans appear to have a higher rating agencies, servicers and CMBS investors, all of debt-service coverage ratio than they might have had whom were committed to putting the industry on a without the buy down.