Wednesday, September 17, 2008

So where do the bailouts end? You tell me.

I honestly don't know the answer to the question. But the deal is done for the Feds to bail out AIG, just like it did with Bear and Fannie and Freddie but not with Lehman or Merrill. At least the loan, once again made under the "unusual and exigent" clause of Section 13(3) of the Federal Reserve Act, is at 850 bps above LIBOR.

Where do you draw the line? Is Ford or GM a "national treasure," too? (Those are Hank Greenberg's words, not mine.) What about the airlines (again)? Or some other distressed company? The line was drawn in the sand and then changed. Why bail out the bondholders? Certitude would be nice. But again, even though I am a free-marketer at heart, maybe this one had to happen too. Unlike Fannie and Freddie, I don't know. Some say it had to be done to prevent a collapse, but others say that the Fed should have let the market take its course.

Apparently Steven Udvar-Hazy wants to buy back ILFC, the aircraft leasing unit he founded eons ago. He's got the team so that deal makes sense of the money's there to do it.

Yes, AIG did home mortgages and insured lenders on defaults as well. They did do some CMBS work, too, I guess. (Someone correct me if I am wrong.) But they sure have real estate holdings.

But the effect of all these deals, especially Lehman, will be more write-downs and hopefully some much needed portfolio transparency. Interestingly, the big fear seems to be home builders more than commercial property. (Lehman was known, however, for doing risky dirt deals.) And I think that's right. Another interesting development is that B-piece buyers in the few CMBS issuances out there are negotiating heavily to throw out any loan they think is a loser.

P.S. Check out the huge spreads right now -- wow.


David Bodamer said...

This is all really unbelievable.

What is AIG's relationship to commercial real estate? I'm sure they did some insurance. They've been part of the group that's lobbied for the terrorism insurance backstop in Congress.

Do they have any direct investments in commercial real estate or own CMBS bonds?

David Stejkowski said...

I spoke to a client about this and learned the following: it isn't so much their own holdings, but the fact that AIG was the underwriter of huge numbers of loan portfolios, insuring that the mortgage bonds would not default and go belly-up. Ouch.

If you want to read more about swaps and how an AIG filing would have meant, deals unwinding, banks having to raise capital overnight and other gloomy matters: see here:

David Bodamer said...

Interesting. Good to know.

Frank said...

Sure, AIG is a big CMBS investor (>$16 billion at end of 1Q '08), most insurance companies are. Virtually all insurance companies buy CMBS focused on the highest rated tranches (and these really do have more than adequate protection in CMBS - it's just not comparable to what is happening in ABS/RMBS). The insurance companies historically were (and still are) big CRE mortgage lenders because it fits in their maturity profile so well. They gave up market share to CMBS and became purchasers of CMBS because the investment in a CMBS tranche many times made more since then going out and originating a large number of mortgages.

They typically would mark all of these to maturity, and your typical super senior AAA CMBS with 30% protection (~3x the rating agency required level; i.e. losses on the mortgages would have to exceed 30% before the investment takes a hit)wouldn't even of been hit during the great depression - the current spreads are completely technical in nature. No one could argue that the current spreads in CMBS reflect fundamentals, and one day they'll tighten in. This is only a problem for the insurance companies if they have to start marking to market, even though they intend to hold to maturity.

B-piece buyers only kick out loans before a deal is priced, not after it is trading. This is one of the mechanisms that CMBS has that makes it better than its ABS and CMBS counterparts. However, it is quite amazing that some of the '06/'07 loans made it in.

David Stejkowski said...

Frank, excellent thoughts, all. The way prices were going, it made perfect sense for insurers to clip coupons instead of underwriting individual investments. And by staying in the AAA tranches, they should be all right. I won't get into the rating agencies here and their models.

I'm obviously no authority on the business side of CMBS, but why do you think the B-piecers were not kicking out the "stupid" deals? Was it aggressiveness? Was it competing with other buyers? Pressure from the underwriter? Euphoria over the market? (Somehow I doubt the last one.) A combination of factors?

Frank said...

The B-piece buyers failure is mostly due to competition. You have a chunk of change to invest each year, and there are only so many B-pieces out there to choose from too...

Obviously the rating agencies failed on nearly every front, in virtually every asset classes. This is as true in CMBS as anywhere else, and it's actually easy to see and measure in CMBS too. CMBS investors are mostly real estate people though (at least until very recently with the shorts from hedgistan), and they've long recognized the failure of the rating agencies. When subordination rates were in the teens for BBBs (now in the low single digits), investors backed up their trucks and loaded up.

When AAA subordination rates got into the low teens, investors required higher ones than the agencies did. So, deals from 2005 on have about 70% of the bonds rated AAA. A sliver of that hits the rating-agency required subordination in the low-teens, another sliver has a subordination rate in the low 20s, and then roughly 60% of the bonds are 30% subordinated. Forgive me if I'm preaching to the choir, or ranting on too long, but I haven't heard any economic scenario (rational or otherwise) that puts commercial property losses high enough to take out the 30% AAA (most rational predictions are between 6 - 12%, and 12 seems awful high to me).

David Stejkowski said...

Thanks again for some really first-rate analysis. Rant away!

I think 12% is way high. Look at where default rates are right now. 8%, maybe; 10%? I can maybe see that. But I can't see 12% and if we get to 30%, lock all the high-rise windows.

Yes, all bets may be off on some things right now, but realistically I think you are spot on.