Is the CMBS bubble about to burst?

From this article at Zero Hedge it seems that at least in some cases loan-to-value rations of 90% and up have been used to finance certain projects in the commercial real estate business.1

Lets have a closer look at the following example used by Deepak Moorjani in the story referenced above  (Highlighting by me) :

Project Lindberg

Perhaps we should consider an example. The attached documents detail “Project Lindbergh,” our lending proposal to Morgan Stanley’s real estate investment group in late 2006. Internally, this lending transaction was supported by Frank Forelle and Steve Adang of the Deutsche Bank Commercial Real Estate (“CRE”) lending business.

As reported, Morgan Stanley was in the process of purchasing “13 hotels and two property management units from Japanese airline All Nippon Airways Co. Ltd. for $2.4 billion in the biggest hotel transaction in Asia, the U.S. investment bank said on Friday, making it the largest hotel owner in Japan . . . Under the deal, ANA will sell its stakes in ANA Property Management Co. Ltd., ANA Hotel Management Co. Ltd. and subsidiary companies of 13 hotels as of June 1 for 281.3 billion yen . . . Analysts said the deal underlines a shift in investors’ strategy to seek riskier assets including shares of companies that hold properties.

For Morgan Stanley, this investment was sponsored internally by Sonny Kalsi. As reported in February 2009, Mr. Kalsi was placed on administrative leave after Morgan Stanley disclosed in a filing to the Securities and Exchange Commission that one of the members of his group in China “appear to have violated the foreign corrupt practices act, a US law that prohibits corporate bribery.”

The Deutsche Bank CRE business delivered a highly-aggressive proposal for these risky assets. While we “lost” this deal to Citigroup, this lending proposal illustrates that bankers sought to commit billions of dollars of shareholder and depositor capital in a highly-leveraged transaction. The reason is simple: our incentive structure encourages this excessive risk-taking. Had we won this lending assignment, bankers would have been paid millions of dollars of bonuses for their “success.”

How risky was our proposal? While the properties were appraised at only JPY 236 billion (US $1.97 billion), Morgan Stanley purchased these properties for JPY 281.3 billion (US $2.34 billion), a 2.74% cap rate. Our lending proposal offered JPY 220.1 billion (US $1.83 billion), approximately 93.27% of the value of the properties. In any market, this 93.27% loan-to-value purchase would be considered risky. In hindsight, this lending proposal is seen as ridiculous given (i) the assumption that the underlying cash flows would increase more than 65% by 2010 and (ii) the realization that much of this loan could not be securitized due to its riskiness; much of this loan would have been forced to remain on the Deutsche Bank balance sheet.

The original letter went to Josef Ackermann, Angela Merkel among others. See it in its enitrety here:

Moorjani talks about a misguided risk-management culture. We are thus led to believe that this is not the only instance and that deals were done in this way as a rule rather than as an exception.
Deutsche Bank and Citibank are not alone in having done deals this way – the indications are that others, like Merril Lynch, Bank of America, Royal Bank of Scotland, UBS and Credit Suisse have done their deals in a similar fashion.

So far this would only be a problem of the commercial property owners and their lenders. From the above we know that considerable risks might still be lurking in the banks’ balance sheets, since only part of it could be securitzed and sold to others.
We do not know, however, what the size of this exposure is, this is because these assets are currently valued using the mark-to-my-bonus methodology.

Unfortunately, some of it has been securitzed into neat little bombs such as CMBS, CDOs, etc which have been distributed all over the world. The question is now how much did go beyond the usual bunch of global players and landed with unsuspecting investors such as mutual funds, etc?

Of course, bankers wouldn’t be bankers if they hadn’t also bought CDSs (or LCDSs in this case) to protect against counterparty default. This will help only partly to mitigate the issue. First, who has written those LCDSs, and second what is the recovery rate in case of default on such loans.
We have already seen what happens when residential mortgages start going bad, now we fear that we ain’t seen nothing yet.

1 Note: Commercial real estate is things like office buildings, malls, industrial property, casinos, etc

This post ist available in German.


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