CMBS, or commercial mortgage-backed securities, may not be the biggest class of impenetrably written paper in the US, but, with about $550bn outstanding, they count for something.
In their present 2.0 form, CMBS were designed to avoid some of the structural weaknesses from their pre-financial crisis form. In recent decades the securities helped build all those franchised restaurants, hotels and suburban offices you will drive through after getting off a late-night plane to the US’s interior.
Since Covid-19, it has become clear that money offered by CMBS has become too expensive and its terms too hard to modify. If you borrow money from an ordinary bank for your business, you can, in theory at least, go back to the loan officer or “relationship manager” you started with, and seek to restructure the loan.
That’s not how CMBS works. The promise they make to their investors is that the securities assembled to make up the investment grade mortgage bonds suitable for sale to the public are far better secured than the equity-thin packages put together before the 2008 crisis. But the structures are, usually, inflexible.
The “master services” and, after a default, “special services” who manage the properties’ cash flows for the investors, work within fairly inflexible terms. The most vulnerable slices of the capital structure, the B piece of the debt or the actual equity, lose their rights to the cash waterfall first. Eventually the special service takes over, and the property is liquidated and sold.
This process may work in normal times. But when a systemic problem, such as Covid-19 comes along, the CMBS machinery becomes jammed up.
The general consensus is that sometime early in the next US administration would be a better time for a crash. Not only does the industry need new Federal laws to stitch together the patchwork of state property laws that govern CMBS today, they need Federal money because commercial property values have been collapsing. Or they need to spend a lot of time in Federal bankruptcy court.
The problem is most obvious for retailers, joined by the hoteliers. And in just a few more months, we will find out how many offices will be cut back by the work from home phenomenon. Will the offices be 80 per cent occupied? Or 50 per cent? After a vaccine. After the next administration takes over.
So CMBS sponsors and holders are killing time by creating two fictions for everyone to believe. The first is that the US only needs a month or two to get back to a V-shaped boom.
To get the second leg of the V there has been an industry-wide effort to find little corners of liquidity that can be tapped, even for a month or two, long enough to get past the US elections. For CMBS borrowers, the finance industry has found caches of “FF & E money”. These are millions of dollars set aside to do normal maintenance for lodging companies, fix up their furniture, fixtures and equipment.
With technical help provided by the Commercial Real Estate Finance Council back in May, every one saw their way to letting the borrowers use that FF & E money to pay principal and interest. Mind you, that will only be allowed to work until September or so, when the paybacks into the FF & E accounts have to start, along with regular principal and interest payments.
Then there is the curious spectacle of the Hope Act, introduced in the US House earlier this week with more than a hundred co-sponsors. The idea of Hope is that the Federal government would take preferred equity positions in troubled CMBS issuers, making them financially sound once more.
In reality, there is no Hope Act. The bill may have more than a 100 co-sponsors, but it has no Senate counterpart. It seems very unlikely that $400bn or $500bn of federal money will go into propping up commercial property values. It is just a piece of theatre that lenders and borrowers can point to — magic government money.
Commercial real estate will have to be entirely restructured in the US. More equity and less . . . hope. Starting next year. So burn the furniture and lobby for a government cheque.