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Analysts growing wary of CMBS market (again)

NEW YORK, Oct 14 (IFR) - Morgan Stanley sounded the alarm this week in the CMBS market, saying some recent bonds could lose as much as 8.9% - enough to leave several layers of investors wiped out.

The dire warning underscored that the commercial mortgage bond market is still plagued by some of the same problems that led to a wave of defaults after the last financial crash.

MS analysts said ballooning debt loads, weak property financials and razor-thin returns could lead to devastating losses.

They warned that losses on some bonds sold only two years ago could be as high as 8.9% once wobbling property prices, rising interest rates and tighter credit conditions take hold.

Even in the base-case model, losses could climb to 8% on some of the more aggressive deals, Morgan Stanley said in an open call with market participants on Tuesday.

Those numbers are among the most dire estimates yet for a key asset class that helps fund office towers, hotels, shopping malls and other commercial properties.

Outstanding commercial mortgage debt now stands at US$2.9trn, according to Richard Hill, Morgan Stanley's head of commercial property debt research.

And refinancing that debt - at likely higher rates - will only add to the sector's woes.

"There is no more constantly being able to refinance at lower rates," Hill said on the call.

MORE OF THE SAME?

Many believed the CMBS market had put its worst days behind it, as some US$370bn of new bonds sold since 2013 have in part helped refinance old high-leverage debt with less pricy loans.

Lenders vowed to shun slipshod underwriting, new rules required investors to do their own credit work - rather than rely on rating agency grades - and the hope was things had changed.

"Doing deals in 2012 and 2013, the view was these were very pristine deals that were squeaky clean," one hedge fund manager told IFR.

"But with the passage of time you are starting to see which deals have weaker properties."

Deals sold in the shadow of the crash were deemed cleaner because borrowers put more of their own money on the line and credit rating firms required bigger credit cushions to protect from losses.

But properties have buckled in oil-fracking boom towns, people stopped shopping at many lower-tier malls and a string of major department chains have been shuttering stores.

New York's Hudson Valley Mall leaned on JC Penney, Macy's and Sears as their top-roster tenants in late 2010 when Cantor Commercial Real Estate lent US$52.5m against the property, according to bond deal documents.

That trio of anchor tenants is now often seen as the death-knell for any mall, and Kroll Bond Rating Agency is projecting a near US$40m loss on the loan.

STILL WORSE AHEAD?

Forecasting losses is notoriously difficult, of course, and Morgan Stanley's latest call is an early warning shot that may be more grim than others.

But JP Morgan last month adjusted its models to better predict fallout on CMBS loans that default, and many in the market think the doomsayers may be right.

"I think 8% is reasonable on some deals," said an analyst at a rival bank that is also studying potentially higher CMBS losses but has yet to publish its findings.

Jason Callan, the head of structured products at Columbia Threadneedle Investments, told IFR that everyone should be revising their estimates.

He worries that commercial real estate is already late in the cycle, that central bank policies have caused market distortions and that weak malls could inflict major damage on CMBS.

"Now is as good a time as any," Callan said about the need to study how high losses could climb.

According to Morgan Stanley, the roughly US$500bn CMBS market has already absorbed cumulative losses of 5.6%, which is mostly due to soured loans written before the crash.

The bank said its base-case average for losses across bonds sold in the past six years is now 4.6%, with 2010 deals at a lower 3.6% average range and 2014 deal at a higher 6.1% average.

To put the figures into a broader context, a 4.6% loss to a typical CMBS deal would nearly wipe out the entire bottom 5% of bonds that some investors plan to keep to satisfy risk retention rules that take hold later this year.

"Our intention was not to say: this is the end-all, be-all. It's a starting place," Morgan Stanley's Hill said on the conference call.

"Not everyone agrees with the findings." (Reporting by Joy Wiltermuth; Editing by Natalie Harrison and Marc Carnegie)

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