CMBS 2.0 – What went wrong and how we fix it

To have the need for 2.0 of anything, by definition, 1.0 could have been better.

Certainly that was the case with many of the internet’s first sites, and it is the case with Commercial Mortgage Backed Securities.

CMBS 1.0 had all sorts of problems, including:

  1. Too many lenders chasing too few deals resulting in high-leverage and low-cost debt financing that inflated the equity markets. Classic “Bubble” behavior that tolerated incomplete or inaccurate broker/borrower disclosure.
  2. The diminishment of the “B Piece Buyers” credit check as a result of the CDO arbitrage opportunity that existed from 2004–2007.
  3. Conflict of Interest between the issuers and the rating agencies.
  4. Inadequate reporting requirements and tools to effectively share true credit risk with all interested parties.
  5. And a whole lot of other things. …

Some of these items have a way of fixing themselves. There are no more CDOs, so B Piece buyers care about credit again, and no one would say we have too many lenders right now. The rating agency issue is a bit tricky given the historical roles of these companies; regulators will likely help decide their future role/revenue model. That leaves us with reporting requirements and standards as the only things we can truly affect as we wait for the market to return.

So what would be different about CMBS 2.0?

Lots of things but, primarily, a standardized real estate underwriting and data platform.

The “math” associated with real estate loan underwriting is basically broken up into two items: Notes and Properties. After modeling the Note to include the debt repayment terms (the liability) and the Property to model the net cash flow available after collecting the rent on the leases and paying expenses (the asset), the user can determine the Debt Service Coverage Ratio (or DSCR = Cash Flow From Property / Cash Requirement of Notes). The higher the DSCR, the safer the loan. The lower the DSCR, the riskier the loan.

On a typical CMBS loan, the debt side stays constant as most loans are fixed rate. On floating rate loans, interest rates and, therefore debt service requirements, change. As an industry (CMBS 1.0), we do a good job on the debt side of the equation, so that is not the problem.

Strengthening the property side

Since rental rates change and tenants come and go, the property side of the equation changes all the time.

As an industry (CMBS 1.0), we did not do an adequate job on reporting on the property side. The problem can be pinpointed to a lack of reporting on rent rolls and the inability for investors to run models on existing CMBS pools based on current rent rolls.

The good news is borrowers need to submit updated rent rolls as often as once a quarter, so the info is contractually available. The bad news is the Investor Reporting Package (IRP) does not require disclosure of the rent roll. So, the master servicers do not provide them electronically and the existing investor / CMBS bond modeling systems do not handle rent rolls adequately for underwriting because, historically, an underwriting was nothing more than last year’s income and expense number (as adjusted, or not, by the servicer).

There are many paths to fix the property reporting deficiencies, and the issue raised above is not a new problem for the industry. To date, standardization efforts have been waged by the CMSA and the MBA. Being actively involved in these industry efforts, I can say the timeline to reach standards is still measured in years, not months. In good times, that may have been acceptable. Not today.

The power of a common underwriting platform

When we all share a common underwriting platform and have open access to required data, we will have much-needed transparency, and every member of the CMBS market will enjoy improved processes:

  • Borrowers and brokers who are either looking for a new CMBS loan or reporting on an existing CMBS loan could enter the required data and report it to the lender or servicer in a standardized format.
  • Existing borrowers would send their rent rolls and operating statements to the master servicer in an XML format that seamlessly updates the terms of the new rent roll in the investor system.
  • Mortgage brokers could put together packages that feed directly into the lender’s system.
  • Lenders would be able to analyze credit risks of new loans for internal approval and share that data efficiently with the rating agencies and investors.
  • Investors would have access to updated surveillance reports conducted by the rating agencies, and they would be able to create their own versions of the cash flows for their bond books.
  • Appraisers could create their valuation models using the same objective data as the lenders.
  • These all seem like good enough ideas. …

We are building CMBS 2.o now

We are working to make the common CMBS platform. We are promoting acceptance by offering free accounts for all existing CMBS borrowers and individual user accounts for as little as $49/month.

Will it work? Will the borrowers come and register their loans? Will investors gain unique insight into the bonds? Will brokers prepare debt and equity marketing packages on the standard? Will the old-line banks get off their proprietary systems?

Who knows? Stay tuned.

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Jim Flaherty is CEO of and the creator of the Backshop loan origination system. He is a trained credit professional with experience installing enterprise underwriting systems for commercial real estate lenders, rating agencies and investors.

Transparency vs skin

There is no question that the way in which we have conducted securitizations in the past is broken.

I agree with Ethan Penner (in his July 10, 2008 Opinion Article in the WSJ, The Future of Securitization) when he says “Yesterday’s business model has been invalidated.” However, I do not agree with his conclusion that securitization can survive “with a simple tweak.”

Mr. Penner makes the case that, in addition to transferring credit risk, the two primary benefits of securitization are

  1. a vehicle that allows a lender to match the terms of its assets and liabilities and
  2. the “transparency that it brings to bear on the system.”

Penner’s article concludes that for securitization to return the lender must originate loans and have enough equity/balance sheet to keep the first loss piece, while securitizing the senior pieces with CMBS bonds to get the benefit of risk transfer and to match fund the loans.

In other words, by the lender keeping skin in the game, the interests of the lender and the investor stay aligned and, therefore, everything will work again. The article makes no mention of the role of transparency and standards (other than them being one of the key benefits of securitization).

While aligning economic interest is absolutely a good idea, I would suggest that point is so fundamental that it should be assumed as mandatory. If the equity and the investor do not have aligned economic interests, we should not even consider bringing back securitization.

But how much equity is needed to keep all players’ interests aligned? 10%, 20%, 50%? The amount of required equity will no doubt vary depending on the market, the assets and the relationship between the equity (lender) and the investor.

History has shown that in good times the lenders will be required to keep very little (if any) skin in the game. In bad time, lenders will be required to put up more equity.

While coming up with equity is a fairly simple “tweak,” it does not represent the permanent reforms that are required.

Standards and transparency

For me, Skin in the Game is not the long-term answer (although it will probably be required for lenders to re-enter the securitization market as it crawls back to life).

The keys are standards and transparency with all parties using common underwriting models. Having spent the last eight years creating the most widely used common underwriting tool in the CMBS market, I can say that all lenders do the math the same way. Bank of America, Royal Bank of Scotland, Hypo International, CWCapital, AIG and Genworth all underwrite using the same software. Rating Agencies including Standard and Poor’s and DBRS underwrite using the same tool. The reason the market has not historically shared underwriting has to do with the fact the no common underwriting platform existed, not because the math is different from shop to shop.

The systems used by the big players were developed (at great cost) internally and typically have an Excel-based calculator. Since the models are fairly complicated (although the math itself is fairly simple), each party sets up its systems a bit differently. They do not share identical structures, and they do not communicate. And, since these systems were expensive and painful to develop, many people have vested interests in keeping the systems in place — so they don’t look like wasted technology dollars.

Underwriting is NOT an “art form”

Of course, some lenders have not been interested in sharing the math because, when times were good, they simply did not need to. I remember one prospectus where the issuer actually called underwriting an “art form” and, therefore, could not explain the math behind the numbers.

If underwriting is defined as an Art Form, then making up numbers because of aggressive assumptions becomes OK and very hard to detect. If they could sell the assets without the disclosure, why bother? One true benefit of the credit crash is that this position, as we have said, has been declared invalid.

A common underwriting platform

How do we, as an industry, get to a common underwriting platform?

To date, the industry effort to create standards has been led by the CMSA through its work on the IRP (Investor Reporting Package) and the MBA under the C-MISMO banner (Commercial Mortgage Industry Standards and Maintenance Organization).

The CMSA IRP is a decent standard in that people generally use it, but the data available in the file is deficient. The MBA has tried hard (and continues to try hard) to “herd the cats” and get everyone to agree on the data standards. It should be noted that CMISMO is not trying to standardize underwriting, only data terms and structures. Even with this reduced scope, the process of creating standards has been painfully slow and, after eight years of trying, only a handful of standards have been created with minimal industry adoption.

However, even if CMISMO were successful in short order, since there is nothing in the standards regarding underwriting, the ultimate value of the standard is questionable. That being said, we are members of CMISMO and have offered our tools, free of charge, to help the CMSA gain traction in rolling out IRP 6 (in XML).

On the private sector side, my product (Backshop) has been the most successful in gaining market acceptance. It is the only third party application in which 100% of the underwriting is done within the website and the database (no Excel!), so the system is 100% structured.

But Citi Bank, Goldman Sachs, JPMorgan, Morgan Stanley, Wachovia and others still use proprietary models. I can attest that selling enterprise software into these big companies is a slow and painful process with all sorts of barriers that often have nothing to do with the product. That being said, these institutions have never experienced an “Invalidated” business model, so the time may be now.

True, long-lasting change

If we, as a market, all used the same “calculator” and were willing to share our underwritings with the rating agencies and the investors in an open, transparent manor, that would bring true and long-lasting change to the securitization market.

It is more than a “tweak” — because creating standards is harder than raising capital.

However, if the legacy systems of a few major players are shelved and the remaining players have a path to join a common standard, the math would open up, and the risks of the loans and securities would be transparent.

Investors would no doubt return if they were comfortable they were getting a positive risk-adjusted return and that, in my opinion, is the way to bring back the CMBS market.

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Jim Flaherty is CEO of and the creator of the Backshop loan origination system. He is a trained credit professional with experience installing enterprise underwriting systems for commercial real estate lenders, rating agencies and investors.