The bond market is reeling from rising default risk in Pro-Forma Commercial Mortgages.

Mortgages on offices, shopping malls and hotels that were based on projections of soaring income during the real estate boom are roiling the bond market.

A $209 million loan made by JPMorgan Chase & Co. to finance the Westin La Paloma Resort & Spa in Tucson, Arizona, and the Westin Hilton Head Island Resort & Spa in South Carolina, is near default after cancellations sapped revenue, according to Standard & Poor’s. In southern California, the owner of the Promenade Shops at Dos Lagos missed two payments, according to analysts at Deutsche Bank AG.

Both loans were given to borrowers based on estimates that rents and hotel revenue would rise, and then were packaged with similar debt into a $1.16 billion bond sold by JPMorgan to investors. So-called pro-forma loans outstanding total more than $40 billion, according to Barclays Capital, all of which were put into securities. Concern that the Westin Portfolio and Promenade debt may be the first of many of those loans to default sent yields on commercial-mortgage backed securities to record highs relative to benchmark interest rates.

“These kinds of loans written during the height of the real estate boom could be the first to have problems,” said Christopher Sullivan, who oversees $1.3 billion as chief investment officer at United Nations Federal Credit Union in New York. “They were underwritten with outlandish expectations on rents and property appreciation that will turn out to be fiction.”

Similar loans across the nation are starting to turn bad. In New York City, Stuyvesant Town-Peter Cooper Village, a housing complex in downtown Manhattan and Riverton Apartments in Harlem are also struggling to meet their promised targets, according to statements by the borrowers and ratings companies.

Pro-forma loans became a “common phenomenon” in late 2006 through the end of 2007 as property values soared and rents skyrocketed, New York-based Deutsche Bank analysts said in a Nov. 18 report. They allow borrowers to take on more debt on the assumption that they will have higher incomes to pay the interest and principal. Cash reserves are set aside to cover the difference until the income rises to the anticipated level.

Yields on top-rated bonds backed by loans for commercial debt are at a record 15.2 percentage points more than benchmark interest rates, compared with 8.5 percentage points on Nov. 17 and 0.8 percentage points in January, according to Bank of America Corp. data.

The Westin Portfolio and Promenade loans are reflected in indexes linked to commercial debt, causing the cost of buying protection against default on the debt to rise. Credit-default swaps on AAA securities rose 133.5 basis points to 847.5 basis points based on the latest Markit CMBX index contracts, according to administrator Markit Group Ltd. That means it would cost $847,500 in annual premiums to protect $10 million of the debt, or about $619,000 more than on Oct. 31

Alt-A Losses Outstripping Expectations

Moody’s Says Alt-A Losses Outstripping Expectations.

Severe delinquencies on recent-vintage Alt-A RMBS are quickly getting worse than expected, Moody’s Investors Service said earlier this week; the rating agency said worsening trends in Alt-A have forced it to undertake a revision of lifetime loss projections for 2006 and 2007 vintages, as a result. Moody’s last revised its loss expectations for the Alt-A sector six months ago.

As of Oct. 2008, serious delinquencies for Alt-A pools — including option ARMs — averaged 20.3 percent of current balance for the 2006 vintage and 17.5 percent for the 2007 vintage, up from 16.9 and 12.2 percent six months ago. At the same time, prepayment rates on these pools are at historical lows and are currently averaging in the mid to high single digits, Moody’s noted. Serious delinquencies refers to mortgages more than 60 days in arrears, in this case.

Moody’s said it is also updating its loss expectations on pools backed by option ARM loans, as well; and it’s likely to be worse than the above estimates, given that the pace of delinquency build-up has recently outpaced that of regular Alt-A. The rating agency — not surprisingly — would only say that it expects loss projections for option ARMs, on average, to come in higher than the estimates applied to more vanilla Alt-A deals. At HW, we’d tend to side with those suggesting losses could be much higher than in other loan classes.

Alt-A problems have been under way for a long time, and are about to take a severe turn for the worse along with rising unemployment rates. The Fed is well aware of the Alt-A problem but cannot do much about it other than what it has already done (slash the Fed Funds Rate).

In theory, 1 month LIBOR could fall to zero and if that happened our mortgage rate would be 1.25%. Falling LIBOR and 1-year treasuries will help those in existing ARMs, provided of course the mortgage holders have a job and they don’t walk away if they do have a job.

No such “cure” exists for commercial real estate. And importantly this is just the tip of the iceberg of commercial real estate woes. As consumers get increasingly frugal, occupancy rates are going to plunge as will lease rates.

Looking ahead, both commercial and residential defaults are going to soar. The Shopping Center Economic Model Is History. Regional banks that escaped the residential bust are going to get clobbered by the commercial real estate implosion.

Mike “Mish” Shedlock
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