1. A Model of CMBS Spreads Joseph B Nichols and Amy Cunningham Federal Reserve Day Ahead Conference January 2, 2009 Note: The analysis and conclusions expressed herein are those of the author and do not necessarily represent the views of the Board of Governors of the Federal Reserve System and its staff.

4. Why? CMBS has been an increasingly important source of financing for CRE. Market has seen several significant disruptions. –9/11 attacks. –Subprime crisis. What has been the effect of these disruptions on pricing?

5. What CMBS market is still evolving and changing. –CMBS pools are very heterogeneous. –Pool composition and credit quality have changed. –Some changes in response to shocks. Increase use of fusion pools after 9/11. Increase in credit support after subprime crisis.

7. How to Model Effects Changes in composition raises challenge for use of on-the-run spread models. Address that by using spreads on new issuance. –Allows us to control for change in composition both across time and cross-sectionally. –Measure premium paid for higher credit support or higher risk exposure.

8. 9/11 After 9/11 there was an significant jump in the perceived risk exposure for large commercial buildings. The existing levels of terrorism insurance was viewed as insufficient and too costly. –GMAC and the Mall of America. Concerns about impact on construction. Increased use of fusion pools in CMBS.

9. The Terrorism Risk Insurance Act of 2002 Passed November 11, 2002. Federal Government will act as reinsurer. –Triggered by terrorism attack where the damage exceeds a given threshold (currently $100 million). –No premium payments prior to attack, payments assigned after attack. –Designed to be temporary until market for terrorism insurance develops. –Renewed in 2005 and in 2007 for seven years. Extended to cover domestic acts and nuclear, biological, chemical, and radiological attacks.

10. Subprime and CMBS – Part 1 CMBS spreads started to widen in response to subprime crisis in late February, 2007. Initial response was due to fall in demand from CDOs, which had been significant buyers of BBB CMBS. In April, Moody’s announced higher levels of credit support to address ongoing concerns regarding higher leverage and looser underwriting. The market pushed back, eight of the first twelve CMBS pools issued in Q3 did not have Moody’s ratings. Originations for CMBS peaked in June, and started to slow. Conditions worsened in August. Market largely shut down in Fall. Credit support rising and leverage falling for new issuance since fall.

11. Subprime and CMBS – Part 2 CMBS saw significant increases in leverage and looser underwriting in 2005-2007. –Increased demand from private equity for LBOs of REITS. –Increased use of pro forma instead of historical rents. –Increase in interest-only loans. CMBS differs significantly from Subprime MBS. –Investors can examine loan and property level data for entire pool. –Collateral is income-generating properties. –No oversupply of properties.

12. Literature Brown, Kroszner, and Jenn (2002) –Impact of milestones leading to passage of TRIA on stock prices of affected industries. –Results show largely negative impact. Deng, Gabriel, and Sanders (2008) –Model of on-the-run CMBS spreads –Impact of demand from CDOs Maris and Segal (2002) –Model of spreads of new CMBS issuance. –Used data through 1999. –Starting point for our model.

13. Hypothesis BBB CMBS spreads for pools containing large loans should be responsive to changes in perceived terrorism risk. Investors differentiate between similarly rated tranches based on the levels of credit support and pool composition. The premium demanded for lower credit support and higher default risk started to rise before the onset of the subprime crisis.

14. Data Generate models using both on-the-run spreads and spreads on new issuance. –On-the-run spreads from Morgan Stanley, weekly. –Spreads on new issuance, and pool characteristics, CMAlert. Use junior AAA tranche. Convert spreads to be on 10-year treasury. Control for autocorrelation by including lagged term.

15. Independent Variables

17. Results from On-The-Run Models Sign on corporate credit spread opposite from Maris and Segal results. –Our sample includes Enron scandal period. –CMBS was used as substitute for corporate bonds during that period. Volatility measures act as risk proxies. Despite declines in nominal spreads, model shows increase in BBB spreads prior to onset of subprime crisis.

20. Results from AAA Spreads on New Issuance Results from macro variables consistent with on- the-run models. Signs for tranche and pool amount consistent with Maris and Segal. –Larger tranche = increased liquidity. –Larger pool = difficulty absorbing increased supply. Little results from pool characteristics. –AAA tranche largely insulated from credit risks.

23. Results from BBB Spreads on New Issuance Results from macro variables consistent with on- the-run model. Higher LTV on loans or lower subordination rates results in higher spreads. Controlling for pool composition, BBB spreads fell 16 bps after TRIA passed. Premium for lower subordination rates started to rise prior to onset of subprime crisis.

24. Conclusions CMBS market responded to shocks by changing pool composition and levels of credit support.. TRIA reduced premium paid on pools with large loans. –Result of transfer of risk to government or widespread adoption of fusion pools. Premium paid for lower credit quality and credit support starter to rise prior to onset of subprime crisis. –Reflecting pre-existing concern regarding weakening underwriting standards.