The Fed announced Tuesday that previously issued (legacy) commercial mortgage-backed securities (CMBS) will become eligible collateral for the Term Asset-Backed Securities Loan Facility (TALF). This comes less than three weeks after announcing that only newly issued CMBS would become TALF-eligible.
The mission of the TALF is to increase credit availability. So how does expanding TALF-eligible collateral to include legacy CMBS help the Fed achieve this goal? High yields on legacy CMBS discourage the extension of new credit towards the purchase of commercial property. From the perspective of a lender, owning senior CMBS arguably provides a safer exposure to commercial real estate than new loan extensions, while at the same time, delivers a yield well in excess of what could reasonably be obtained in the market for new credit extensions.
As of last Friday, the yield on TALF-eligible CMBS securities was 684 basis points above the 10-year Treasury rate. (This implies a yield near 10%.) By making legacy CMBS securities TALF-eligible, the Fed hoped to spur demand for these securities, and as a result, decrease their yield spread. A week later and three days after the Fed’s announcement, the spread on TALF-eligible legacy CMBS has narrowed to 495 basis points. This suggests that the Fed’s announcement has helped narrow spreads.
So will the Fed’s latest move renew interest in commercial real estate lending? To answer this question, consider that in May, 2007, CMBS that would now be TALF-eligible traded at a 30 basis point premium to 10-year Treasuries. While we are unlikely to see CMBS spreads return to such levels, a decline in TALF-eligible spreads of additional 200-300 basis points may be possible. What remains remarkable is that the yield spread on AAA-rated but TALF-ineligible CMBS remains at an incredibly high 1710 basis points over 10-year Treasuries, and this reflects a decline of 800 basis points in the last week! If we generously assume a 200 basis point TALF-eligible spread and a future securitization structured such that half of the securities are TALF-eligible and the other half priced at an average spread equal to the AAA but TALF-ineligible level, a securitizing lender would face a weighted-average cost of funds of 955 basis points over 10-year Treasuries – still well in excess of what can be achieved in the primary market. This suggests that although extending the eligible collateral for the TALF to include legacy CMBS may help lower spreads on legacy CMBS, spreads remain at levels unlikely to renew significant interest in new commercial real estate lending.