Cerberus repackaging near-junk CMBS into top-rated securities

New York

WALL Street's alchemists are at it again, this time spinning supposedly safe investments out of the pandemic-stricken market in commercial real estate.

In a manoeuvre that recalls the complex home mortgage investments in the mid-2000s, Cerberus Capital Management has used relatively low-quality commercial mortgage bonds to create triple-A debt. Although the investment firm didn't invent these securities, it's selling them at a moment when the property market is being clobbered by the pandemic.

Around 9 per cent of commercial mortgages that have been bundled into bonds were delinquent in August, according to data from research firm Trepp, as Covid-19 keeps shoppers out of malls, travellers away from hotels and workers home from offices.

But the challenges to the commercial real estate market also mean that hedge funds are looking for opportunities to profit amid the fallout.

The Cerberus securities mature in essentially 2.2 years, and the AAA portion is being marketed at a price of between 1.4 and 1.5 percentage points over benchmarks, according to people with knowledge of the matter.

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The high ratings combined with relatively high yields and short-term maturity could attract some investors.

"I'm sure the ratings are what's driving the demand," said Jason Callan, head of structured assets at Columbia Threadneedle Investments.

Cerberus is taking derivatives of commercial mortgage bonds, known as interest-only strips, and packaging them into around US$390 million of notes, about US$300 million of which have top ratings from DBRS Morningstar.

Most of the commercial mortgage securities at the foundation of this transaction have the lowest investment-grade rating, BBB-, but through the magic of securitisation they're transmuted into AAA instruments, similar to subprime mortgage bond derivatives that were bundled into top-rated collateralised debt obligations (CDO) during the US housing bubble.

"This is a CDO," said Jen Ripper, an investment specialist at Penn Mutual Asset Management in Horsham, Pennsylvania. "There could be a real risk of some principal loss at the BBB- level, which most of these interest-only tranches are 'stripped' off of."

The transaction is being referred to as a "resecuritisation" in deal documents seen by Bloomberg. Those marketing materials say it's structured so that cash flows have some protection from early repayment of principal through refinancing, and losses due to defaults.

The deal is backed by about 9,300 mortgages, 27.6 per cent of which are office, 25 per cent retail and 15.5 per cent hotel, while the rest is a mix of other commercial real estate sectors, initial marketing materials show.

CMBS interest-only strips are linked to the performance of corresponding bonds with the same ratings that pay both principal and interest. They represent securities backed by the excess interest generated from a pool of commercial mortgages.

A representative from DBRS Morningstar said that the ratings are still pending and that no presale report was available yet.

A representative for Cerberus didn't immediately provide a comment.

The deal is being arranged by Deutsche Bank AG, JPMorgan Chase & Co, and Wells Fargo & Co. Representatives for JPMorgan and Deutsche Bank declined to comment while a press officer for Wells Fargo didn't immediately provide a comment. BLOOMBERG