CMBS Part I: Basic Structure
Commercial Mortgage Backed Securities can be rather confusing. Today, my goal is to provide a quick and simplified overview of what a CMBS is. Whether this is a review or a first-time explanation for you, my goal is to describe the structure and the intent in as plain and simple a manner as possible. It may still be difficult to follow, but hopefully the example used along the way will help.
Even if you don’t understand what a CMBS is, you’ve probably heard at least someone blame them for the financial crisis that came to be known as the Great Recession. This article isn’t about assigning blame, but simply explaining what they are and what they were intended for. Part II will dive deeper into the issue and also explain how certain conflicts of interest played a role in CMBS not working in reality the way they were intended.
What is a CMBS?
CMBS stands for commercial mortgage backed security. Let’s break that down piece by piece. A security is anything that you can invest in where your results are dependent upon someone else. For example, a publicly traded stock is a security. You don’t personally run the company and thus whether the stock price goes up or down is dependent upon the management. If you ran your own business selling t-shirts, your success or failure would be a result of your own efforts. That makes running your own business not a security.
Mortgage-backed means that the security is backed by, based on, or supported by mortgage loans. Finally, commercial is an adjective that refers to the type of mortgage loans. There are residential mortgage loans for people buying houses and condos to live in, and there are commercial mortgages for businesses that buy things such as office buildings, warehouses, and apartment complexes. Thus, you can think of a commercial mortgage-backed security as simply an investment managed by someone else that’s based upon a mortgage loan, which is in turn used for a piece of commercial property.
This is where things can get complicated as there are multiple parties involved in the transaction. First, as we’ve just established, a CMBS includes a mortgage loan. That means that we have a borrower and a lender. To be more precise, instead of using the word lender, we’ll use the word “originator” to refer to the person or business that created the loan.
Let’s consider an example. Julie is a CEO of a software company. Her business is successful and she decides to buy the office building where her company is located. Julie goes to the bank and talks with Max. Max gives Julie a loan to buy the building, that is, Max gives Julie a “commercial mortgage loan” since it’s a loan that will be used to purchase a non-residential (i.e., a commercial) building. In this example, Max is the loan originator, the one who created a loan where one previously did not exist. Julie can now buy the building and will make monthly payments to Max.
Max may decide to sit on the loan for the next ten years or so waiting for Julie to pay him back in full. But he has another option. He can sell Julie’s mortgage loan to someone else for immediate cash. So, let’s say that Max sells Julie’s loan to Mateo. Mateo pays Max in cash for the right to collect monthly payments from Julie.
Why would this happen? Well, different people have different investment objectives. Mateo may like the idea of having a regular stream of income that he can count on every month. At the same time, Max may be happy knowing that he no longer has to wait for Julie to pay off the loan. He no longer has to worry about whether or not Julie’s business will continue to thrive and the possibility that she could fall on hard times and stop making her loan payments. Further, Max now has a lump sum of money burning a hole in his pocket. He can use that money to make, or originate, a new loan. Each time Max originates a new loan he charges processing and other fees, and so even if he doesn’t make any money in interest from Julie (Mateo is now receiving that interest), Max is still making a profit.
This process can continue indefinitely. Every time that Max makes a new loan, he makes a profit off of fees and then immediately sells the new loan to Mateo. Max doesn’t worry about whether or not the loan remains in good standing or not because he only owns the loan for a very short period of time. Mateo is the one taking the long-term risk. Mateo is the one that needs to wait to get paid, and in exchange for taking the risk that some loans may default, he earns interest, which over time really pays off.
But it doesn’t end there. Mateo looks at Max and realizes that Max is making money off of fees and has seemingly little risk that these loans may go unpaid. Mateo also realizes that he doesn’t have enough cash to endlessly buy loans from Max. This is where we add another layer and another party to our situation.
Mateo wants to buy more loans from Max, and so he finds other investors who like what he’s doing, and uses their money to buy more loans from Max.
Zoe and Amar are both investors who want to purchase mortgage loans and receive long-term payments of capital and interest. They go to Mateo and each ask to buy a loan. But instead of selling one full loan to each of them, Mateo creates a trust and sells shares to both Zoe and Amar. By selling them shares instead of entire loans, Zoe and Amar have the flexibility to invest as little or as much money as they want. The concept is similar to buying stocks. When you purchase shares of a stock, you can buy as much or as little as you want. You’re not forced to buy the entire corporation.
Pulling it All Together
To summarize, Julie went to Max for a loan. Max created or originated the loan for Julie. Max then sold Julie’s loan to Mateo. Max used Mateo’s money to originate a second loan, which Mateo also bought. Mateo then put both loans into a trust and sold shares of that trust to Zoe and Amar. Using the money from Zoe and Amar, Mateo can now go back to Max to buy more loans. Without money from outside investors like Zoe and Amar, Mateo wouldn’t be able to buy any more loans. But by working with others, the process can continue indefinitely.
When Julie, or one of the other borrowers makes a payment, the money (indirectly) goes to Zoe and Amar. That means that Zoe and Amar are making money off of interest. We already know that Max is making money off of origination fees. But how does Mateo make a profit? Well… he takes a little interest off the top before Zoe and Amar get paid. If for example Julie pays a 6% interest rate, Mateo may take 0.5% for his troubles before passing the remaining 5.5% on to Zoe and Amar.
Zoe, Amar, and other investors like them are putting up the money to make this happen which is why the system depends on investors who are interested in receiving interest payments. As far as Max and Mateo are concerned, notice that neither of them have to use their own money. Max gets the capital to lend out from Mateo and Mateo gets the money to buy loans from Zoe, Amar, and others like them.
That’s it. That’s the basic structure. The trust is the legal entity that owns Julie’s mortgage loan along with several other mortgage loans. The “security” as in commercial mortgage backed security refers to the investment made by Zoe and Amar, who are relying on and dependent on, the performance of someone other than themselves for whether or not they’ll be profitable. In this case they’re reliant on Mateo, hoping that he will only buy loans that will pay off and not go into default.
Hopefully that wasn’t too difficult to follow. Unfortunately, it does get more complex. We’ll discuss the concept of tranches, where risk is purposely assigned in disproportionate amounts to different investors, troublesome incentives, and conflicts on interest in later articles.