the Bears have no shares

Bondholders Face Commercial Mortgage Losses as Principal Is Due

By Sarah Mulholland
June 11 (Bloomberg) -- Investors in bonds that packaged $62 billion of debt for U.S. offices, hotels and shopping malls are bracing for more loan defaults through 2010 as Bank of America Merrill Lynch says landlords’ monthly payments may jump 20 percent or more.

Principal is coming due on the so-called partial interest- only loans as an 18-month-old recession saps demand for commercial real estate. About $179 billion of such loans were written between 2005 and 2007 and bundled into bonds, according to data from Bank of America Merrill Lynch.

With soaring vacancies and falling rents, some cash- strapped borrowers will fail to cover the higher costs, said Andy Day, a commercial mortgage-backed securities analyst at Morgan Stanley in New York. About 87 percent of mortgages sold as securities in 2007 allowed owners to put off paying principal for several years or until maturity, compared with 48 percent in 2004, Morgan Stanley data show.

“The worst is yet to come,” MetLife Inc. Chief Investment Officer Steven Kandarian said yesterday in a Bloomberg Television interview. “Typically there’s a lag between when the economy softens and when the defaults actually occur.”

Investors have already seen prices on top-rated senior debt drop below 70 cents on the dollar from 95 cents a year ago, according to Aaron Bryson, a commercial mortgage-backed securities analyst at Barclays Capital in New York.

Just a Stopgap
Interest-only mortgages were designed as a stopgap to allow owners to do renovations and absorb other costs. Owners delay paying principal for the first several years, lowering their initial monthly expenses. Partial interest-only loans allow for postponement of principal payments for a portion of the term. Full-term interest-only deals require the principal at maturity.
Loans that postpone principal payments had become the norm by the time the commercial-mortgage bond market peaked two years ago, said Frank Innaurato, managing director of analytical services at Realpoint LLC, a Horsham, Pennsylvania-based credit- rating service.

“The proliferation of interest-only loans was symptomatic of the loose underwriting standards of that time,” Innaurato said. “Borrowers were taking advantage of the best terms possible.”

Property owners turned to Wall Street to finance office towers, apartment complexes and hotels as banks bundled the debt and sold it to investors. A record $230 billion in commercial mortgage-backed securities were sold in 2007, up from $93.3 billion in 2004, according to Morgan Stanley data. About $750 billion of such debt is outstanding, bank data show.

Subprime Losses
A similar type of loan fueled the U.S. residential housing boom, allowing people to borrow more than they could afford as they assumed home prices would keep going up. The collapse of the subprime mortgage market, which led to almost $1.5 trillion in losses since the start of 2007 at banks and financial companies worldwide, was triggered in part when owners defaulted as their payments rose.

Interest-only loans raised concerns “as an example of excessively aggressive underwriting during 2006 and 2007,” said Kent Born, senior managing director at PPM America, an investment manager in Chicago. “But commercial real estate fundamentals were good, and there was a huge demand for these bonds.”

The jump in monthly payments on commercial property won’t be as severe as in the residential market, though it will still sting, according to a May 1 report from Bank of America Merrill Lynch in New York. The mortgages may be one of the “significant contributors” to delinquencies on loans in commercial mortgage- backed bonds, the analysts said.

Investment Grade
Concern that commercial real estate is poised for a protracted slump comes as credit markets thaw. Borrowers have sold a record $615 billion of investment-grade U.S. corporate bonds this year, according to data compiled by Bloomberg. Junk bonds, which are rated below Baa3 by Moody’s Investors Service and BBB- by Standard & Poor’s, have rallied 33 percent since March 9, Merrill Lynch & Co.’s U.S. High-Yield Master II index shows.

The yield gap, or spread, relative to benchmark interest rates on top-rated bonds backed by commercial real estate has fallen 3.8 percentage points to 7.8 percentage points since the Federal Reserve said on March 23 that it would lend to investors to purchase securities sold before Jan. 1, 2009, as part of its $1 trillion program to unlock credit, according to Bank of America Corp. data. Spreads on the debt have widened 1.5 percentage point since before S&P said on May 26 that it may cut ratings on top-ranked commercial mortgage-backed debt, rendering the bonds ineligible for the program.

A year ago, the debt was trading at about 1.6 percentage point more than the benchmark.

Unemployment Effects
While the U.S. services industry contracted at a slower pace in May and the number of Americans collecting jobless benefits shrank for the first time in almost five months, unemployment will continue to depress non-residential real estate, said Mitchell Stapley, chief fixed-income officer for Fifth Third Asset Management.

“The notion that the rate of decline has slowed, and that we are seeing improvement, doesn’t change the fact that the consumer is retrenching,” said Stapley, who oversees $22 billion in Grand Rapids, Michigan. “We need job growth, not just slowing job losses. There are massive fundamental issues.”

Defaults More Likely
Delinquencies on commercial mortgages placed into securities have climbed to the highest levels ever, according to data from RBS Securities Inc., the Royal Bank of Scotland Group unit based in Stamford, Connecticut. The late payment rate on them is 2.77 percent, up from 0.47 percent at the end of 2007.

“Interest-only loans will be a problem for borrowers who can’t reach targets on rent growth, or have been hit by vacancies,” said Morgan Stanley’s Day, who is based in New York. “The added burden increases the likelihood of these properties defaulting, translating to losses on CMBS investments.”
Scaffolding surrounds the ground floor of a 26-story tower at 1775 Broadway in New York. The 1928-vintage building on 57th Street is being refitted with a glass facade and renamed 3 Columbus Circle in a $60 million renovation.

Newsweek, the magazine that’s cutting the circulation rate base of its U.S. edition by 42 percent to 1.5 million by January, vacated 203,000 square feet of the building last month. The unit of Washington Post Co. accounted for 34 percent of the space, according to loan documents. The publication relocated downtown to 395 Hudson St. in Greenwich Village.

Cheaper to Wait?
“Filling that much space will be extremely difficult in this environment,” said John Levy, a principal at John B. Levy & Co., a real estate investment banking firm based in Richmond, Virginia. “That will require several good-sized tenants in a market where most people aren’t making decisions. There is no penalty for indecision. There is no pressure to do anything, and people think it might get cheaper if they wait.”

Overall occupancy has decreased to about 30 percent, according to loan documents. The building was 98 percent occupied in January 2006, when the Moinian Group took out a $250 million interest-only mortgage, according to loan-service documents reviewed by Bloomberg. When principal starts coming due early next year, the monthly bill will climb by $225,000, or 18.4 percent, to $1.45 million, the documents show.
$3.9 Billion Bond

Joseph Moinian, 55, the chief executive officer of Moinian Group, declined to be interviewed, said Roxanne Donovan, president of Great Ink in New York, which represents the firm. Moinian Group owns more than 20 million square feet of space in office, residential, retail and hotel properties, 13 million of which is in Manhattan, according to the company’s Web site.

New York-based Moinian Group’s mortgage was wrapped into a $3.9 billion bond with 304 other commercial property loans across the U.S. and marketed in February 2006 by Wachovia Corp., now part of Wells Fargo & Co., according to the prospectus. More than half of those contained in the bond delayed paying principal for part of the term, the documents show.
Across the U.S., office vacancies climbed to 15.5 percent in the first quarter from 13.3 percent a year earlier, according to CB Richard Ellis.

The U.S. government has made reviving the market for commercial mortgage-backed bonds a cornerstone of the program to get credit flowing and end the recession. Sales of the bonds plummeted as investors shunned the debt and the cost to sell them became too high for investment banks to profit, choking off funding to borrowers that need to refinance.

No Sales
There have been no sales of the bonds so far this year, and only $12.1 billion were sold last year, according to Morgan Stanley.

The portion of the plan aimed at creating commercial mortgage-backed bonds is intended to avert a wave of defaults because “getting refinancing for existing commercial projects is very, very difficult,” Fed Chairman Ben S. Bernanke said in congressional testimony on June 3.

“Even with government support, the commercial real estate fundamental picture will continue to get worse before it gets better,” said PPM America’s Born, who holds about $7 billion in commercial mortgage-backed bonds as part of a fixed-income portfolio. “Interest-only loans that start to amortize in this environment are one more piece of that picture.”

By Rich Miller and Matthew Benjamin
June 8 (Bloomberg) -- As if General Motors Corp. didn’t have enough to worry about, a 60 percent jump in gasoline prices this year may cause inflation to soar as it did in 2008 and throw another roadblock in the way of recovery.

It’s “one thing that we have to keep our eye on,” said Mike DiGiovanni, executive director of global market and industry analysis for the automaker, which filed for bankruptcy last week.

It isn’t only GM’s sales that might suffer. Higher energy costs helped trigger a 20 percent rise in a Standard & Poor’s index of 24 commodities during May, the biggest monthly percentage gain since September 1990. The increases threaten a burst of inflation that could sap demand just as the U.S. economy is starting to right itself after the biggest contraction in five decades.

“You could end up with something like a stagflation scenario,” said David Hensley, director of global economic coordination for JPMorgan Chase & Co. in New York. “There’s a risk the economic recovery might be stifled.”
Gasoline was up to an average $2.59 a gallon nationwide last week from $2.05 on May 1, according to AAA. A 50-cent-a- gallon markup removes about $70 billion from consumers’ annual spending power, says James Hamilton, a professor of economics at the University of California, San Diego.

Prices still remain short of the $4.11 record set on July 15, which helped push inflation that month to a 5.6 percent annual rate, the highest in 17 years.

Fuel-Efficient Models
DiGiovanni told Wall Street analysts and reporters June 2 that Detroit-based GM was better positioned to deal with more expensive gasoline this year than last as it introduces several fuel-efficient models, including a Chevrolet Equinox sport utility vehicle that the company says will get 32 miles per gallon on the highway.

At United Technologies Corp., it’s copper that has gotten executives’ attention. The metal has climbed 59 percent this year on the New York Mercantile Exchange to $2.28 a pound as of June 5.

Gregory Hayes, senior vice president and chief financial officer, told a conference on May 14 that Hartford, Connecticut- based UTC is keeping tabs on price movements because its Otis elevator and Carrier air conditioner divisions buy 75 million to 80 million pounds of copper per year.

At that rate, the increase so far this year would cost UTC about $65 million, about triple Carrier’s $22 million operating income for the quarter ended March 31.

All-Time High
The metal is still down more than 40 percent from an all- time high of about $4 last year, and that’s “good news” for UTC, according to Hayes. “We’ll see where that goes,” he said.

The S&P GSCI Total Return index, which tracks metals and agricultural commodities as well as energy, has surged 39 percent since touching an almost seven-year low on Feb. 18.

Concerns about higher inflation are reflected in the widening difference between rates on 10-year notes and Treasury Inflation Protected Securities. The spread on June 5 was close to a nine-month high at 2.01 percentage points after the government reported payrolls declined in May by 345,000, the smallest decrease since September.

Spurring the commodity rally are signs of an economic recovery worldwide, particularly in China, the world’s biggest consumer of iron ore, rubber, copper and zinc; more interest from investors; and an 11 percent drop over the last three months in the dollar, the currency in which most commodities are priced. Stockpiling by China’s government and supply constraints have also played a role.

Stockpiling
China’s Ministry of Land and Resources in January announced plans to build emergency supplies of coal and metals to guard against potential shortages. The nation’s imports of Australian coal have soared more than 10-fold from a year ago.

Macarthur Coal Ltd., the world’s biggest exporter of pulverized coal used in steelmaking, is seeing new demand this year from China, said Shane Stephan, chief development officer in Brisbane, Australia. That is “a major change,” he adds. “We historically have never sold coal into China at all.”
If the advances in raw materials were being driven mainly by U.S. demand, there would be less worry that inflation might stymie growth. That’s not what’s happening this time. Economists surveyed by Bloomberg forecast the economy will contract at a 1.9 percent annual pace this quarter after shrinking 5.7 percent in the first three months of the year.

China, India Growth
What’s pushing up commodities instead is growth elsewhere in the world, particularly in Asia, Hamilton said. India’s economy grew at a 5.8 percent annual pace in the first quarter, topping economists’ projections of 5 percent. Chinese manufacturing picked up for the third straight month in May, according to a purchasing managers’ index published May 31.
Investors have also helped fuel the price surge. More than $6 billion has poured into commodity-industry funds so far this year, swelling assets under management by more than 21 percent, according to Cambridge, Massachusetts-based researcher EPFR Global, which tracks global fund flows. In all of 2008, new investment boosted assets by just 1 percent, EPFR figures show.

“Investors have been strongly attracted to commodity and energy plays this year,” said Brad Durham, managing director at EPFR.

Stagflation
Higher commodity costs are reminiscent of their climb in the 1970s and early 1980s, when a 10-fold jump in oil prices drove both unemployment and inflation above 10 percent. Economists coined the phrase “stagflation” to describe what was then a new phenomenon of accelerating inflation coupled with stagnant demand.

Hensley sees a risk of that happening to a lesser degree in the third quarter, as costlier gasoline lifts annualized inflation to 4 percent from 1.4 percent in the second quarter, depressing consumer demand in the process.
“This is unambiguously bad news for consumers, who are already feeling the squeeze from slowing wage gains and collapsing home prices,” said Ian Shepherdson, chief U.S. economist at Valhalla, New York-based High Frequency Economics.

Consumers’ sensitivity to gas prices is “extraordinarily high,” according to Richard Hastings, a consumer strategist at Global Hunter Securities LLC of Newport Beach, California.

“You don’t have to go back to record-high fuel prices to see damage to the economy,” he said.

Federal Reserve Chairman Ben S. Bernanke noted the rise in oil and other commodities in testimony to Congress on June 3, while saying excess capacity in the economy would keep a lid on inflation. U.S. factories, mines and utilities operated at a record-low 69.1 percent of capacity in April, according to Fed figures.

Capacity Constraints
The picture is different for some raw materials. Global oil production capacity use is about 95 percent, “and with the cutback in capital expenditures and drilling, future capacity is dropping,” according to a May 8 Goldman Sachs Group Inc. report. Production of copper is at 85 percent of capacity and corn and wheat are above 90 percent, the report said.

Soybean supplies are squeezed by drought in Argentina and tighter credit that curtailed plantings. Argentine farmers may harvest 32 million tons of the crop, down from a record 48 million tons last year, the Buenos Aires Cereals Exchange reported on June 3. Goldman Sachs says output in Brazil will fall as much as 10 percent this year. Soybeans on the Chicago Board of Trade have gained 22 percent in 2009 to $12.26 a bushel, the highest since September.

Corn, Wheat Supplies
The U.S. Department of Agriculture this week may reduce its projections of U.S. corn and wheat inventories before the 2010 harvests, according to average estimates in a Bloomberg News survey. Soybean supplies on Aug. 31 may fall to the smallest in five years on record export demand.
Not everyone is convinced that the rally in commodities, including oil, is sustainable.

Weaker demand “will eventually force those prices back down,” Jim O’Donnell, president of BMW of North America LLC in Woodcliff Lake, New Jersey, said in an interview. Commodities are in “an artificial market. I don’t think it’s real at this time. Worldwide demand is not there.”
Still, a growing number of companies aren’t taking any chances and are acting to protect themselves against higher costs. Emerson Electric Co., the St. Louis-based maker of industrial equipment and garbage disposals, hedges its risk from copper-price gyrations a year to 18 months ahead, according to Chief Executive Officer David Farr.

“We have seen more of our customers coming to hedge this quarter than the previous one,” said Craig Smyth, Citigroup Inc.’s Singapore-based vice president of commodities in Asia. “We have seen a two-fold increase in hedging.”