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CMBS could be hit harder than the ’08 sub-prime market, says Deer Park Road CIO

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Deer Park Road is maintaining an aggressive short position in commercial mortgage backed securities as the market continues to fall because of lockdown. Although the Colorado-based structured credit manager, which was established by Michael Craig-Scheckman in 2003, expects to shift to a long position in CMBS when the right entry point emerges towards the end of the year, or in early 2021.

“Coming into 2020, we were fairly concerned with CMBS, in particular on the retail side,” comments Scott Burg, CIO and Portfolio Manager. “We went into the beginning of this year with a significant short position on the CMBX index (Series 6 through Series 9). We are short BB, BBB and single A securities. 

“With the pandemic, and the structural shifts within commercial real estate, we’ve added to our short position over that time. In some cases, the price of BB securities has been cut in half. 

“At the same time, we’ve built long positions in some of the best residential MBS assets, such as seasoned sub-prime mortgages created in 2007 and earlier, which survived the global financial crash.”

Burg has worked in the structured credit space since 2001, focusing on MBS, in particular sub-prime securities. Between 2001 and 2003 he worked on credit risk management in MBS before moving into the pricing side. Prior to joining Deer Park Road in 2010, Burg was a Principal at General Capital Partners. He also worked at Pursuit Partners, a USD550 million fixed income hedge fund where his focus was on analysing mortgage and asset-backed securities opportunities. 

“We focus primarily on RMBS but we also look at commercial real estate (CMBS) and aircraft leasing franchises – anything that can be structured and securitised,” adds Burg.

Structured credit has invariably been hit by the coronavirus outbreak, just as other asset classes have. The dislocation in March led to a write down in Deer Park’s long book but these should be assets that survive, according to Burg, given that the book is comprised of seasoned RMBS paper.

“We are concerned about new issuance RMBS. We are pitched a lot of deals but we find that prices don’t support the credit risk, similar to what we’ve seen in CMBS. Some of them are starting to look interesting, on the CMBS side, but for both areas we still think it is too early. Everyone is guessing what the extent of delinquencies will be,” explains Burg.

He says that March was one of the most aggressive liquidity events “I’ve ever seen”; including trading and owning CLOs and RMBS during 2008. 

“Fortunately, we had a cash position from our hedges and we were able to buy USD250 million worth of predominantly US household mortgages at discounts that were, in some cases, 20 to 50 per cent lower than they’d be trading the prior month.

“All those opportunities have since tightened up but it shows the fragility of the credit market – not just RMBS, but corporate credit, CMBS, credit cards, autos.” 

Aside from shorting CMBS, Deer Park was also short US and European high yield bonds in Q1. The team has subsequently closed the European position and maintained its exposure to US high yield. 

Covid-19 has had a profound impact on commercial real estate. In London, New York and other financial hubs, corporate offices are empty – or at best working with skeleton staff – and with tech giants Facebook and Google confirming that staff could work remotely until the year-end, it remains to be seen to what extent office life will return to normal. Of course, offices are not going to disappear, but how they are utilised could change over the coming years. 

“This is setting up to become a crisis that will potentially be bigger than in ’08; the only difference is that the owners of these assets are not your average everyday American holding sub-prime mortgages, they are major US corporations,” observes Burg. 

As a result, the team at Deer Park is currently paying close attention to how fundamental-based delinquencies develop within CMBS. 

A lot of companies in the RE space are announcing restructurings and bankruptcies, and announcing that they are furloughing people “but we haven’t seen any of that come through yet (in terms of pricing)”, Burg says, adding: 

“Our belief is that many of the holders are living in hope that it won’t be too bad. It’s similar to what we saw in ’08 and ’09 on the residential mortgage side, when people were buying on the way down, hoping that a recovery would happen.”

For now, it is a case of staying disciplined and waiting for prices to fall further, before determining when the right entry point might arrive to go long.

Burg hopes that they will get some idea on where delinquencies are in August but it is unlikely the real extent of the crisis will be known until the end of the year. For now, however, there is very little price discovery taking place, both because of the lockdown and how quickly things have changed in a couple of months.  

“Our view is over the next six to nine months, we will start to get hard data. Once we see transactions, we think it’ll start to have a material impact on CMBS. That’s why we are short. 

“But on a forward-looking basis, we think there’s going to be a tremendous opportunity to go long. Offices aren’t going to disappear, retail shops aren’t going to disappear. We are just waiting for the right moment to go long, but we’re not close to that yet,” explains Burg.

As with any hedge fund manager worth their salt, the secret sauce is identifying the right time to go long, or short, depending on the investment strategy. Right now, Deer Park is maintaining its long position in RMBS paper dated 2007 or earlier; these are seasoned mortgages with lots of equity in the homes. 

People are very focused on paying their mortgages in this period and for this reason, Burg thinks RMBS will continue to do well. 

And although the portfolio will continue to remain short CMBS for the near-term, with prices likely to fall even further, Burg re-emphasises that “the longer-term house view is, when we are able to flip from short to long, it will set us up for the next four to five years”.

To conclude, Burg says the most important lesson he learnt from the previous financial crash in ’08 was to stay patient; this is something he tells the team day in day out. In a volatile period such as this, drawing upon that experience counts for a great deal. 

“We’re now back to a point where there’s a view among some equity investors that the market will return to normal, but the bottoming of a bear market is a process. It takes time. There is no light switch. That’s not how any previous market cycles worked, and this one will be no different. 

“When there is more data coming out, you might see further fear and capitulation. That’s when you get to a real bottoming of the process.” 

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